Sometimes it’s best to get back to the basics when thinking about investing, finance, and economics. And what could be more basic than supply and demand? This month we’re going to talk about how the basics of supply and demand can help us predict long-term market appreciation.
For those of you who have never taken an economics class, supply and demand are simple and intuitive concepts. For every good/service/thing in the economy, there is supply (how much of that thing there is), and there is demand (how much people want that thing).
Supply and demand are generally explained as two curves, or basically two lines, as in the illustration below.
There is a line for supply (S), that represents the behavior of sellers in the market–because sellers control the supply. This could be a store or, more relevant here, a homeowner. The supply curve generally goes up and to the right, which indicates the willingness of sellers to sell more of something as the price goes up. If property prices are increasing, more sellers are going to be willing to sell their properties.
The demand curve (D) represents the buyers in the market. Demand curves are almost always sloping downward, which represents the fact that buyers are generally willing to buy more of something the less it costs. Again, using property as an example, when prices drop in the market, more people are willing to buy houses.
The place where the two lines meet is often called equilibrium and is really just the sweet spot of pricing. Sellers and buyers are always doing this little dance to find equilibrium. This happens when you negotiate a property to buy, it happens millions of times a day in the stock market, and it even happens with sales and promotions at your local grocery store. Supply and demand are the most basic underpinning of our economy.
The pandemic has put some supply and demand examples on steroids over the last few months. My personal favorite was the toilet paper craze of March 2020.
Normally supply and demand for toilet paper remain relatively constant. People generally need toilet paper at a consistent rate, suppliers know how much the market needs, and the price remains stable.
Until last year, when demand for residential toilet paper spiked way too quickly for suppliers to adjust their logistics, which were previously dedicated more to providing toilet paper for commercial supply. People were stealing single-ply from their offices, Costco was putting limits on bulk buying, prices on Amazon were jacked up—it was a frenzy. All because of a demand spike.
So, could something like that happen in real estate? On the scale of toilet paper? Probably not.
But it does raise the question, what drives up real estate demand (and home prices)?
In reality, there are a lot of things that factor in here, but the simplest of them all is population. How many people are there in a city (demand), compared to how many homes (supply)? If the population of a city grows faster than the number of homes in the city, home prices are very likely to appreciate.
With this in mind, I pulled together a list that I am really excited about. It uses Census data to measure supply and demand from the years 2010-2019. I then combined that with some BPInsights data to show sales and rent info for the current market.
The table below shows the top 15 markets for what I am calling the “Supply/Demand Ratio.” Basically, what I did was create a new metric that answers the question “how many new people move to a city for each new unit built?”
Note that these are not the fastest growing cities in the U.S. These are the cities where demand (as represented by population growth) is exceeding supply (as measured by total units in the city).
At the top of our list sits Cambridge, Massachusetts, where one new unit has been built for every 36 people who have moved to the city since 2010. How does that work? Well, I guess with all those college students, people are getting roommates.
These cities all have populations that are growing faster than they are adding units. This is going to put a lot of upward pressure on pricing.
Growing populations also increase the tax base for the city, so cities can provide more essential services, build infrastructure, and support their populations. All positive things for appreciation as well.
Below you can also see the rent-to-price ratio and appreciation rates for these cities over the same time period.
This is consistent with many of the patterns we see in our BPInsights data: There is generally a tradeoff between cash flow and appreciation. These markets skew heavily towards the appreciation side of the equation.
Of course, there are other factors aside from population growth that impact these numbers, but you can see just from the eyeball test that these cities generally have excellent appreciation.
That said, there are cash-flowing properties in all of these markets. I guarantee it. If you can find a cash-flowing deal in one of these markets, it could make for a home run.