Imagine for a moment that you have a crystal ball.

Looking into it, you can see everything that’s going to happen in the real estate market — which neighborhoods are going to climb in value and which ones are going to depreciate; which houses are going to sell fast and which houses are going to sit on the market; which improvements will help sell a property and which improvements won’t. You’d be able to make the right decision every time and make lots and lots of money.

Well, what if I told you something like this crystal ball actually exists?

It’s called the Law of Supply and Demand. If you’ve taken a civics or economics class, you’ve probably heard your professor droning on about it and its importance, but you never thought it would be useful. In the everyday life of a teenager or college student, I suppose it’s not, but in the real estate world, it governs several of the most important variables we track:

• Appreciation
• Depreciation
• Price
• Days on market

In other words, Supply and Demand influences how much money you make and when. If you know what price real estate is going sell for and when it’s going to sell, you can time your purchases, improvement, and sales for the maximum benefit. You can also get out of the way when the market takes a nosedive.

Sound important? You betcha.

How Supply and Demand Applies to Real Estate

If you pick up in economics textbook, it’ll probably tell you that Supply and Demand is the study of the relationship between price and the sale of goods. If supply is high and demand is low, then the price of the goods will go down. If the supply is low and the demand is high, then the price of the goods will go up. If supply and demand are equal, then the price will stay stable.

How does this apply to real estate?

Let’s say you live in a neighborhood with 50 houses. A major employer just closed down, so more people are moving out of the area than into it. Out of the 50 houses, 15 are for sale and there are approximately 5 buyers shopping for this particular type of house in this particular area.

• Supply: 15 Houses
• Demand: 5 Buyers

It’s a simplistic example, but you can use the above numbers to make a prediction. Since there are more houses (supply) than buyers (demand), then the price should start drifting down. Sellers will have to compete over the shortage of buyers, and eventually, the only way to do that is by lowering your price.

Days on Market: an Indicator of Demand

Of course, there’s one glaring problem with this example. Unless you’re psychic, you don’t know how many buyers are shopping for houses at any given time, nor can you know for sure whether you’ll have more or less buyers six months from now. So, how are you supposed to calculate the demand in the real world?

Days on market.

The Days on Market (DOM) variable is the number of days the property has been for sale on the Multiple Listing Service (MLS). In the above example, let’s say that those five buyers each purchase a house, leaving 10 houses on the market. The owners of those 10 houses will have to wait for the next crop of buyers, and because of that, their house will sit on the market for a longer time than the first five houses.

So, as a general rule, if you notice houses sitting on the market without anyone buying them, then demand is probably low. Using the MLS, you can even see when houses were listed for sale and how long they’ve been on the market. Then you can compare the days on market of the current houses for sale to houses that have already sold, and you’ll see whether it’s going up or down.

For example, let’s say there are 10 houses for sale with an average Days on Market of 180 days. Last year, five houses sold with an average Days on Market of 90 days. Since the Days on Market has doubled from one year to the next, then it’s probably a safe assumption that the market is suffering from demand being lower than supply. You’ll probably start to see prices go down over the next few months.

Likewise, if you notice the Days on Market decreasing, then it’s usually safe to assume that the demand is higher than the supply. You’ll probably see the price of real estate increase over the next few months.

Taking It a Step Further: Watching Market Indicators

Why do newspaper columnists spend so much time talking about upcoming developments and the activities of major employers? For two reasons, actually. One, because people think it’s relevant, so they buy more newspapers, and two, because it is relevant… sometimes. In fact, there’s a host of indicators that control whether the market is going up or down, and the wisest of investors pay attention to them.

Here are just some of the indicators:

• Job growth and layoffs
• Average household income
• Crime rate
• Property taxes
• Quality of schools and roads
• Rate of development
• Availability of city water and sewer
• Road traffic counts
• Proximity to a major highway
• Proximity to water

By looking at the trend for the Days on Market, you can make a basic estimate for what the market is going to do, but it’s only good for a few months at best. If you really want to know what the market is going to do long-term, you need to pay attention to the above factors.

Just about all of the successful investors I know read a stack of newspapers every morning in their target markets to keep an eye on what’s going on. If you see an announcement for a new 500 home community coming up in a rural area, it’s a good indication of growth. The same goes for a major employer moving into the area and hiring 10,000 people.

Then again, the reason I say it’s only relevant sometimes is because you have to put changes in context. If you see a new develop popping up, keep track of how fast houses are selling. If they’re having trouble clearing their inventory, then maybe they overestimated the demand. You might actually see a dip in prices.

Also, be aware that indicators change supply and demand in different ways. One neighborhood might benefit while another will suffer, and vice versa. It’s all about the interaction between the different variables affecting the market, as well as the type of people buying and selling in that market.

