If you’re in real estate, it pays to understand how supply and demand impact your business. The basic economics of real estate are the same as for any other good or service. When supply and demand are perfectly matched—when every prospective buyer can buy what they need, and every seller is able to sell all they are offering—the market is said to be balanced, or in equilibrium, and prices are stable.
But supply and demand in real estate aren't easy to balance. Creating more saleable properties takes time, considerable work, and a lot of effort. It's not possible at all in some cases, and even when it is, it might not be possible for supply to increase in time to meet consumer demand, as we saw during the housing market boom in 2021.
Understanding the basic economic principle of supply and demand can help consumers decide the best time to buy or sell their properties. Knowing the forces at play can help real estate brokers and agents prepare for and respond to them as well.
Key Takeaways
- In real estate, as with other businesses, when demand is higher than supply, prices rise, and if supply outpaces demand, prices fall.
- Factors that impact real estate supply include labor and materials supplies, government policies, and local sentiment about development.
- Factors that impact demand include interest rates, buyer demographics, and consumer financial well-being.
- The COVID-19 pandemic added other factors that threw supply and demand out of balance.
How Supply and Demand Work in Real Estate
Real estate follows the law of supply and demand: When there are more buyers than properties for sale, prices rise. Tip the balance the other way, and prices go down.
It’s easy to see this in operation. If you bought and sold homes in 2021, you dealt with an extreme seller’s market in which house hunters and investors lined up to bid for a near record-low number of homes for sale, and home prices skyrocketed. In 2022, demand has fallen as rising interest rates have made homebuying more expensive.
A rough barometer of supply and demand is a statistic the National Association of Realtors (NAR) creates called “months’ supply.” That refers to how long it would take to sell all the current homes on the market at the current pace of sales. Typically, a six-month supply means a balanced market with moderately appreciating prices, and anything lower than that means prices accelerate faster. In January 2022, the months’ supply got as low as 1.6 months, an all-time record low.
Factors That Affect Housing Supply
Let’s take a closer look at why housing supplies go up or down.
Existing Inventory
The inventory of homes for sale consists of previously-owned houses as well as new ones being sold by homebuilders. These two pools of homes, referred to as “new” and “existing” homes, generally are tracked separately and subject to different influences.
The National Association of Realtors estimates the number of existing homes for sale using data from real estate listings. The supply of existing homes is influenced by how many people are putting their homes on the market, especially when homes open up because of aging and mortality in older generations.
Some experts estimate that one-quarter of existing homes will be up for sale by 2040 due to baby boomers transitioning out of their own homes or eventually dying.
Homes are also listed when people sell one house and buy another, but this has a net-zero impact on the total housing supply, since they’re taking a house off the market somewhere else.
New Home Construction
The number of new homes for sale comes from a survey of builders that the U.S. Census Bureau conducts to calculate the number. New home construction changes depending on:
- How confident builders are that they can find buyers
- How easily builders can get workers and materials they need
- How good the weather is for construction
Government Policies
Federal and local policies both have important impacts on supply and demand in the real estate market. Zoning controls and opposition to new construction by local residents with Not-In-My-Back-Yard (NIMBY) attitudes in certain areas slows development, according to Freddie Mac. That’s because NIMBYism can feed into local decisions to discourage development.
Local laws may also restrict building height or the number of homes allowed to be built per acre, which decreases the supply of homes and makes them less affordable.
To help increase the housing supply, the administration of President Joe Biden launched a program in 2022 that favors state and local governments applying for federal transportation funds if they reform their land-use policies to promote housing density, among other goals. The intention is to close the housing gap within five years. The Biden administration also allocated more funding to subsidizing the construction and repair of affordable housing.
Factors That Affect Housing Demand
Housing demand also is subject to various economic and societal forces that affect real estate businesses.
Mortgage Interest Rates
Interest rates are major factors in how much buyers can and will pay for homes. When mortgage rates are low, it doesn’t cost as much to finance a house. That means homebuyers are able to afford more expensive homes on the same monthly budget.
For example, a buyer with $40,000 for a down payment and a $1,500 monthly budget for mortgage payments could buy a home worth $412,242 at the ultra-low interest average rate of 2.65% for a 30-year fixed mortgage that prevailed in January 2021, according to Freddie Mac. That same buyer could only afford a home worth $310,122 at the typical 5.3% interest rate offered in July 2022.
You can calculate the monthly mortgage payment for any property with a mortgage calculator, such as this one.
Because they can have such a big impact on monthly mortgage payments, mortgage rates alone can significantly alter demand for homes. In 2022, the Federal Reserve’s efforts to rein in inflation by raising interest rates caused mortgage rates to spike.
Interest rates for fixed-rate mortgages typically move up or down along with yields on 10-year Treasuries, which, in turn, tend to rise if bond traders think the Fed is going to raise interest rates sharply. The Fed’s rate hikes hurt demand and slowed home sales—although prices continued to rise because of the restricted supply.
Consumer Financial Health
The broader economy and the state of people’s pocketbooks also have major bearings on demand for homebuying. When people are flush with cash and feel secure in their jobs and good about the direction of the economy, they’re more likely to invest in buying a house.
