Suppose there was no real estate market for several years. No homes sold, no homes for sale.
Suddenly, in Serra Retreat, in the heart of Malibu, word leaks out that somebody would like to leave and not come back. They want to give up their home. The news spreads like wildfire across the Southland. Over several weeks, inspired by the hope of living in a beautiful neighborhood close to the ocean, nice restaurants and a controversy-ridden lagoon, hundreds of thousands of persons come forward to make a claim on the property. How to decide who gets it?
The answer is obvious. The owner would pick the person that exchanged the most value to him, in US currency. All interested parties, after viewing the home, would assess their financial strength to determine how much money they would be willing and able to exchange for the property. On a special, appointed day, all suitors would be asked to declare their highest bid, with free cookies in the back of the room. Perhaps a few individuals would go as high as $3.4 million. Ultimately, one person would be willing to pay $3.5 million. The homeowner would give it to that highest bidder.
That, in essence, is how value is attributed to property. The above scenario takes place in truncated form almost every day in Malibu, as well as millions of places throughout the world. When a transaction takes place, and a buyer and seller agree on a mutually beneficial exchange, it represents the highest bid on the property at that time.
The price paid for a home is a gauge of how much demand there is for the asset. A $2 million home, by definition, has higher demand than a $1.5 million home. Unlike in the above scenario, however, there are always other competing properties for sale. They may not be in Serra Retreat, specifically, but other choices exist somewhere for the bevy of buyers that wishes to make a move or investment at that time.
Traditionally, an estimate or hope of the winning bid amount is created in the very beginning of the process. The property owner establishes an asking price, often referred to as a listing price, if a broker/agent is selected to represent the property.
With the price working from the top down, every sale is essentially a process of market forces producing a winning bidder. Frequently, it is just one entity that bids for the property, and while they usually disagree with the seller at the outset regarding the value of the property, they may come to an agreement on price in the end. Usually, the highest bidder is determined only after the seller agrees to lower their anticipated price.
Being on the market for a couple years with no offers will do that.
While the framework is the same for every deal, every situation is unique.
In some cases, multiple buyers are bidding on the property, as there may be a scarcity of homes like it, and the seller may take a bid of more than what they hoped. Other times, the seller has an inflated expectation and nobody wants the property. It is essentially worth zero at that point. The moment the seller lowers their expectation to inspire a bid, or the moment a buyer makes an offer of a certain amount, a new value is established.
It may be only a fleeting value, however. A sale may not consummate and the home may not transact until some time later. A seller may turn down $2 million and end up taking $1.5 million later (see years 2008-2011).
Conversely, a sale that never happens may precede a hot market where the same home sells for $3 million (see years 2013-2015—maybe). Time plays a very important role in the motivation of the buyer and seller.
As such, there may be occasions that a property sells for a lower amount than anticipated, perhaps because the seller felt very motivated and the buyer did not. Meanwhile, a very similar property sells for more money because the buyer in that case was anxious and the seller was not. Every deal, while it represents the combined reality of the general market forces and the specific motivations of the principals, is a new snapshot of value.
Sales prices of previous comparable properties provide a guideline to what a future result may be. And while anticipated future value of property is always in flux, having knowledge of the trends can be financially beneficial. Knowing the supply of sellers and their aggregate motivations can give one an advantage as one negotiates on a price.
Principals in real estate transactions often take a more cavalier attitude, rather than accept the above tenets. Sellers often ignore information of recent results and rely on their emotions to set a wishful estimated value of price, ignoring the plentiful other choices available to buyers at the time or perhaps the lack of buyer confidence in the market. Doing so has its risks. Inevitably, the agreements of sellers and buyers are subject to the fundamental market forces in play. Buyers who wait to buy may be better off or worse, depending on the decisions other buyers are privately making.
With every transaction, there is a zero sum gain of winner or loser. To the extent one party has apparently benefitted beyond recent comparative results, the other party has lost.
What is more important is that both parties, based on their needs and motivations, have chosen to go forward with the exchange. Both sides are willing to carry out the transaction for their purposes. And a new value is momentarily established for that property.