provided by: 
There are 8 different components worth thinking about when trying to figure out why real estate prices are where they are today and where they are likely to go in the future.
-2 Physical factors, land and structure
-2 Legal factors, laws and contracts
-2 Economic factors, the economies performance and economic value
-2 Psychological factors, fear and greed
Real estate values rise and fall due to the interaction of these 8 basic components. Each component lives somewhat in its own environment and may or may not be directly related to real estate prices at any moment in time, but each one can and all together do dictate where prices are now and where they will be in the future.
The simple all encompassing concept behind real estate prices is supply and demand. The ratio of the number of buyers and sellers at any given time in a free and open market dictates market price. More buyers or less sellers = higher prices. Less buyers or more sellers = lower prices. Supply/demand ratio=price. Each of the 8 factors either affects supply or demand, one way or another.
Weve been taught to believe that real estate is one of the freest and most open markets in North America, but how free and open is it and how are prices affected by restrictions?
How each of these 8 factors affects the Real Estate Market
Land and Structure
Real Estate technically is just the land. Any structures that are permanently situated on or in the land are considered to be separate from the land and rightly so. Land value itself is influenced by a different set of factors than structures. Structures are more or less valuable depending on the cost to replace or bring a structure up to current standards. Land is more strictly influenced by pure supply and demand.
The two can run together, both increasing and decreasing with similar demand, but there are specific instances when they dont coincide. After a recession construction costs tend to be at their low, along with real estate prices. As the economy increases, spurred on by low interest rates housing demand increases faster than construction costs, pushing up the land value. Latter on in an economic up period, construction costs increase, sometimes dramatically. This can increases the value of renovated and newly onstructed structures, faster than the land value itself.
Lands value as a function of location is strictly dictated by supply and demand. Think of locations as being part of a pyramid structure. The most desirable at the very top and the least desirable at the bottom. Few at the top, many more towards the middle and the bottom. As the money supply increases (lowering of interest rates) demand increases overall but supply is most limited towards the top, this pushes prices higher faster the closer you get to the top of a pyramid. I believe that every market and all local markets have this pyramidal type structure.
Laws
There are very few restrictions on who can own, but there are some barriers. Financing a purchase in Canada, by a foreign resident is much harder than for those who live here. Governments dictate who can own and how they can own. Governments routinely change land use classifications, zoning by-laws and building codes which are all restrictions to a free and open market. Governments, at rare times, have restricted price increases and or the ability to buy or sell to meet government objectives.
One real estate market segment that governments seem to be more interested in restricting is the rental market. Here some governments have created a multitude of restrictions and inducements to influence the market to attempt to meet government social policy. Another arena of market restriction to meet social policy is land designations, such as green belt, wetlands and brown-lands.
At least compared to the health market, real estate is reasonably open and free. Baring new major government intervention, causing a slap to the side of the head, knock out punch, or jackpot win, the other 7 factors basically set prices with some proviso for the rental market.
Being so, this leaves the other seven components to be the major influencers of the demand for and the supply of real estate most of the time.
Contracts
Any contract that encumbers the property, rental or otherwise, which adds restrictions to the use or sale of a property influences the market value. This includes lease or rental contracts, easements, right of ways etc. If you have your property leased for a long time to a class A tenant who is paying mucho rent, then your property is worth mucho more than next door which is leased for a long term to a no-class tenant at low rent. If you lease your garage in a high garage demand area to your brother for a long time for brotherly rent, then you may have affected the value of your property downwards.
The Economy
Real Estate, in general, is mightily affected by the economy. When the economy is good earnings increase, jobs are more plentiful, most feel positive about the future and there is more money around especially when interest rates are low to stimulate economic activity. In good times lenders will give almost anyone money to buy property. When the economy is good demand for property increases, prices go up. Whats me Worry!! Governments, at least government created organizations like the Bank of Canada and the US Federal Reserve use interest rates to try to influence economic activity one way or the other, to increase it or decrease it. Real estate is affected by the increase and decrease in rates, but is more affected by the attitude towards the economic future than the rates themselves. There have been times in the past that rates went up substantially and had no effect on real estate prices, because the economy was still going strong. But when the economy turned down and the rates were still high, what a head ache. Peoples perception of their economic future is the most important economic factor in their deciding whether to buy or sell.
Economic Value
Every piece of real estate has economic value; this value can be the amount of consideration that is received at a moment in time for your ownershipa sale. Or it can be consideration to give up certain rights over a period of time to someone else a lease, rental, option or the like. Every property can be either leased or sold to release its economic value. The two values are somewhat related in that the more you can get for rent the more someone will pay for the right to own that property, but the driving forces behind the rental market and the ownership market arent always in sync. During an economic downturn the demand for ownership drops and the demand for rentals increase. The opposite is true in an economic up-period, the value of ownership increases as more people move out of rentals.
Fear and Greed 2 sides of the same coin
When the economic outlook is good and especially when interest rates are low renters, actually anyone who is interested in buying property, or more property, fear that if they dont buy soon they will lose out. Demand increases. Speculative sellers, or anyone who has a reason to sell, feel that if they sell to soon they will lose out, so they dont put there properties on the market restricting supply, sometimes dramatically. Where new construction (supply) is not available, supply doesnt increase to meet demand and the supply/demand ratio tilts in favour of sellers and prices go up. .
When the economy starts to turn down speculators, actually anyone who has a reason to sell, fear losing out and put their properties on the market to capture as much current value as they can, increasing supply. Renters, actually most buyers, fear that they may not have a stable economic future and may be buying as prices decline so they exit the market decreasing demand. Those who trade properties dont feel the urgency to move anymore fearing unsettled economic times and declining prices. The supply demand ratio turns to the favour of buyers causing prices to decline. Everyone is in a bad mood except renters with jobs. An interesting aside; all owners of property have a vested interest in seeing property values rise. All renters have a vested interest in seeing values drop, but the second a renter becomes an owner their vested interest becomes to see property values rise.
Greed fuels demand and lower inventory increasing prices, while fear decreases demand and increases inventory pushing prices lower.
Summary
Big increases in economic activity can cause prices to rise quite quickly. Big declines in economic activity can cause prices to decline sometimes quickly too. An economy that continues on at a reasonably positive level over time can lead to a more balanced market where the top of the pyramid continues to see high demand but as the increase in number of new buyers decline the middle range inventory increases and demand slows stabilizing prices. At the low end of the pyramid where most first time buyers buy, supply of new construction can increase dramatically in relation to demand keeping prices in check or even putting them into decline until the supply demand ratio levels out.
The economy and economic outlook are the most important factors affecting overall prices in a market. Fear and greed are to a large part an offspring of the economy but can also influence pricing (supply/demand) when laws change, (ask Montrealers about property values after Quebec passed their language law) or are about to change or when some irrational thinking takes hold for whatever reason.
Contracts, local laws, location, structures and economic value will always affect a specific properties value in a very individual way, in addition to fear and greed and the effects of the economy and its future outlook.
article at HomeRenovationGuide.com