Rizzo: Real estate conundrum seems to defy economic theory

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Real estate prices in the U.S. continue to rise while inventories— supply— falls. These patterns are less pronounced in the Northeast and on Long Island but are still apparent. At first blush, this is not what economic theory would seem to predict. So, what can explain this phenomenon? And what might one expect going forward?

Turning to the first question, economics can still provide useful insight, though the explanation is a bit more involved. Potential sellers do not put their homes on the market in lock-step as prices rise. They are heterogenous along a number of dimensions. Some have to sell, possibly because they are relocating for job-related reasons. And they differ in terms of what they paid for their homes in relation to what they can get if they were to sell now. Some homeowners bought when market prices were relatively low, so they can realize a tidy profit were they to sell. But for those who purchased their homes when the market was at its peak, current prices may still be too low, leaving them under water if they were to sell now.

In such a situation, one can predict that some owners will sell quickly in response to modest price increases while others play a waiting game, hoping that prices will continue to rise. As the former group sells their homes, fewer and fewer of them come onto the market, while the second group continues to wait and will only sell if they can get their price. In such a case, one may well observe rising sales prices even as the available supply is dwindling.

What does this mean for future real estate prices and sales? One possibility is that prices will continue to rise until people who bought at the peak find it profitable to sell and more homes come onto the market. If that is true, we would observe a consistent pattern of rising prices and supply. But there is a fly in the ointment here. And that is on the demand sign. Simply put, prospective buyers want choice. If someone wants to buy a ranch home but only sees colonials on the market, or if few homes are available in the school district where they wish to purchase, that potential buyer may become discouraged and stop looking—demand falls. And in a world where both supply and demand are falling, it is difficult to see how prices can rise to call forth further supply. The market will simply stagnate.

Long Island’s strong labor market and high consumer confidence offer some reassurance against falling demand. But it remains to be seen whether this will be enough to push the real estate market onto a path of stronger growth.

 Rizzo is chief economist for the Long Island Association.