Just like any other good or service, the price of real estate is affected by the law of supply and demand. At its most basic level, when demand for homes is high and supply is low, prices tend to higher, and when demand is low, prices tend to be lower.

But what are the factors that influence demand and supply in the real estate market? Why are homes in certain locations much more expensive than in others? What causes sharp, and sometimes sudden, declines in home prices? Why can it still be tough to purchase a home at a reasonable price, even with a stable supply?

Let's examine some of the main factors that influence the demand-supply of real estate:

Interest rates

Interest rates play a fundamental role in the demand for real estate. In general, the lower the interest rates, the higher the demand for real estate. A low-interest-rate environment means that the cost of borrowing is lower, which means buyers will be comfortable spending more on a home. Conversely, higher interest rates mean higher borrowing costs, which dissuade buyers from taking on expensive mortgages or even foregoing buying a home altogether.

The Economy

The economy plays a key role in shaping the demand for real estate. A booming economy, marked by low employment, rising wages, solid business investment, and healthy consumer spending, generally results in higher demand for real estate. The reverse also holds true; a sluggish economy marked by low unemployment, stagnant wages, low business investment, and tight consumer spending, usually translates into a low demand for real estate.

If a recession is on the horizon, consumers feel less secure about job retention and being able to afford mortgage payments. Consequently, they may decide to wait until the economy improves, before committing to a home purchase.

Immigration and foreign investment

Immigration is an important factor that drives the demand for real estate. The more immigrants there are in the country, the higher the demand for real estate, with the converse, also being true.

As immigrants arrive in Canada, they purchase homes, driving up the price of real estate in the city they reside in. Certain cities in Canada are more popular with immigrants, such as Vancouver and Toronto. Consequently, the cost of real estate in these cities is much higher than in places like Edmonton and Winnipeg.

Foreign investment in real estate also has an impact on the demand for real estate. As more foreigns look for safe and lucrative investments inside the Canadian real estate market, home prices will remain high. Should the trend reverse, prices would drop accordingly.

Government policies

Government polices that surround real estate play a role in the demand for real estate.

In recent years, the government has introduced stricter mortgage qualification rules for homebuyers. The most notable of these is the mortgage Stress Test, where prospective homebuyers must qualify at the greater of their approved mortgage rate plus 2% and the Bank of Canada's five-year benchmark rate. The result has been the erosion of homebuyers' purchasing power, which translates into lower demand for real estate.

To alleviate some of the pressure put on homebuyers by the stress test, the government has introduced the First-Time Home Buyer Incentive program (an arrangement where the government offers to finance a portion of the home, in return for an equity stake), as well as increased the amount one can withdraw from their RRSP (under the Home Buyers' Plan) to put towards the purchase of a home.

Active listings

The number of homes available for home buyers greatly influences the supply of real state. A greater number of homes means that there are many choices for consumers, which generally translates to lower prices. Conversely, if there are relatively few properties available, consumers have fewer choices, which pushes prices upward.

Permits

Government regulation in the real estate market greatly influences the supply of real estate. If policies related to permits are liberal, firms will build more homes, resulting in lower prices. However, should policies severely constrict the approval of permits, fewer homes will be built, sending prices upward.

New home construction

If demand for homes is high enough, this usually spurs construction of new homes, particularly in an expanding economy where prices are soaring and builders know they can easily find buyers.

If new home construction is restricted due to red tape or lack of available land, the result will be a low supply of homes, which translates to higher prices. Should the opposite occur, a greater number of homes will become available, resulting in lower prices.

Land

Land is finite. You simply can't produce more land if there is an increase in demand for real estate. The amount of land available will dictate the supply of real estate. If there's plenty of space, more homes can be built, which puts downward pressure on prices. If little land is available, fewer homes can be built, resulting in upward pressure on prices.

Land use can be restricted due to the natural environment (mountainous landscapes, for example, are generally not desirable locations for home construction), government policy, and local opposition to new home expansion.

There are many factors that affect the demand and supply of real estate. Whether you're planning to buy or sell, it's beneficial to get acquainted with the factors that drive demand and supply in the real estate market - you will be better equipped to make smarter decisions.

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