How in the world does the market create pricing?

Real Estate Broker/Owner with Broad & Bailey Realty LLC

How many times have you been in situations where you saw a house that was priced much lower than the same house in another neighborhood or state? I feel that I run into these situations all the time.

So what is it that creates these fluctuations in price? How does the "Free Market" do this?

It's really a lot simpler than most people might imagine.

A house can only be sold for the price that a buyer is willing (or able) to pay. Why do I say able? I say this because most people will pay approximately 1/3rd of their income on housing. So a buyer is willing to pay approximately 1/3rd of their income because they are able to.

Yes, there are conservative people out there who buy modest homes in comparison to their income. Needless to say, that these people either have financial security because they're wealthy or because they're just conservative. They most likely will never face foreclosure on their homes.

And yes, there are people who buy homes that they cannot afford. They expect to make more money in the future which may not always happen. They may lose their jobs or sustain other unforeseen losses. These days, we're seeing a lot more of this type of buyer, hence the foreclosures.

If we analyze this middle section of people who pay approximately 1/3rd of their income on housing, this is actually the Market and what creates the Market Value (or price) of homes.

Let's look at this backwards. If you earn $36,000 per year; you will be able to afford approximately $12,000 per year for housing. This just happens to break down nicely to $1,000 per month. Whether you are renting or buying, your monthly housing costs cannot exceed $1,000 per month. Makes sense so far?

Now with your $1,000 per month you begin your real estate search, knowing your budget, you eventually find a house or apartment.

Let's say that everyone in your town also makes $36,000 per year (or at least let's say this is the average household income). What do you think the average cost for housing is going to be in your town? If you guessed $1,000 per month, you're right. Of course there are always some variations, but it cannot be any higher because the average household cannot afford to pay any more. Also, it will not be any lower because the seller will always hold out for the highest price which in this case is $1,000 per month.

Still doesn't make sense?

In this example, the average household can only afford $1,000 per month for housing. To simplify this, we won't factor in utilities, taxes, etc, but focus on basic housing costs. If the average household can pay $1,000 per month, then the average sale/rent cannot exceed this. This means that the average sale (or rent) cannot exceed a price which will cause the monthly payment to exceed $1,000.

An average house in this neighborhood will most likely be around $200,000. How did I come up with this? If you buy a $200,000 house with 20% down payment, you will qualify for a $160,000 mortgage. At 6% interest, a $160,000 mortgage payment is just under $1,000 per month.

This is the basis of how this works:

If the average household income is $1,000 per month, then the average home will cost no more than $1,000 per month.

One of the factors that can greatly change the price of a home is the interest rate. If the interest rate was 10% (instead of 6%), then average home would only be about $140,000. At an interest rate of 10% the same person would only qualify for a mortgage of $110,000 plus 20% down payment, making the average home $140,000.

What if the average home in this neighborhood is listed at $250,000. What do you think would happen? Don't think too deep, that is exactly what is happening right now. That is why we have more inventory then buyers and until the prices start coming down, sales will be slow.

Basically, the average home is currently greater than the average income, the result is fewer sales.

(The chart was taken from: it clearly illustrates my point).

Remember, it's not the home that sets the price, but the income of the household. Interest rates, taxes, utilities, travel expenses, etc are factors that also play a major role.

A few years ago, home prices began to rise at unsustainable rates. What caused these prices to rise so sharply? Did you notice what a drastically difference in price of our $200,000 home when the interest rates went from 6% to 10% (down to $140,000)? Without getting into too many details, people were getting mortgages at 3% with a low down payment. This allowed them to buy that same $200,000 home for as much as $250,000. Before anyone realized what was happening, those $200,000 homes were selling for $250,000. If the 3% interest rate was fixed for 30 years, there would be no problem. But the problem become clear when the interest rates adjusted back to 6%, thereby devaluating those homes back to $200,000.

Do you know someone who bought that $200,000 house for $250,000? They probably took out a mortgage of $225,000. What happened? It seems that the value of the house is actually lower than the mortgage. Where are these houses today? Foreclosure?

A town with an average annual household income of $36,000 will have homes that average $200,000 where a town with an average annual income of $72,000 will have homes that average $400,000. Those homes could be identical in every way except price.

The difference? Average household income.

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