Property Value Increases

Understanding how property value increases can be triggered is very important in real estate investing, since in most cases, high returns are achieved when the property appreciates a lot after its purchase. The important thing to keep in mind when thinking about property value increases within the context of a free economy is that when the demand-supply balance is disturbed, market rents and prices start moving accordingly in order to bring the market back into balance.

If we assume the market begins from a point at which space demanded is equal to the space supplied, prices should be stable. Economists describe this situation as the market being at equilibrium. If this balance is disturbed, either in favor of demand or in favor of supply, prices should start moving. In particular, if demand becomes greater than supply (due to non-rent/price factors) then rents/prices have to rise in order to force enough buyers/renters to drop out of the market and enough suppliers to enter the market so that the amount of space demanded equals the amount of space supplied. Similarly, if supply decreases while demand remains constant, there will be excess demand, which will again force prices/rents to rise. However, because of the durability of real estate, sudden decreases of an area's property inventory cannot occur in the normal course of events. An area's inventory of properties, however, may decline gradually if the amount of space build is smaller than the amount of space that "drops out" of the market due to physical deterioration and functional obsolescence.

If supply increases while demand remains constant, or if demand decreases while supply remains constant, there will be excess supply, which will force prices to fall in order to induce enough suppliers to drop out of the market and enough buyers/renters to enter the market.

Based on this discussion, we can identify two broad principles of rent and value increases, with the condition that the market is neither oversupplied nor undersupplied:

1) An increase in the demand for space or properties while supply remains constant

2) A decrease in the supply of space or properties while demand remains constant

To better understand the first principle of property-income and value increases, consider a nice residential community, called Paradise, with few vacant housing units and limited development under way, due to zoning controls. If, for some reason, demand for housing suddenly increases considerably so that the existing vacant units are far from adequate to cover it, housing rents and prices in Paradise will register strong increases.

Demand for housing in Paradise may increase considerably, due to a number of reasons, such as intensive office development in a nearby community, which brings a great number of new white-collar employees to the area. Since there is a tendency for people to seek housing close to their workplace, it is logical to assume that many of these new employees will seek housing in Paradise too.

An important characteristic of the supply of real estate, which explains why short-run increases in prices/rents can be very strong in response to a strong increase in demand, is the construction lag, that is, the lag between the time a real estate project is perceived and the time it comes out in the market. This lag, which is due to the time needed to complete necessary studies, de-sign, secure financing, get permits, and build a project, ranges from one to many years, depending on the size and nature of the development. This characteristic is very important, because if demand suddenly increases considerably, supply will not be able to respond immediately, unless lots of new buildings are about to be completed and enter the market. This is not very likely, however, if the demand increase is sudden or considerably greater than usual.

As a result of the supply's inability to respond quickly to changing market conditions, a strong increase in demand will originally create supply shortages, which will force prices to start rising, at least in the short-run. Because of the inertia/rigidity of supply, strong demand increases can trigger strong rent/price increases as long as the market is not oversupplied. However, as new supply starts to come out gradually, rent and price growth should decelerate, unless demand keeps rising faster than supply. As we have seen in the discussion of the cyclical behavior of the real estate market, property prices (and rents) seem to rise for a few years at an accelerating rate when the market comes out of the downturn, but after that, rent and price growth decelerates and turns negative eventually, due to a combination of strong supply growth and a slowdown in demand growth.