Surreal World of Real Estate: When More is Less and Less is More

Disclaimer: The views and opinions expressed in this article are mine and do not necessarily reflect the views or positions of my employer.

I observed that the law of supply and demand - the stronghold of all economic relationships - does not work as expected when it comes to real estate. For instance, in Germany, the amount of available housing grows faster than the population, yet prices and perceived scarcity increase. Similarly, in Ukraine in the mid-2000s, despite a shrinking population and rapid housing development, prices continued to climb. History knows numerous examples when house prices followed a trajectory seemingly unrelated to such factors as geography, new construction, and population dynamics. In this article, I will describe the peculiarities of the real estate market, explain their underlying reasons, and lay out the thoughts on future trends.

Today’s peculiarities

Peculiarity #1: It is a seller's market. In real estate, the buying or renting process often involves numerous bidders chasing a single property, akin to a cageful of rats fighting for a piece of cheese. This is in stark contrast to purchasing other goods like shoes or cars, where buying is easy and straightforward and where it is the seller’s task to fight for customers. The absence of promotions like "Try out living in this big house: first three months for $1, cancel anytime" or "Sign the rent contract now and get 50% off for the first year plus electricity for free" further illustrates this point.

Peculiarity #2: Funding is easy. Mortgages are a unique form of credit. As of Q3 2023, the total one-to-four-family residential mortgage debt in the USA stands at $12.9 trillion, dwarfing other consumer credit at $5.0 trillion and comparable to the total corporate debt (excluding financial institutions) at $13.7 trillion, according to data from FRED. Obtaining a mortgage is generally easier and more favorable than securing other types of loans. Typically, obtaining a residential mortgage takes only few days and requires no more documents than pay slips and a bank statement. However, securing a loan for other purposes, such as opening a shoe factory or a restaurant, involves a long and rigorous process with much higher interest rates and additional conditions. Despite this, we observe shortage of houses, but not of shoes or restaurants.

Peculiarity #3: Little risk, low effort. Not only are banks more eager to lend for buying a house than for any other endeavor, but it is also a general perception that owning real estate is not risky. I have already compared houses with cars in one of my previous posts. Now, imagine telling your friends you got a huge loan to open a shoe store on a street with many other shoe stores, planning to make reliable profits for the next 30 years, despite knowing little about shoe commerce and intending only a minimal time investment. Compare this to the reaction to buying an apartment in a trendy neighborhood with the intention of renting it out.

Despite fundamental economic principles suggesting equilibrium between different kinds of businesses and assets, real estate has defied these norms for decades.

A bit of history

To understand this behavior, a historical perspective is insightful. The exceptional status of real estate has not always been the case. During the Medieval feudal order, land ownership was pivotal and, in many ways, more special than ownership of e.g., merchant capital, as political power and titles and power were tied to exactly land. As research of Thomas Piketty, a French economist and the author of the book "Capital in the XXI Century", shows, with dismantlement of the feudal order and industrialization, share of real estate in total capital, as well as its role in the society (i.e., how much status an ownership gave and how hard it was to buy a house from an average income) was decreasing in a secular trend throughout centuries. John Maynard Keynes, a famous British economist, in his pivotal work of 1936 mentions "houses" among other goods and commodities pointing that everything behaves in the same manner (except for one special commodity: money itself). Apparently, owning real estate before the middle of XX century was as risky as owning any other kind of business or asset. However, in the second half of XX century and continuing into the new century, it staged an impressive comeback.

How did it come to this?

In my opinion, two factors played the pivotal role in this U-turn. First, cancellation of the gold standard in 1930s and arrival of easy money from the printing press. Second, it became much easier to borrow money to buy specifically real estate. The latter also includes housing subsidies and governmental regulations, among them various forms of rent controls. Although these subsidies and regulations were intended to make housing more available for average citizens, its effect was predominantly the opposite, which I explained in Construction Subsidies and Real Estate Prices: What's the Real Deal?

Imagine that starting from tomorrow all mortgages are banned (or drastically tightened). If you are considering taking a mortgage and think that such a tightening would break all your dreams about buying an own home, think again. As the new rules would apply not only to you, but to everyone, suddenly almost no one would be able to buy a house. The only thing that can happen next is sellers lowering their prices to the level, at which you can afford a house even without a mortgage.

Quo vadis?

Currently, we are in the phase when central banks are tightening and governments are scrapping subsidies to balance the budgets. Both factors fueling the real estate trend are turned off – at least temporarily. At the same time, rental incomes got out of sync with interest rates making the buy-to-rent model a negative-cashflow game. This is an instable market condition, which can be solved in one of the three ways: significant drop in real estate prices (for US, Germany, and many other EU countries - approximately by a factor of 2), equivalent rise in rents or a decline in interest rates (prompted by the central banks reducing key rates to approximately zero once again). Which will materialize, we will still need to see.

If the upward trend stops, the business model of many real estate developers will also require a revamp. As I demonstrated on the example of Signa, the business recently consisted mainly in buying and holding properties, cashing in the appreciation. Achieving positive cashflow from rents or actually improving the properties was not so important. If tightened conditions settle, developers will strive to reduce the risk of falling prices by avoiding putting the objects on their balance sheets for too long. Furthermore, they will need to re-focus on improving the properties to make them stand