As consumers, we sometimes have too much trust in the prices of a given market. On some level, the price is the price: sellers are free to sell their goods and services for whatever they want, and we’re free to pass on any offers that seem too expensive compared to the value they provide us.
But in the real estate market, we tacitly assume that prices indicate value. After all, some very wealthy people are willing to pay six or seven figures on properties in the area; shouldn’t we assume that these properties are totally worth it?
The reality is real estate prices are complex. And if you want to be financially successful, you’ll need to consider the dynamics of how real estate prices work.
Why Price Is Important
Price is important for several discrete reasons. Some of them are obvious, while others are less so.
- Relative comparison. First, price is a tool of relative comparison. If we see a house listed for $300,000, and a very similar house listed for $600,000, we can reasonably assume the $300,000 house is a deal and the $600,000 house is a rip-off.
- Monthly costs. Price, in combination with down payment and interest rates, helps to determine what you pay on a monthly basis, assuming you take out a mortgage to buy the home. If you borrow more money, your monthly payment will be higher.
- Resale value and profitability. Purchase price is also important to consider with relation to resale value and profitability. Interest rate fluctuations can make a $150,000 house and a $350,000 house similar in terms of monthly upkeep; but when it comes to selling the house, one of these homeowners will have a massive advantage over the other.
- Potential for deception. Prices are, hypothetically, an objective metric that you can use to make a more intelligent buying decision. But as we’ll see, housing prices can also be deceiving. If you aren’t careful, your biases and assumptions can lead you to a financially poor decision.
How Housing Prices Can Deceive You
These are just some of the ways that housing prices can deceive you as a buyer:
- Price vs. value. First, understand that there’s a big difference between price and value. If you’re sentimentally attached to your $50,000 house, it might be more valuable to you than a $500,000 house that you think looks tacky and unpleasant. You need to think about more than just what a house is worth on the market; you need to think about what it’s worth to you.
- The volatility of the housing market. The housing market is somewhat volatile, at least in the current era. And some areas are especially prone to volatility. A house may be listed at $500,000 today, but in a few weeks, it could easily grow to $650,000 or fall to $350,000; such a big jump isn’t typical, but it is possible, and it shows you just how much of an impact timing the market can have. This is one reason why it’s always important to look up historical prices, rather than exclusively using current price as the basis of your decision.
- The limitations of comps. Real estate agents and property investors typically use comps (comparable houses) to evaluate whether a given house is “worth” the listed price. However, there are some limitations with using these comparative tools. It’s almost impossible to compare houses apples to apples, and comps don’t take unexpected price fluctuations into account.
- Purchase price vs. monthly payments. Homebuyers often disproportionately consider their monthly payments, rather than the total purchase price of a potential home. While monthly payments have a much bigger impact on your recurring budget, and need to be a high priority for consideration, they aren’t everything.
- Hidden issues. Hidden issues can totally compromise the value of an otherwise decent home purchase. If you pay $250,000 for a house and then discover it needs $50,000 of foundation repairs, the potential return on your investment will instantly plummet.
- Expectations of growth. We also need to acknowledge growth expectations in relation to price. Oftentimes, the expected growth of a given asset is priced into its listed price; property values in the neighborhood increase if people expect the neighborhood to be on a trajectory of positive growth. However, expectations of growth don’t always reflect reality. It’s easy for investors to overestimate or underestimate the growth trajectory of a given neighborhood.
Effective Strategies for Considering Price
So what can you do to consider price objectively and intelligently?
- Use multiple comparative tools and heuristics. Use multiple comparative tools and heuristics to compensate for your biases and get a better picture of what a home is worth.
- Avoid allocating too much. In general, you should avoid putting too much of your net worth into a single property. If you’re not sure about the value of a property, don’t dump your life savings into it.
- Consider value. Consider the value of the property beyond its price. Could you rent this in the future? Is this property going to grow in appeal in the future? How much do you personally like this property?
Housing prices can be confusing and contradictory. But if you’re willing to do your research, compensate for what you don’t know, and consider a wide variety of factors when making your decisions, you’ll end up in a much better financial position.
