Principle of substitution in property prices

An economic principle known as substitution can have a large influence on property prices across every market and every country in the world. In a rational market, when two or more properties share similar desire, utility, and purchasing power, buyers will be more attracted to a property with a lower price. To put it another way, a property’s price is deemed by the price and quality of a substitute property. As with the law of demand, lower the price and buyers demand rises – a key reason why Real Estate Agents list properties under market value.

Take the scenario economist’s use – Coke and Pepsi are similar products to drink. If the price of Coke increases, the quantity demanded decreases. Consumers refuse to pay the additional price and choose a similar drink such as Pepsi. This results in a spike in the quantity demanded for Pepsi and creates a positive shift in there demand curve. The decision by Coke to increase their price has had a favourable result for their competitor Pepsi and has even increased Pepsi’s market share.

This is why timing the sale of property is important. Both listing a property and auctioning a property should consider the relevant substitutes in a market as a major priority over other things such as what season of the year it is. The more comparable properties listed in a market the easier the market adjusts to price. If no substitutes exist in the market, you have a scarce asset which increases demand and therefore price.

If you think about it, Real Estate Agents have the capacity to manipulate a market based on their understanding of substitution.  

The principle of substitution for property isn’t perfect. Real estate is heterogeneous or in other words each and every property is unique to each other. Even apartments that share the same design, quality, size, configuration, colour etc cannot share the precise position on the ground or in the air. This means no property is a perfect substitute, therefore people hold a differing view of what constitutes a substitute property in a market, and is somewhat open to interpretation. Because of the differing interpretation, some buyers will desire a property more than others and pay a higher price.

As originally mentioned, in a rational market substitution means a buyer will not pay more for one property than what a similar property sold for. However, this does not consider a buyer’s anticipation of future value. The anticipation of future value refers to paying a price today based on the perceived future benefit of the asset. For example, where a buyer believes a property will return an expected result in the future he/she may pay a premium today. In this situation the buyer may ignore substitutes in the market based on the perceived future benefits.  

Overall, the principle of substitution works well in most markets, however it works best in conformed markets. Conformed markets are found in new suburbs or new apartment buildings. In these areas many dwellings share similarities e.g. 4 bedroom, 2 bathroom, double garage, recently constructed single storey brick veneer on 450sqm of land. Due to the similarities and lack of scarcity, it’s much easier to determine a market value in those locations.

Identifying the right time to buy or sell can be determined by understanding where markets are at. Property statistics will uncover many points raised in this article to maximise potential. To know more about how property statistics can help, download a free ebook now.  

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