One way to measure the overall mood—and get some idea of what’s influencing supply and demand—is the Home Purchase Sentiment Index by mortgage giant Fannie Mae, which polls consumers every month about their income, feelings about job security, and whether it’s a good time to buy or sell a home.
In 2021, optimism about both buying and selling homes was boosted by the healthy shape of household finances in general, with a recovering job market and stimulus payments from the government bolstering homebuyers’ bottom lines. But as time went on, rising prices and mortgage rates soured the homebuying outlook, according to the survey.
Demographic Changes
The number of people in the market for homes can also impact demand, with an influx of new buyers pumping up demand. At the height of the 2021 housing boom, a wave of millennials entered prime homebuying age, meaning there were even more buyers chasing those scarce homes, especially lower-priced “entry level” ones suitable for first-time buyers.
“There is a wave of young adults who are aging into peak household formation,” said Jessica Lautz, vice president of demographics and behavioral insights at the NAR. “And those young adults want to find a place to live and to earn equity and the financial gains that homeownership brings.”
Institutional investors also contributed to the housing boom, making up a small but growing share of the market. In 2021, 13.2% of homes sold were bought by companies, corporations, and limited liability companies (LLCs), up from 11.8% in 2020, according to a study by the NAR.
Pandemic Effects on Supply and Demand
When the COVID-19 pandemic hit in 2020, many businesses switched to remote operations, and a horde of newly minted telecommuters went in search of bigger houses better suited to their new work-from-home lifestyles. At the same time, mortgage rates plunged to record lows, which made it much easier for families to afford houses. In short, the demand side of the supply-demand seesaw went through the roof.
Normally, basic economics would dictate that suppliers of the thing in high demand would respond by increasing production, eventually stabilizing prices. But building a new house is a slow process; in 2021, it took an average of 7.2 months from start to finish, not including any time spent making plans and getting building permits, according to government data.
On top of that, homebuilders had a hard time finding enough workers and building materials to complete projects because of labor-market and supply-chain disruptions caused by the pandemic, so the roaring demand wasn’t matched by an equal building boom.
Longer-Term Supply Issues
It wasn’t just the pandemic, though. Longer-term factors have also contributed to the supply-demand imbalance. The U.S. has underbuilt homes for decades, resulting in a chronic shortage.
There were 3.8 million fewer homes than needed in the fourth quarter of 2020, economists at Freddie Mac estimated in a report. The National Association of Realtors pegged the housing gap at 5.5 million.
Among the reasons for the housing supply gap is difficulty finding land to build houses on in hot housing markets, and a growing lack of skilled workers and building materials, according to Lautz.
With the supply side unable to keep up, there were far more buyers than sellers, and prices spiked. The median home in the second quarter of 2022 sold for $440,300, an increase of more than $100,000 from the typical $329,000 price tag in early 2020. An uptick in mortgage rates in the spring of 2022 slowed the pace of price increases, but not by much.
Real Estate Supply and Demand Varies by Location
Those are national trends, though, and things may be very different depending on where you are buying or selling a home. Pay attention to the factors that influence your local market. Watch local businesses and make note of upsizing and downsizing trends if you do business in a market that has many workers relocating to or from there.
As at the national level, divorce rates, death rates, and demographics can factor in. Other significant factors include the impacts of climate change (increases in flooding, fire risk, and excessive heat may send homeowners fleeing and prices plummeting), an aging population, and investment trends ifyou do business in a resort area that includes vacation homes. Trends that impact discretionary income have more of an influence on this type of market than others.
There are regional trends, too. For instance, prices for homes in the West have stayed relatively stable compared to those in the South from 2019 through 2021, according to NAR data.
To get a good idea of supply and demand in your area, visit the website of your local association of Realtors—most state organizations provide statistics on months’ supply in the local market.
Land Parcels Are Finite and Immovable
Underlying all these influencesare the basic fundamentals of supply and demand.
You cannot fill a real estate supply shortage by manufacturing more units of land. It's a finite supply, not a manufactured commodity. You might be able to create more units within a given space, such as condos or townhouses, but the land itself is unique and cannot be duplicated to accommodate a short supply.
Likewise, when a shortage of land for homes exists in a given area, you can't simply move in more land to alleviate the shortage. Real estate is where it sits. It will always be a local commodity influenced by local conditions.
Frequently Asked Question (FAQs)
When does an equilibrium occur in supply and demand?
Equilibrium is the price at which supply and demand are balanced—there’s no surplus and no shortage. Buyers are willing to purchase exactly as many goods as sellers are willing to sell.
The equilibrium point moves in response to changes in supply and demand. Greater demand in relation to supply will cause the equilibrium price to rise, and reduced demand will cause it to fall.
Although economists believe markets tend toward equilibrium in the long run, real life outside an economics textbook is messy, and prices tend to bounce around a lot on the way to equilibrium.
Why is demand for housing more flexible than supply?
While demand can change at the drop of a hat in response to financial or social conditions, supply in the housing market takes much longer to adjust. Increasing the supply of homes for sale means building a house or apartment building, which takes a long time—7.2 months for a single-family home, and more than a year for an average apartment building in 2021, according to government statistics.
With those headwinds, homebuilding has fallen behind demand by millions of units over the past few decades, according to recent research.
