Why does putting up a new building raise real estate prices in the surrounding buildings instead of lowering them?

February 2, 2006 9:44 PM

Why does putting up a new building raise real estate prices in the surrounding buildings instead of lowering them?

(Specifically, with respect to NYC, but explanations based on other areas will do in a pinch.)

It seems that every time a new residential building goes up, rather than lower prices by feeding the demand with some extra supply, all of the prices in the surrounding area go up because this is evidence that the neighborhood is now "hot" (or "hotter"). New construction buildings in the area are pitched as positive selling points for existing apartments.

Prices are apparently very closely tied to what the purchasers think they'll be able to resell for, rather than what the apartments are "worth", but I don't really understand how this phenomenon works in terms of motivation and demand. Expected resale value is presumably an element of worth, but I'm interested in correlations beyond that observation, given that it's not actually possible to predict how the market is going to go when a person will decide to sell.

Is this characteristic of a bubble? Is there an area of economics that deals with this?

Do market principles work differently if a large portion of the available goods are being frequently resold, rather than consumed?

Are there other markets which follow this same pattern?

posted by Caviar to grab bag (23 comments total)

New construction in an area would only be done (by someone intelligent, anyway) if there were demand for more space in that area, be it commercial or residential.

Construction is considered "development" and is viewed as a good thing... it means that area is desireable and it therefore increases the value...

I understand why you'd think that's counterintuitive -- "now there's more space, so supply has gone up!" .. but that's not really how it's looked at...
posted by twiggy at 9:54 PM on February 2, 2006

There are new buildings because there's more demand for space in the area, but demand is going up because there are new buildings.

That doesn't answer my question.
posted by Caviar at 10:09 PM on February 2, 2006

Real estate prices are determined not only by supply/demand issues, but also location-location-location.

New development in area = more desirable location = prices go up.

You can have low supply and high prices in exclusive, hoity-toity neighborhoods. You can also have high supply and high prices in those same neighborhoods, because they're perceived as being a better quality location overall. I live in Orange County, California -- supply is going up with tons of new construction, and prices are going up, too, because ... well ... because everyone thinks OC is a great place to live.

Prices are apparently very closely tied to what the purchasers think they'll be able to resell for, rather than what the apartments are "worth"

Yes, but "worth" is how much they're able to sell for. The two things are the same. These are not two different values.
posted by frogan at 10:19 PM on February 2, 2006

Also, consider what the new building is replacing. If it's replacing a bombed-out vacant lot, then the neighborhood is being improved because a vacant lot serves no one but the squirrels. If the new building is replacing an old building that was an eyesore, then the new building just makes the neighborhood look better.

Moreover, a new building in the area may also mean that local infrastructure -- e.g. phone lines and sewerage -- was improved to meet the needs of the new tenants.
posted by frogan at 10:23 PM on February 2, 2006

I believe it would be what's called induced demand (frequently applied in transport economics). The availability of something not only satisfies existing demand, but increases demand due to it's location and benefits.

I'm sure someone can explain it better, it's been a long time since I've done economics...
posted by djgh at 10:24 PM on February 2, 2006

Wikipedia link to induced demand
posted by djgh at 10:25 PM on February 2, 2006

Prices are apparently very closely tied to what the purchasers think they'll be able to resell for, rather than what the apartments are "worth", but I don't really understand how this phenomenon works in terms of motivation and demand.

I'm no economist or real estate agent, so instead of proposing any didactic or tautological formulae, I'll just give the following anecdote. About 10 years ago, my cousin lived in an apartment in the Bayview neighborhood of Toronto. She decided to move into a new condo development midtown. It was a pretty, brand-new building and she liked the view of the city she got, the floor space, and the walking distance to the subway. The price tag was high but she figured it was worth it, hoping the property would appreciate over time.

Meanwhile, the surrounding neighborhood has seen an influx of service related businesses. For example, there is now a Starbucks within walking distance, and a few other businesses filled out some commercial space that had been empty for a while.

Ten years later, her condo is worth a lot more, and while the fees are fairly high, at the end of the day, were she to sell it she would make a profit.

