Supply and Demand Falling in Lockstep

Econ 101 says that demand and supply (which is quite different from inventory, of course) converge at the point where price equals marginal cost of production.

The marginal cost of production of a Brooklyn brownstone is the lowest of: (1) construction cost for a new unit that might appeal to the least committed brownstoner, (2) cost to convert an existing rental to owner-occupancy, or (3) cost to renovate a substandard unit to current expectations.

Moreover, Econ 101 predicts that rental values and home prices will converge (if they differ, developers will assiduously work to convert the cheaper form into the more expensive one.

Rental values are about half current asking prices, at least if the Love Lane house is any indication.

If you believe that current sale prices are stable, you should also expect that rents are likely to double in the near future. If you believe that current rents are likely to drop as unemployment rises and incomes drop, then you should anticipate huge reductions in sales prices.

If you reject both these possibilities, you must believe that Econ 101 doesn't apply to NYC for some reason.

Posted by: FinanceGuy at January 15, 2009 11:23 AM

Econ 101: "most" (potential) sellers are irrelevant. The price is determined at the margin: the most desperate seller makes a deal with the most spendthrift buyer.

In rational markets, buyers expect to be paid for the risk and hassle of homeowership, so prices drop until it is slightly cheaper to buy than to rent (enough cheaper that investors can make an immediate profit renting, even if they honestly account for their time, opportunity costs and maintenance expenses).

In bubble markets like the one just ending, buyers will pay silly prices because they plan to sell at even sillier prices. Banks become enablers, on the same theory: they don't care if the buyer is overpaying or over-borrowing, because if the borrower can't pay, he/she will just sell to an even sillier buyer. But when the bubble ends, those buyers and those banks rapidly disappear.

In declining markets, the bubble logic can work in reverse: you'd be crazy to pay full value (let alone double value) today when it is going to be cheaper tomorrow. So the market is just as likely to overshoot on the way down as on the way up. At some previous NY bottoms, it cost half as much to buy as to rent.

Transactions are dropping because sellers are attempting to demand more than the market clearing price. In effect, we have a sellers' cartel. However, Econ 101 predicts that cartels usually fail. Especially when the only coordinator and enforcer of the cartel is real estate agents.

Sale price drops are now inevitable unless Obama decides to hand the entire stimulus package, no strings attached, to Manhattan investment bankers.

If you are willing to pay double fair value based on current rents -- you should first ask yourself whether your seller is really the best object of your charity. Wouldn't it be better to just give away half your money to someone deserving, and then wait 6 months to buy?

Posted by: FinanceGuy at January 15, 2009 4:11 PM

DIBS, if you calculate your opportunity cost as the S&P500's returns for the last year, you made a fortune on your house.

Congratulations! At that rate, you'll be even richer than my girlfriend got shopping at the Bloomingdale's 50% off sale.
If she had only spent a bit more, she'd have saved so much I could retire right now.

Posted by: FinanceGuy at January 15, 2009 4:24 PM