In a free market, a good or service is priced by determining the level of supply and demand. In an efficient market, where prices instantly change to reflect new information, the price would be an accurate reflection of all current supply and demand factors currently known and would also include an adjustment based on expected future changes in the supply & demand relationship. Interesting, you might say, but why do we care about whether the market is efficient?
In an efficient market it is impossible to “beat the market” because all information known about an asset is already baked into the purchase price of an asset. The stock market is this way, and although many will point out that so and so made $X Million or $X Billion in stocks, the vast majority don’t beat the market, and those that do are typically lucky (there are some that beat the market in casino’s and state lottery also). If real estate is inefficient, however, it would mean that it would be possible to beat the market by capitalizing on information not readily known to other investors. So, is the real estate market efficient, which would make it impossible to “beat the market” or is the market inefficient, enabling investors to beat the market?
In many ways it could be said that real estate is efficient. Real estate trends are tracked and broadcast instantaneously to market participants enabling them to adjust prices as needed. There are multiple real estate investment companies that are traded on the New York Stock Exchange, as well as other exchanges. These companies’ values change instantaneously based on changes in information, reflecting what many would call an efficient market.
I believe that real estate is not efficient, or at least not as efficient as other asset classes. The reason for this is that real estate, more than any other asset I know of is extremely local. If you buy a share of GE stock, the value of that stock is going to be the same in Connecticut as it will be in Florida, Washington or Kansas. However, the value of a 3 bedroom, 2 bath, 1,600 square foot single family house will be completely different in those same places. You can even add in detail comparing the quality of build, proximity to transportation arteries and job centers, rating of school district, type of neighborhood, location within neighborhood, etc, etc. In short you could have a clone house in a clone neighborhood and the value would be completely different when placed in different locations. But, does that fact make real estate inefficient? Couldn’t the differences between pricing simply reflect supply/demand differences or possibly other factors not mentioned that can be accounted for and adjusted in the price, such as cost of living, desirability of climate, etc?
Yes, they could be. However, efficiency refers to the speed at which the market adjusts to the new data. Since new data is coming out constantly and we’re not seeing prices change instantly on our 3 bed, 2 bath properties, then clearly the price does not accurately reflect the value of the property. Again, there is a counter-argument that the list price is not the final price – that usually there is some sort of negotiation over price and the final accepted price will be reflected in the value of the property at time of acceptance of offer. However, the fact remains that the value usually doesn’t change all that often.
Complicating any assessment of value is the fact that different economic factors hit different locations differently. An overly simplistic example is that should there be an economic downturn, a community with many manufacturing jobs will have housing prices decrease faster than a community with more jobs related to education. Since each piece of economic news will have a slightly different effect on a property in State A as opposed to State B, it becomes extremely difficult to accurately determine an effect on any given property. Add in the variations within State A, and then within each town within State A, then the different neighborhoods within each town and then the streets in each neighborhood – it becomes difficult quick!
Besides outside economic factors, there is also differences in taste shown in different locations. Some locations will value certain fixtures, layouts, colors, amenities more than other locations. For example, understanding that Neighborhood A, will pay more for a granite counter top than Neighborhood B is extremely useful information and highly relevant, but when considering how many variations there could be, it again becomes very complicated.
What this complication means is that there will always be opportunity for the investor who knows his or her local market. An investor who has worked/lived/played in a certain area for a period of time will get to know how the value of a particular piece of property changes. Another investor in another town will not understand those intricacies and therefore will not know to act when a favorable buying opportunity opens up.
In short, change in supply and demand are going on all the time, however, due to the vast majority of market participants not understanding the effects of that change – or even that change took place in a particular area, the people who do realize that values have changed will be in a position to take advantage. They will be in a position to exploit inefficiencies in the market.