That's the end of the story, but it's safe to assume with all the development, property values went up because a more affluent population moved in, Starbucks popped up, it was yuppified. Older buildings proximity to these developments raised their value in the eyes of purchasers, probably raising prices. I don't know specifics about the economic growth of the city or population growth. If they stayed flat, then this development happened to the detriment of some other neighborhood, or prices went down slightly over several neighborhoods b/c people took money elsewhere. Provided economic growth occurred to sustain the areas people moving into the condo vacated, I would assume that some of the neighborhoods did not go into decline.
posted by tweak at 10:26 PM on February 2, 2006

The new developments near our flat have pushed prices up because those new developments are trendy and attractive to richer people (richer than those already in the area). More beautiful people with nice cars move into the area (because there are now river- and oceanfront apartments for them amongst the warehouses and fishing-boat moorings), and people look at the neighbourhood and see there are more beautiful people with nice cars around and they look at our one-bedroom flat and they say "I'll pay you more for that today than I would have last year because last year, there weren't beautiful, rich people in the area. Now that the beautiful and the rich live here I want to live here, too. I can't get into one of the brand new apartment buildings, but I can offer you more for your flat than you ever thought possible". That's what happened in Fremantle, anyway. I think that's how it works all over, but - CLEARLY - I am not a property expert.
posted by bunglin jones at 10:30 PM on February 2, 2006

induced demand

Is this one of those things that the modern rationalist mind thinks it has explained by giving it a name (birds fly south because of "migration"), or is there actually a mechanism that explains it?

I'd guess "elasticity of demand" goes partway, but this seems limited. I'm not sure how it's different than saying there's more demand than supply.
posted by namespan at 10:32 PM on February 2, 2006

The short answer: purchasing something as highly personal as a place to live is usually an emotional decision rather than an economically logical one, and people are emotionally attracted to shiny new places.

A few comments:

1) The laws of supply and demand show themselves in macro, but are often outweighed by other factors in micro. What is micro and what is macro is situational -- for example, a new set of apartments in an isolated small town would be a large event, and likely would result in the expected lower prices. A new set of apartments in NYC is a small drop in a very sloshy bucket.

2) A "bubble" is generally an unsustainable growth rate in an area. A heating up and cooling off of local housing market is a normal fluctuation, common to every real estate market in the world.

3) Markets certainly behave differently if there is a perception that the commodity can be resold at a profit. This doesn't cause the first jump in prices, but once that happens, everyone else wants in.

4) The stock market frequently behaves the same way, right down to the "halo effect" where a single company's good performance causes a rush on the whole sector.
posted by tkolar at 10:38 PM on February 2, 2006

"given that it's not actually possible to predict how the market is going to go when a person will decide to sell."

While this is true, strictly speaking, everyone assumes that housing represents an ever increasing return on investment. It's just seen as a truism that homes appreciate over time.
posted by oddman at 11:05 PM on February 2, 2006

I'm not sure that induced demand applies. It seems like what's going on here is that if an adequate indicator of demand is lacking, then the fact that others are increasing supply is viewed as one.

But that's not necessarily accurate. Is there any way to tell the difference between demand driven up by new supply and demand driven up by exhausting the existing supply?

Historically or theoretically speaking, what are the factors that cause people to back away from this "supply leads to presumed demand" cycle? (Anecdotes are good too - have you been in a situation where you decided that prices were inflated too high from this effect and you backed away?)
posted by Caviar at 11:16 PM on February 2, 2006

To understand the economics behind real estate, first try to forget the concept of "real estate" as it conflates two very different things: land and buildings. New buildings reduce the value of nearby buildings by increasing supply, but they also increase the value of nearby land, in this case by more than enough to cause a net increase in the value of the combined building+land packages. It can occasionaly go the other way if so many apartments are built that the vacant percentage of them starts to get too high.

Re expected resale values, you can ignore that if you like. It does happen an overheated market (such as land in the english speaking world at the moment) that people start to treat it as a collectable (like stamps, art, etc.) and ignore the real value (which you can calculate from predictions of the rental return and the interest rate) but the effect you ask about happens during periods of sanity too, so the bubble isn't the whole answer.

As for why land is different from other markets, its supply is totaly inelastic - they're not making more of it (heading off the inevitable nitpick: by "land" I mean locations, so the dutch didn't "make more land", they just improved some very wet land). If you want to find what economists have written on this kind of thing then "land" is a key word, it has a particular technical meaning as one of the 3 classical factors of production.

Reasons for land to go up in response to nearby construction: ask yourself which of two otherwise identical vacant lots is worth more: the one in New York or the one in the middle of nowhere. People will pay a great deal to live near the services and infrastructure which are attracted to (and provided by) other people.

Disclaimer: I am not an economist, I'm a geoist, but then some economists are also geoists, so maybe that's OK.
posted by Canard de Vasco at 11:50 PM on February 2, 2006

NYC is not like other real estate markets. The (economically insane) rent control laws kept in place after WWII for decades, plus the fact that the city is probably the most desirable place to live in America (and the fact that Manhattan is an island, if you live in Manhattan), means that demand is essentially infinite, and the important point about putting up a new building is not that it increases supply but that it signals "this is an area people are going to be moving to" and triggers off the latest stampede.
posted by languagehat at 5:23 AM on February 3, 2006

Yes, but "worth" is how much they're able to sell for. The two things are the same. These are not two different values.

