Monday, February 23, 2009

Determinates Of Home Prices

House prices are composed of two primary components. The total value of a house is the combined value of the land that the structure sits on and the value of the physical structure. While there are regional differences in the cost of lumber and other materials primarily due to differences in transportation and storage costs and in the regional costs of labor, these do not account for the significant difference in regional prices of comparably built homes. The land's value is the primary cause of regional difference in comparably built homes. Over time, it is the value of a home's raw materials, labor, land and depreciation that determine a home's value.

The house structure as opposed to the land, depreciates over time due to the wear and tear of its components. For example, roofs will need replacement. The exterior will need repainting or need siding repair or replacement. Plumbing wears out and leaks. Weathering damage occurs to the structure, and many other parts of the house will need maintenance, repair or replacement. Any one who has ever seen an abandoned house recognizes that it will deteriorate over time without maintenance and repair.

A home's value will decline yearly due to this depreciation unless there is enough appreciation to compensate for the natural decline in a home's value or unless a potential buyer can assume that the current homeowner added back to the home's value the cost of the depreciation through repair and maintenance. In a robust economy, one can assume that the current owner is making the necessary repairs and maintenance and that the value of the replacement is equal to the depreciation value.

Assuming a 20-year average life for the combined house structure (it is just a reasonable guess to use as an example and not an actually computed value), the value of a home's structure will decline in value by 5 percent per year. Assuming that the land a house sits on is worth about 20 percent to the total house price (again just a reasonable guess for an average with the understanding that in some areas such as DC, San Francisco, NYC, etc it will be higher), the value of a home will decline by 4 percent per year (80 percent of 5 percent). A four percent increase in the total value of a home will be just enough to compensate for the loss due to depreciation and hold constant the total value of a home. To say that a home increases in value by the CPI is in effect to say its value increased by CPI plus 4 percent or that it increased by CPI and the homeowner added back to the home the 4 percent value of the depreciation. In recessionary times, homeowners will defer maintenance and repairs. Home prices will decline by their depreciation amount since the homeowner is not adding back the depreciation value, where in better times home prices will remain stable. Therefore, a 2-3 percent CPI increase in home prices will not be enough to compensate for the depreciation loss and lead to a 1-2 percent decline in home values. Currently, we are facing a deflationary price period and many of the raw materials needed for repairs have declined in price. For example, lumber prices are at a five year low. Due to the slow down in residential construction, labor costs are also low. Any repairs made by owners (if made) will cost less than anticipated and not compensate for the decline in a home's value due to depreciation. Plus, there is the increased likelihood that maintenance and repairs will be deferred.

Land value is set by supply and demand, which is determined by the desirability of an area and the availability of approved (or potentially approvable) buildable land in the area. Local government regulation determines if available land is approved for building a home. The availability of employment and the salaries paid for the jobs is a determinate of an area's desirability. The other is leisure, including retirement. When an area's total employment declines, the value of the residential land in that area will also decline causing a decline in a home's value. Likewise, in poor national economic times the value of leisure plus a delay in retirement decreases the value of land in leisure and retirement areas.

Therefore, home values will continue to decline due to two factors. Poor regional economies will cause a decline in land values in regional areas. The national downturn will cause a decline in retirement and leisure land areas. The decline in raw materials and labor for houses will also cause a decline in the replacement value of a home.

Home prices will not stabilize until regional employment stabilizes, until retirement and leisure return to normal levels and until raw material and labor prices recover to a level to compensate for the loss in value due to depreciation and homeowners add back the replacement cost of depreciation.

1 comment :

  1. I have read many posts regarding home posts and found that everybody is busy discussing about the comparison of present home prices to that of past years but none of them ever tried to discussed about determinants of home prices. You are the first one and really you have explained it well. Thanks for sharing this information here.