The sensitivity of real estate demand to price changes is very important when selecting markets for real estate investments. For example, markets in which real estate demand is less sensitive to price changes are more preferable from an investment point of view because even if prices increase significantly, there will be a small decrease in demand.The sensitivity of real estate demand to price/rent changes is measured by the price elasticity of demand.
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Depending on the property type examined, the price elasticity of demand, eD, is calculated as the ratio of the percent change in the number of housing units or square meters of commercial space demanded divided by the percent change in property prices, per the formula below:
eD = Percentage change in quantity demanded / Percentage change in price
Note that the price change in the formula above ideally should be calculated on the basis of a constant-quality price index for the particular property type under consideration.
In essence, the price elasticity indicates by what percentage the number of housing units or square meters of commercial space demanded will decrease in response to one percentage point increase in property prices.
Given the negative effect of prices on demand, the price elasticity of real estate demand is negative. To better understand the concept of price elasticity of real estate demand consider a housing market with an estimated price elasticity of demand of -0.8. What is the interpretation of this number? This number tells us that if house prices increase by 1% housing demand in this market will decrease by 0.8%. Obviously, if house prices increase by 5% then we would expect housing demand to decrease by 4% (0.8*5).
According to economic theory, a price elasticity of demand that is less than one denotes an inelastic demand. Per this statement, the housing demand in the example above can be characterized as price inelastic, since it is smaller than one.
According to Mourouzi-Sivitanidou (2020), an inelastic demand schedule implies a small sensitivity of demand to price increases or that “large price increases induce relatively small decreases in the quantity demanded”.
Example of calculation of price elasticity of demand
To understand how the formula for calculating the price elasticity of demand for a property market is applied, consider a housing market in which an increase in house prices from $200,000 to $220,000 reduces total housing demand from 800,000 units to 760,000 units, assuming that no other factor that affects housing demand in this market has changed. We need to make this assumption in order to fully attribute this change in demand to the change in prices. In this case, the price elasticity of demand in this market can be calculated as follows:
Percentage change in house prices = (220,000-200,000)/200,000 = 20,000/200,000 = 10%
Percentage change in housing demand = (760,000-800,000)/800,000 = -40,000/800,000 = -5%
Price elasticity of housing demand = -5% / 10% = -0.5
Therefore, the price elasticity of housing demand in this market is -0.5, indicating that if house prices increase by 1% housing demand will decrease by 0.5%. This estimate suggests that the market under consideration has a quite price inelastic housing demand.
Price elasticity of demand and property investment
According to economic theory, the price elasticity of demand of a particular market and property segment is determined by the availability of substitutes. For example, a property segment or location with few substitutes should have a less elastic demand than a property segment or location with many substitutes.
Within this context, properties at unique and scarce locations, such as seafront houses and houses on hilltops with unique views, should have a more price inelastic demand than houses in any other location in the urban area due to the scarcity of such locations.
Similarly, one could argue that property demand for a particular submarket within an urban area must be more price elastic than property demand for the whole urban area since there are many substitutes for the former (other sub-markets) but hardly any substitutes for the latter (Mourouzi-Sivitanidou, 2020).
For example, if someone wants to go to live in the Los Angeles metropolitan area because his/her job is located there, there is a small chance that he/she will be looking for a house in other metropolitan areas, even if they are close to Los Angeles. However, there are many housing submarkets within Los Angeles where he/she may seek a place to live, depending on the location of his/her workplace.
A similar argument is true in the office market because most of the companies housed in a metropolitan area serve the local population and businesses. These companies can move from one submarket to another submarket within the same urban area and still be able to serve their local clientele. However, they cannot do so if they move to a different metropolitan area (Mourouzi-Sivitanidou, 2020).
The price elasticity of demand is relevant when assessing markets for property investment purposes because it can help assess the impact of changes in market prices on the amount of commercial space and/or number of residential units demanded.
Developers and investors should pay special interest to markets and projects with price inelastic demand because if prices/rents increase, revenues will increase as well. This will happen because the decrease in demand /absorption will not be enough to eliminate the gains from price/rent increases. More specifically, if property prices, P, go up, the quantity demanded, Q, will go down, but still revenue, P*Q, will increase because the decrease in Q is considerably smaller than the increase in P (Kau and Sirmans, 1985).
References
Mourouzi-Sivitanidou, R. (2020). Market Analysis for Real Estate 1st Edition. Ed. P. Sivitanides, London, UK: Routledge.
Kau, J. B. and Sirmans, C. F. (1985). Real Estate. New York, NY: McGraw-Hill, Inc.
