AMA - Can New Supply Stimulate Demand?

Robert from Detroit says, ”Victor, I love how you talk about real estate from a business perspective. It’s fresh, clear and its devoid of the industry jargon.

The question was if you’re in an area where there is a lot of new investment going into an area, such as downtown Detroit. This large scale development seems to be attracting new residents. It seems like the new development is creating new demand. Is this an area that would be a candidate for your buy on the line, move the line strategy?”

Robert, thank you for the kind words. This is an outstanding question. There are a number of forces at play here and we need to take all of them into account. You are correct in noticing that real estate is hyper-local. The revitalization of the downtown in Detroit is an ambitious project and I truly hope it is successful.

As you’ve hear me say many times, successful business always follows the laws of supply and demand. The revitalization project is creating new supply. What I want to see before I would invest in an area is the demand that will absorb all that new supply, plus a bunch more excess demand left over that didn’t get satisfied.

What I’m worried about in Detroit is that it’s a shrinking city. There is not the inflow of jobs that is creating additional demand. So this new supply will compete with existing supply in the market. It will steal market share from other properties and you will likely see other areas become run down as residents leave those areas. It becomes a game of substitution for one product over another.

Some people think that lots of brand new supply can stimulate demand. Here’s how I think about it. Imagine if you were a city planner and you were tasked with creating a public transit system. It might be light rail, or busses. Imagine for a moment that you decide to start small and you are going to put one bus per hour on each bus route throughout the city. Even though you added supply, I don’t believe it would get used very much. People would still use other forms of transportation. The new busses would be too inconvenient. If you realized that insufficient frequency of service was the problem and you decided to invest very heavily and now you have a bus or train coming every three minutes like they do in Tokyo. You would get a lot of riders using public transportation. It would be way more convenient, it would cost less than driving and parking your own car, and it would be faster because you would avoid all the rush hour traffic. More people would use public transit than ever before.

But notice, nowhere in this example did the demand for transportation increase. What happened was a substitution of public transit over other modes of transportation. Investment in a new product and bringing a lot of new supply of that new superior product can cause substitution. But it’s not creating additional demand that didn’t exist in the first place. So if your city has a shrinking population, the need for housing is actually going down. In a shrinking market, prices will eventually fall. They have no choice but to fall. That’s why you can buy houses in Detroit for under $20,000. Yes, eventually over time these houses become distressed, the city forecloses on them for unpaid property taxes and the homes become condemned and eventually disappear from the market. Now you’re left with vacant land in the core of the city. It’s a modest improvement, but not much.

You can get some local market effects happening when there is development in an area. I would definitely look for those types of conditions to see if there truly is demand. Otherwise it’s just a bunch of developers who have too much money on their hands and they don’t know what to do with it. The landscape is littered with major projects that have resulted in over-building.

The problem is a failure to properly assess the demand.