How does the Market Downturn Impact Property Values?

Whether you purchased your property during the Pandemic or you purchased your property prior to the GFC (Great Financial Crisis) of 2008, it has been quite a long time since the United States has experienced a more traditional recession.?

As noted in the graphic below, the gray vertical bars are periods of economic contraction, also known as recession.?

Removing Covid and the GFC, the most recent recession experience is nearly 20 years ago….quite a long time for most property owners.?

The graphic below highlights an infrequent phenomenon, known as yield curve inversion, and it is also an indicator of forthcoming declines in property values.

In response to the economic growth resulting from the flood of money printed by the US government and the Federal Reserve dropping the effective Fed Funds interest rate to zero percent due to the Pandemic, there was a significant surge in demand for many goods and services, including homes and investment properties.?

The significant demand boosted prices paid even as the supply of goods and services, and real estate, did not expand. ?

Bringing out The Way Back Machine, when demand increases and supply stays the same, then prices paid have to increase until the demand is satisfied.?

Unfortunately, escalating prices paid is a dangerous scenario that can lead to destabilizing conditions for any economy (this scenario is also referred to as overheating).

In an effort to stabilize the United States economy, and cool it off, the Federal Reserve aggressively acted by raising the Fed Fund rate from zero percent to its current level of 5.0% to 5.25%.

This action by the Federal Reserve seeks to tame rising prices and do so in a manner that slows down the United States economy without killing the United States economy.?

Yes, much has been written by economists about the success or failure of the Federal Reserve’s ability to achieve it’s intended outcome….this article will not address that likelihood.

Suffice to say, we are focused on “what’s going to happen to real estate now” as the economy is slowing down, the cost of borrowing is going up, and the demand for many good and services is lower than recent years?

As noted in the graph below, historically the Federal Funds rate, also known as short term interest rate, has been significantly higher than the present level multiples times in the past 50 years.?

Nonetheless, many market participants were not old enough to have lived through these experiences.? So a refresher is not only helpful but warranted.?

As depicted in the graphic below, from The Appraisal of Real Estate, for a typical property, that undergoes regular maintenance but never receives a complete or gut rehabilitation during its lifetime, in a typical market area that experiences negative economic conditions, the land value and the building value BOTH FALL.?

How far and how fast a property value falls is completely dependent on factors you CANNOT control.?

Three significant factors are: interest rates, access to capital, and market sentiment.? More on these in upcoming newsletter articles.

In the graphic above, the blue line is Market Value (Building/Structure Contributory Value + Land Value), the orange line is Building/Structure Contributory Value and the red line is Land Value.??

Note that this visual depicts year 15 as the peak in the market and then a Market Downturn, so think of 2023 as year 15 in this graphic

Looking at year 15 in the graphic, no matter if the typical overall market is increasing or decreasing, the orange line illustrates that Building/Structure Contributory Value decreases over its lifetime because the Building wears down, wears out, and generally does not meet current market occupants demands.?

For an explanation of the Building/Structure depreciation and decline in contributory value, refer to the initial newsletter article in this series.

The red line illustrates Land Value.?

To understand how values move up and down it is important to point out that Land Value is sensitive to the overall economy’s strength or weakness.?

As noted in the prior week’s article, when the economy is strengthening, demand is increasing and land values are being driven upward due to typical market factors of supply and demand, inflation, amongst other factors.??

Conversely, as the economy slows down, demand weakens.?

As demand weakens, the value of the land begins falling and will continue to fall until UNTIL either the new lower level of demand aligns with the existing supply or an economic turning point is reached.??

The reality of 2023 is successive increases in the Fed Fund rate drove up the cost of borrowing.?

Higher costs of borrowing reduce a buyer’s ability to qualify for a loan and reduce the total amount of funds they can borrow.?

Fewer borrowers competing decrease demand and prices paid begin to fall.?

Remember The Way Back Machine reference earlier in this article?

Therefore, even as sellers desire their asking price, borrowers cannot meet their demands because their access to borrowing has been reduced.

What’s next??

With the exception of a few markets and property types across the United States which are still experiencing higher demand than supply, as the economy slows, the period of time required to sell a property begins increasing and the asking prices no longer increases.?

As the period of time to sell a property continues to increase, the number of sellers considering a price reduction increases.

Concurrently, as the Federal Reserve continues to increase the Federal Funds rate, the cost of borrowing continues to increase.?

This increased cost of borrowing decreases a buyer’s ability to qualify for a loan and decreases the amount of money a buyer can borrow.?

This cycle of declining prices and slowing economic activity is called a recession.

For sellers, they face a tough choice, either accept the best offer they currently receive (no matter how unpleasant it may be), if they receive an offer at all, or reduce their asking price to find any buyer who can afford to purchase their property in this current market.??

Or, the seller must wait…and they may be waiting for quite a while.

In the next article, we will look at WHEN…..When is this recession going to hit bottom?

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