The Sole Determining Factor of Real Estate Prices

A Buyer's purchasing power is a driving force behind real estate pricing.

On one side of the pricing scale sits the buyer. On the other is the seller with a property. Between them sits the lender with the funds necessary to close the transaction. Like a seesaw, the lender's mortgage rate moves the buyer's purchasing power up and down.

The lender determines the buyer's mortgage amount.

Each buyer has a maximum price they can pay to purchase a property. This price depends on the following:

• the buyer's down payment; and
• the mortgage amount they qualify for.

The amount a buyer can borrow is based on two factors:

• the buyer's income, which adjusts annually at the rate of inflation; and
• current mortgage rates, which change constantly.

Lenders know buyers are less likely to default if they allocate no more than 31% of their monthly gross income to their monthly mortgage payment. Accordingly, lenders refuse (as mandated) to lend more money than the buyer can repay at that 31% gross income ratio, amortized over 30 years.

The buyer's income and mortgage control the seller's price

On the other hand, sellers seek the highest possible sales price from a buyer whose standard of living is typical for the location. The sales price of all homes sold within each pricing tier cannot, on average, exceed the purchasing power of buyers shopping within that tier.

When all sellers hold out for above-market prices, buyers for that property tier will eventually be unable to buy. Thus, buyers control the price sellers will receive, based primarily on mortgage funds available at current interest rates.

Sellers of any asset have received significantly higher prices over the past 20 years, driven primarily by a continuous drop in interest rates.

However, the pricing trend has reversed, moving out of the zero lower bound interest rate regime we left in 2012. And the downward pressure on prices will continue as interest rates rise — except temporarily during Fed-engineered business recessions.

Rates hovered near zero from 2009-2015 and again in 2020 — and while a zero rate was too high to stimulate the economy, the Fed (unlike other countries) was unwilling to go negative.

As mortgage rates rise, the maximum price a buyer can pay for a home declines since the amount they can borrow is capped.

The static 31% debt-to-income (DTI) ratio is set for buyers needing a mortgage. In the future, buyer income will rise annually based on consumer inflation of around 2%. This inflation figure has been typical for nearly two decades — with the rapid inflation of 2022 the giant exception. However, wages have not kept up with consumer inflation, much less asset inflation (think homes) over the past 15 years.

Consider this...

A buyer who is interested in acquiring a particular home. A year earlier, the buyer qualified to borrow enough to pay the seller's then-asking price.

However, in the intervening year, mortgage rates jumped, and the buyer could not borrow the same amount of money.

Unsurprisingly, the property the buyer was able to buy just a few months ago is now priced out of reach due to the interest rate change, not an increase in the price. The buyer now only qualifies to purchase the property at a lower price.

However, as is usually the case, the buyer is not interested in purchasing a lesser quality of property than the one they once were previously qualified to buy. Buyers, psychologically, will rarely downgrade. They will wait until prices or interest rates drop or their income significantly increases.

Interest rates will continue to rise during the next couple of decades. In turn, sellers' prices will need to drop correspondingly when asking for more than the equivalent rise in annual consumer inflation.

The agent's initial solution to keep their sales volume from dropping is to negotiate a change in the seller's price to accommodate the realities of the mortgage rate change. If not, buyers and sellers will stand still with little to no ability to make a deal.

When making an offer to buy, the buyer's income is static, like the position of a fulcrum about which other dynamics move events. Most sales involve a mortgage lender, but the maximum principal they lend to fund the purchase is static, as no more than 31% of the buyer's gross income for mortgage payments. Further, the lender's mortgage rate when the buyer is approved for a mortgage is also static, set by the bond market, which dictates mortgage rates and no one else.

So, who needs to give? Buyers can't; lenders won't. So, sellers need to adjust by asking the "going price" for their property — when they intend to sell, not simply test the market at the expense of the listing agent's efforts.

When the seller does not adjust their price expectations, they exit the market — but only after the seller's agent spends time and effort marketing the property. Thus, seller agents will fast learn to "fire" their sellers who are not ready to sell at today's prices.