Why Should I Care: Real Estate & Price Discovery

This post first appeared on Minyanville and Cirios Real Estate.

Price discovery. It sounds simple enough, right? If you separate out its component parts, you have "price" -- the amount buyers are willing to pay and sellers are willing to accept -- and "discovery" -- the uncovering of that price.

But price discovery -- a term which is bandied about in all corners of the financial markets -- has a meaning far deeper than this cursory analysis.

In a financial sense, it's defined as the point at which the free market -- the natural interplay between supply and demand -- converge on a single point where buyers and sellers can find mutual ground. There, you have price discovery.

In a practical sense, it happens every day; each time an economic transaction occurs. Coffee at Starbucks (SBUX) costs more than, say, coffee at any other establishment on the planet, because consumers have determined they're willing to pay a premium for it. Starbucks, for its part, has generously sprinkled its stores on street corners around the world, matching supply with this persistent demand. The price, even though most of us scoff at the mere thought of forking over more than $4 for some contrived, flavored coffee-like drink, is what the market will bear.

So why then do financial-market participants make such a big deal about "true price discovery" in trying to analyze specifically when and where markets will bottom? The key is in the definition.

Let's examine the housing market to see why this distinction matters, and how the dynamics effecting price discovery are so important.

Homes, unlike cups of coffee, are rarely bought and sold -- other than when entire neighborhoods are turned over (which seems to happen with frightening regularity). But buying or selling a home typically involves uprooting one's family, hauling boxes across town (or across the country), switching schools, changing jobs, and otherwise disrupting the flow of life.

When talking about the housing market, most pundits and so-called experts typically focus on the demand side of the equation. How low are interest rates? Did Wells Fargo (WFC) just tighten its mortgage guidelines? Are property values increasing or decreasing? How is the job market doing? On a more personal level, getting married, having kids, changing jobs, seeking out a slower (or faster) pace of life, or looking to trade up into a better school district or bigger home can all lead buyers to jump into the market.

Sellers, on the other hand, are typically hard-pressed to sell. Many of the same circumstances (jobs, retirement, family, etc.) lead a seller to enter the market, but leaving a home and the emotional attachment therein, is an extremely difficult decision to undertake without a very compelling reason.

In the current housing downturn, as social mood has swung violently towards risk aversion and shorter time preferences, the decision to sell one’s home has effectively become that of necessity, or nothing at all. In other words, the vast majority of sellers on the market right now are forced sellers -- those who don’t have any choice.

So what does this all have to do with price discovery?

The destruction of a widely held economic belief -- namely, that housing prices only go up --has thrown the interplay between supply and demand out of whack. Couple that with insane leverage, abnormally low interest rates, virtually non-existent underwriting guidelines, and massive government intervention in the form of Fannie Mae (FNM) and Freddie Mac (FRE) that caused the recent boom, and in reality, the fundamentals of supply and demand have been wonky for years, if not decades.

As these imbalances are worked through and the weakest hands are forced to fold, markets are slowly starting to heal. And even though massive loan-modification efforts and foreclosure moratoria are once again throwing true supply and demand out of whack, the free market is a powerful force: Certain real-estate markets around the country are beginning to show signs of healthy stabilization.

Price discovery is emerging, as housing prices return to more traditional measures of affordability where buying begins to make just as much sense as renting. To be sure, there's a fear of losing equity as prices tumble, but the emotional pull of owning a home is, and always will be, a powerful force. Other markets, however, have a very long way to go.

Since founding Cirios Real Estate, I've spent a dizzying amount of time looking at local housing markets in California. And in trying to identify trends on a neighborhood-by-neighborhood, street-by-street basis, I've found one trend that's 100% consistent around the state. And although California is a rather unique case, I know enough about markets around the country to be confident this is true there as well.

Markets that have seen the most extreme home-price declines are the ones where owners faced massive amounts of negative equity and foreclosures ran rampant. Virtually every sale in these markets over the past 2 years has been the result of a seller being forced to sell.

On the other hand, markets where job losses have been less severe have seen prices ramp up less severely during the boom; schools are better and fundamental desirability is higher. Sellers have broadly had the luxury of holding out, hoping the market would turn before they, too, would be forced to put their home on the market.

When there are no more forced sellers in a given market -- or at the very least, the proportion of forced sellers and non-forced sellers returns to more normal levels -- healthy stabilization can occur. And in order for this to happen, years of froth and excess must first be worked off. This can happen via 2 methods, which Toddo often discusses when analyzing the stock market: time and price.

Time can heal wounds as demographics shift and new buyers enter a given market, or low prices can bring investors out of the woodwork to snap up underpriced homes.

There isn’t some magic formula or complex property-valuation algorithm (sorry Zillow) that can determine where a given markets is in the bottoming process or where the best real-estate investment opportunities currently lie (to be sure, they're out there). But with careful analysis of individual markets, trends can be identified.

Submarkets where price discovery -- that is, the process of returning to an environment where natural supply-demand fundamentals can thrive -- is further along pose a far smaller risk than those markets where sellers have been hunkering down, hoping the maelstrom would blow over their quiet streets.

So while pundits argue over whether the housing market has “bottomed,” we can all ignore their drivel, knowing this is a meaningless statement. Price discovery doesn’t happen on a national scale; the massive and disjointed real-estate market is made up of thousands of tiny micro-markets, each of which is at a different point along the highway of price discovery.