In the short run, home prices will be strictly determined by demand. Supply cannot be brought in line in a short time-frame. It takes time to get permits, draw up architectural plans, bring in earth-moving equipment, etc. Therefore, a spike in the number of buyers along with a fixed supply of homes will result in home prices shooting through the roof.
In the long run, however, prices will be mostly determined by supply, particularly from the cost of construction and land prices. If homes are selling for $300,000 and the cost to buy the land and build a near-identical home is $200,000, then home builders will find themselves busy. Sufficient supply then would bring the price back down to the point where incentives to further build would disappear.
If the cost of construction were to spike, say due to rising prices of lumber, bricks, copper, the construction crew’s wage rate and/or many other considerations that go into construction, then naturally home price will be pushed up as well. If the cost of construction is not rising, but home values are, then one should pause to consider how home builders will respond to those situations before submitting an offer.
There will be times when home values will fall well below the cost of construction and persist at that low level for a long time. One good example of this is Germany in the early 90s. After the fall of the Berlin Wall, many from the east of the country went searching for better paying jobs in the west. That left a depressing number of vacant homes in the eastern part and hence home prices fell well below the cost of construction and remained there to this day. At the same time, demand for homes rose in what used to be West Germany but without a rise in home prices because plenty of new homes were built to match the increases in population. In the U.S., parts of the Detroit Metro region have plenty of homes selling at bargain-basement prices, well below the replacement cost. Yet home prices are not moving up because a sizable number of residents have left the city. Only when population stabilizes or sees a rise can home values be expected to trend back up to their natural equilibrium, in line with the cost of construction.
It would appear then the natural long run home price is solely determined by the cost of construction. This cost, however, should be fairly similar across the country. The price of bricks in Portland, Oregon should be not that much different than in Portland, Maine, other than to account for the cost of transporting them. Then what accounts for the differences in home price between San Francisco (where the median price is $466,000) and Houston ($149,000), or from one neighborhood to the next?
In Houston and many interior parts of the country, the dynamics of the natural equilibrium price are always heeded. If there is strong housing demand, the builders simply build more at that price. Supply increases in line with rising demand. If demand falls, builders stop building.
That is not the case in San Francisco. If demand rises, builders do not build, because they cannot obtain housing permits. In some neighborhoods with unique, spectacular views from a hilltop, for example, there is simply no land available to build. In other nearby places, there is land but there are too many hoops to go through and loops to satisfy the planning office. Therefore, home price will be unrelated to the cost of construction in San Francisco. Prices simply rise, at times far above the cost of construction, and there is no new supply to bring it down. One would therefore expect the potential for sudden large changes in home prices in San Francisco depending on how demand changes. Given that supply does not respond to changes in demand, there will always be an affordable housing problem in San Francisco. There will be constant discussion among city officials about how to house the moderate-income families and what measures need to be taken to alleviate housing costs, but one should not expect any meaningful success as long as supply does not respond. Houston, on the other hand, mostly solves its affordable housing problem by letting builders respond to demand.
Finally, it is worth noting that at this point in the housing cycle, home values appear to be back to natural equilibrium from a broad nationwide perspective. If one assumes that home prices were justified in 2000 then prices are now justified in 2011 because the home values and the cost of construction in both cases match up nicely. Locally, you as the area-expert REALTOR® would know best on whether prices are justified and what should be the natural equilibrium price, based on whether supply can easily respond along with the local cost of construction.