Is the Real Estate Market Inefficient?

[Mike Russo]

I recently heard a investor on a podcast say, "The real estate market is the most inefficient market in the world." I stopped to think about that statement and I'd like to flush it out. Do you agree or disagree and why?

Thanks much!

Mike

[David Faulkner]

This topic has got me thinking further and I think there is great potential for discussion as the answer can be quite nuanced. So, forgive my wordy reply, but here is my attempt to drill down into some of that nuance.

First, what conditions create an inefficient market? To me inefficiencies can occur when there is a low number of buyers or sellers. Other useful definitions are demand is the number of willing and able buyers at a given price and terms; supply is the number of willing and able sellers at a given price and terms. You have to have both a buyer and a seller that are both willing and able to close in order to create a transaction, and price and terms are the market mechanisms for equalizing supply and demand to create transactions across a market of buyers and sellers ... inefficiencies can occur when there are distortions in the market that limit the number of buyers or sellers or otherwise creates an inequality between buyers and sellers that cannot be easily resolved by the usual market mechanisms of price and terms.

Inefficiencies can have a dark side, as eluded to in comments above ... if an inefficiency is artificially created so that a more sophisticated operator can rip off a less sophisticated, weaker, and/or desperate person, that may be profitable and even legal, but can also be morally appalling IMO ... this never gets discussed in polite conversation here on BP but think it is important to understand. Besides the moral implications, as a pragmatic matter creating and exploiting this sort of inefficiency in my observation over the years is neither scaleable nor long term sustainable. For me, the liptnus test is "am I really adding value to this transaction?""Value" comes in many forms ... labor, money, knowledge, skills, creativity, etc. If the answer is no, and yet you are making lots of money (or you are making way more money than you reasonably should in proportion to the value you are adding), then it is highly likely IMO that type of transaction is immoral (and perhaps illegal), not scaleable, and not long term sustainable. Also on the dark side of inefficiency, both buyers and sellers can get fleeced ... I would not always assume that you will be on the winning side of "inefficiency", especially if you are a newbie.

There are other inefficiencies that are much better to seek out IMO. If you've ever heard the phrase "the riches are in the niches", that is all about seeking out and exploiting market inefficiency. By limiting your scope to a very narrow RE asset class and becoming an expert in it, you are in effect limiting the competition. There may be lots of buyers for single family homes, but there are not many buyers for under 900 SF, 2/1, single family homes between the 800 and 1000 block of Houston Street, in the city of Springfield. Plus, it is much easier to become the most knowledgeable investor around in that particularly narrowly defined asset class so you can more easily find and exploit inefficiencies for profit.

Finally, there is gold in the definition of willing and able buyers, particularly in the "able" part (buying stuff that others are not "willing" to buy can be much riskier). If you are able to seek out situations that naturally occur (trying to artificially create them is bad practice IMO) that severely limits other buyers' ability to close, and you become an expert in finding and closing those type of deals, then there will likely be lots of inefficiency and likely lots of money to be made. The simplest example is a property that requires an all cash buyer ... there are fewer of those, so that property will tend to trade at a discount. Take that further, though ... what if your niche is properties that require an all cash buyer, that is stuck in probate between multiple feuding heirs, and has serious title problems that must be cleared before anyone can buy ... how efficient do you think that market is? If you know how to close those transactions, how much competition do you think you will have? Are you adding value to those transactions and are the conditions that limit competition artificially created by you or naturally occurring? Again, the riches are in the niches. That is just one made up example too ... there are as many micro-niches like that as there are successful REI investors out there.

The above are just my theory, opinion, and observations over the years ... I hope that this sparks some further thought and conversation or at the least helps others navigate the intricate and fascinating landscape of RE market inefficiencies.