Not to argue about semantics, but I think the previous poster was referring to intrinsic worth. A tech stock may sell for $100 but may only be worth $1 according to fundamentals. People found this out in 2001.
posted by malp at 6:07 AM on February 3, 2006

I think the previous poster was referring to intrinsic worth. A tech stock may sell for $100 but may only be worth $1 according to fundamentals.

I am not an economist, but this statement makes zero sense to me. There's no such thing as "intrinsic worth." Something is worth what you can sell it for. If everyone wants to buy your widget, then it's worth more. If no one wants to buy it, then you're out of luck. The tech stock bubble was everyone suddenly realizing that shipping dog food via snail mail wasn't going to make anyone a profit, which meant no one wanted to buy the stock. No buyers = no worth.

There is an intrinsic value, but this is a technical term that describes the difference between current prices and option prices. It's also a term used to describe a company's current cash flow.

Prices are apparently very closely tied to what the purchasers think they'll be able to resell for

Take out the words "apparently very closely tied" from that phrase and you have a true statement.
posted by frogan at 9:45 AM on February 3, 2006

Something else: new development in an area may signal not only the presence of new demand, but also demand from a different socioeconomic group (in other words, yuppiefication). tweak hints at this process. More affluent residents will demand better services, spend more in the surrounding area, and take umbrage with the seedier elements in the neighbourhood (bars and clubs, for example). As those services are put in, the bars closed and the poor people trucked elsewhere, the area becomes more attractive to affluent people who are perhaps less adventurous than the first cohort. This drives the process further until finally you're left with nothing but chic condos, upscale furniture boutiques, art galleries and brew pubs.
posted by chrominance at 9:50 AM on February 3, 2006

But that's part of my point - a home has worth even if no one wants to buy it.
posted by Caviar at 9:51 AM on February 3, 2006

I am not an economist, but this statement makes zero sense to me. There's no such thing as "intrinsic worth."

I think the poster was refering to the idea that real estate can be rented to generate revenue, and so you could argue that by multiplying the periodic revenue by the time you plan to hold it, you're coming up with a figure that represents how much it's inherent worth as an asset, and that this figure may or may not be related to a sale price.
posted by weston at 10:39 AM on February 3, 2006

a home has worth even if no one wants to buy it.

This is true in a philosophical sense, but not in an economic one, and we're talking economics here. If no one wants to buy something, it has no value (in economic terms); if someone offers a nickel for it, that's its value until another offer comes along. Failure to understand this has led to much grief as people refuse to part with things because they're "worth" much more than other people are willing to pay for them, or refuse to buy something they need because it's not "worth" what they're asking for it.
posted by languagehat at 11:07 AM on February 3, 2006

But that's part of my point - a home has worth even if no one wants to buy it.

Sorry, it doesn't. Prices are determined by sales and the expectation of future sales. If literally no one wants to buy something, then prices could fall to zero. Ever give anything away to Goodwill? Why? It's because you think no one wants to pay you for your stuff (or rather, you value an empty attic more than the stuff, and/or you think no one wants to pay you enough to justify the effort in holding a garage sale).

Now, obviously, that's an oversimplification -- no one will give land away for free (well, not often -- they're doing it again in Kansas and other areas of the Midwest) because they're not making more of it, and someone will probably buy it at some point in the future.

I'm just making a point that real estate prices are based on many factors, including the relative value of nearby real estate. But there's no separate "worthiness number" that everyone agrees to. It's worth what the market says its worth.

I think the poster was refering to the idea that real estate can be rented ... you're coming up with a figure that represents how much it's inherent worth as an asset, and that this figure may or may not be related to a sale price.

That speaks to intrinsic value -- cash flow. The ability to generate a cash flow would affect a potential sale price, yes. But a sale price would be based in part on the expectation that said cash flow would continue into the future, and that cash flow is based on the likelihood that people will rent, and how much they're willing to pay.

It all comes back to "it's worth what the market says its worth."
posted by frogan at 11:08 AM on February 3, 2006

I"m surprised no one has mentioned it, but some new construction can decrease property values; think of an oil refinery or nuclear power plant going in your neighborhood, to use a couple of extreme examples. This is one of the arguments given by people who support strict zoning ordinance-they are thought to protect property value.
posted by TedW at 2:55 PM on February 3, 2006

(Hit post too soon) And this includes maintaining property value by limiting the number and types of residences in a given area; single family, multi-family, mobile homes, and so on. Also, if an area is overbuilt and units go unsold or unrented, you do indeed have a bubble and prices can come down drastically. This happened with the Port Royal condominiums in Augusta; they were touted as a high-end residential-shopping development but so few units sold that the developers sold ouf for pennies on the dollar and actually refunded a significant portion of the purchase price for those few who did buy. The mall at the bottom of the high-rise condos also went belly-up and became the national science center.
posted by TedW at 3:10 PM on February 3, 2006