What Factors Influence the Price of Homes?

Just a few years ago, the United States plunged into a financial crisis and the Great Recession.  A key factor contributing to the downturn was the overheated housing market and the related securitization of mortgages.  For a few years, many people were convinced home prices could not go down.  Some even went into the business of “flipping” houses- purchasing them with the intention of selling a year or two later after the house appreciated.  The dramatic decline in housing prices in the aftermath of the financial crisis has stopped and the housing market continues to improve, but people are well advised to ask themselves what factors influence the price of a house.

Obviously, location affects a house’s value tremendously because people value near-by amenities and good schools.  But viewed in the aggregate, housing prices over the long-term have a very strong correlation with inflation.  Yale professor Robert Shiller states that housing prices rose only 0.2 percent a year in inflation-adjusted terms for the period from 1890-1990.  Thus, people who want to know what their houses will be worth in ten years can look to the financial markets for the best estimate of inflation over that period, and then convert today’s prices into future prices.  For example, a house purchased for $300,000 in 2013 when the estimated annual inflation over the next ten years is 2.2 percent would be worth approximately $373,000 in 2023 if housing prices rise with inflation.

Construction costs are another factor.  If construction costs (labor, materials, etc.) decline, home buyers may pay lower prices, although how much lower is difficult to predict since the savings may simply be retained by the builder in the form of higher profits.

Third, demographic factors can be crucial.  Much of the demand for housing is influenced by demographics.  For example, people with children or people expecting to soon start families may seek a larger house, whereas older people entering retirement may be looking to “downsize.”  A growing population is also likely to increase housing prices, although the construction industry often responds to increased demand very quickly.  Unfortunately, the exact role demographic factors play in housing valuations is difficult to ascertain.

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