Thursday, July 20, 2006
Does It Pay To Wait?
Does it pay to procrastinate the acquisition of a real estate asset during times of prices deflation? Find out...
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If you ask your Realtor whether it is a good idea to delay your real estate purchase when prices are falling, the answer you will probably get is that, no, it is not a good policy to wait out the market because sometimes, somewhere, somehow – in an unspecified region of the planet – prices will go up again, so that you will miss out on the opportunity of a lifetime. Conversely, if you ask me the same question during regular business hours, my standard reply will likely be: “No, don’t do it. I want my commission now” (I have been known to render this type of responses, on occasion).
But seriously, does it actually pay to delay the acquisition of a real capital asset in times of deflation?
Deflation, by definition, is a sustained fall in prices, so sustained, in fact, as to affect the velocity of money, that is how often money is spent by consumers in any given month. Because of its effect on profits, deflation causes a slow-down in business activity and a consequent escape of investment capitals. In its extreme forms, deflation affects employment and wages, thus spreading the drop in income and higher unemployment rate to other sectors of the economy, and seriously hampering growth. Hence, deflation is caused by a collapse in demand and is associated with recession and, more rarely, long-term economic depression.
Since deflation discourages investment and spending, because there is no reason to risk on future profits when the expectation of profits may be negative and the expectation of future prices is lower, it generally leads to, or is associated with a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent just to hold onto money, and not to spend or invest it. Therefore, deflation is a tax on borrowers and on holders of illiquid assets such as real estate, which tax accrues to the benefit of savers and of holders of liquid assets and currency. Because of this, therefore, prospective real estate buyers may decide to hold on to their purchases, since future expectations of realized profits as well as prices are lower than the present.
So, therefore, are the proponents of the ‘waiting game’ correct? Is it better to wait for prices to drop further as opposed to making the purchase now?
Central Banks have a special monetarist tool to combat deflation. By tightening the Feds’ control over money supply as well as short-term interest on treasury bills, the end result is a more valued domestic currency and higher interest rates. In these times of economic globalization, such a move results in an influx of foreign capitals to offset the shortage of domestic investment. Just because price expectations may not be attractive to domestic consumers does not mean that they may not be attractive to foreigners.
Additionally, Real Estate is possibly the quintessential economically inefficient market because different participants typically have varying amounts, degree and quality of market knowledge and interest to actively participate in it. The reason of an investor to purchase a rental property is very different from the reason of a first-time buyer to purchase an apartment or a house. Therefore, the first time buyer, or the married couple wanting to upgrade to a single-family detached unit will go ahead with their purchase even during times of falling prices, since they expect to live in their newly-acquired property for years to come. And even investors, in fact, may want to buy and hold properties, and not to resell them right away. Just like builders, for instance, who do not have to build and sell, but may very well build and move in.
And, finally, price deflation increases the purchasing power of money as opposed to inflation, which decreases it. Therefore, a continued fall in prices leads to the point where the very equilibrium between price and worth is altered. The ratio of the perceived value of a capital asset vis-a-vis its intrinsic risk of acquisition is termed ‘worth’. Clearly the lower the risk, the higher the worth. It follows, therefore, that the perceived value – or simply ‘value’ - of a real capital asset is the total monetary worth obtained by reducing exposure to risk and liability. Put in elementary terms, ‘value’ is the total net benefit a buyer expects to receive from a purchase, measured in currency. The measure of the ‘value in exchange’ of the real estate transaction is the sales price.
When average prices drop below a certain level, just about everything becomes a bargain, and expectations of future returns go in second position. For instance, say that a five-bedroom home on a large lot overlooking a golf course was worth $600,000 last year, and that because of the shift in prices this home has progressively lost ground and is now worth $500,000, and that it continues to lose ground. When will a buyer decide to purchase it? When its price is down to $450,000, or $400,000 or even $350,000? It will get to a point where, in the eyes and mind of a purchaser, this house will be a bargain, no matter the future expectations of profitability. Therefore, the rule of thumb is that in any market the velocity of money will pick up again, and that the relation between supply and demand will be tilted in favor of demand once again, thus spurring a renewed capital influx through investments, and growth. This is what it is known as 'market consolidation'.
Which then, in ultimately analysis, means that your Realtor was correct. It is not a good policy to delay a purchase simply because prices are falling.
Luigi Frascati
Real Estate Chronicle