Sound complicated? Well, it is. This is such an advanced strategy that I hesitated to write about it. The bottom line is start paying attention and you’ll eventually get a feel for it. Seasoned investors that have been in the business for 20 or 30 years can do it almost totally on instinct, and in time, so will you.

Should You Only Buy in a Good Market?

People assume that you should only buy real estate when prices are going up and the market is hot. It sounds reasonable — millions of people make money from appreciation every year, so why not buy in the area that’s appreciating the most?

Because it’s not always the most profitable.

One of the most successful real estate investors I know makes conservative, slow growth investments until we hit a recession and then buys up everything he can at huge discounts. From there, he improves the property and then rides the market back up. He’s done this two times in the last two years and has made over $200 million.

The reality is every type of market has its advantages and disadvantages. If you’re in an up market, you make money from appreciation and you can liquidate your properties faster, but it’s also harder to buy real estate at a discount. Similarly, it’s hard to sell your real estate for value in a down market, but it’s easier to pick up deals.

So which is better? Neither. You can make money in any market. You just need to choose the right strategies for your particular situation.

How to Make Money in a Seller’s Market

In a seller’s or “up” market, the demand for real estate exceeds the supply, causing prices to increase and only short windows when you can buy the property before someone else snatches it up. Because there’s so much competition, it’s hard to buy anything at much of a discount.

So what do you do?

Improve the property. If it’s impossible to buy a property at a discount, then you need to pay full market value and make improvements to the property to increase its value. Then you can sell it to hungry buyers that are eager to pay the new, higher price. In other words, buy high and sell even higher.

The key is making sure that the improvements cost less than the value they create. For example, adding a pool will rarely increase the price of a house enough to justify the cost. So don’t do it. On the other hand, adding a bedroom or improving the landscaping can create a jump in value larger than the cost, so it’s a worthwhile investment.

Here are some other examples of how to make money from improvements in a seller’s market:

• Buy a rundown apartment building, fix it up, increase the rents, and then sell it.
• Buy a house with a large lot, subdivide the lot, and then sell the extra lot or lots to a builder.
• Buy a large tract of farmland in a rapidly developing area and rezone it for the creation of a neighborhood or village. Then sell the rezoned land to a developer
• Buy an older house in a great neighborhood and refurbish it, making it a dream home for the next 20 years.

How to Make Money in a Buyer’s Market

A buyer’s market.

Most investors dread it like the plague. It means there are more houses for sale than buyers, so properties are sitting on the market for a long time and gradually depreciating to account for the low demand. In other words, your investment properties are going down in value and you can’t get rid of them.

If it sounds like a nightmare, it is… for most people. A savvy investor can make money in any market, and the “down” market is no exception. With everyone slashing their prices, you can pick up some properties well below their potential value — 20, 40, or even 60 percent below the appraisal price.

Then you have two choices.

First, you can hold onto the property until the market improves and then sell it for a higher value. The advantage of this strategy is it doesn’t take much work. You just buy and wait. The downside is, you might lose money every month on payments until the property sells. If the rental market is holding up, you may be able to rent it for enough to cover your payments, but sometimes you might have to take a loss.

Your other choice is to somehow transform your property into something buyer’s will want and then sell it for a still reduced but significantly higher price. If you decide to go this route, the most important distinction you can make is you’re competing over buyers. You’ve got to change something about the property to make it more desirable to them. Otherwise, it’s unlikely that you’ll have any better luck than the previous owner.

What kind of changes can you make?

• Put the property in pristine condition. Buyers have their choice, and they’ll want the property to look perfect.
• Rather than just putting the property on the MLS, figure out who your ideal buyer is and target them directly. Think sniper rifle, not shotgun.
• Offer better terms. Offer to finance their down payment, buy down their interest rate, or provide an allowance for further improvements.
• Throw in bonuses. Include a brand new washer and dryer, television, and/or refrigerator. This works well when you’re selling to first-time home buyers.

On Becoming a Market Specialist

In the beginning, it’s important to learn both up market and down market strategies. Your local market will flow up and down, and you’ll probably be limited by time constraints on the geographic area you can invest in. So, you’ll have to adapt to whatever the market is doing, using up and down market strategies at the appropriate times.

Eventually, you’ll notice that you do better in one market than another. For example, I do exceptionally well buying luxury foreclosures in down markets, fixing them up, and then reselling them. I can still make money in good markets, but it’s much harder. My father is exactly the opposite. He makes 10 times as much in good markets, buying and improving land.

Once you start to notice a pattern in your own investing, you’ll have the option of adjusting your lifestyle to suit it. Because my father does well in up markets, he moves to a different area every 3-5 years, riding the market to its peak and then moving on to another one.

If you decide to take the leap into full-time investing, I recommend you take the same approach. Master one particular market strategy and then invest only in that market. It’s a much more active and profitable type of investing, where you use the market conditions to your advantage, instead of allowing them to control your approach.