The Problem with Zillow’s Algorithm

Oct 9, 2023 | Finconomics 101, No Bull Economics

Nobody could afford their own homes if they had to pay market value. What gives?

Commentary

  • A recent conversation that went something like this: my friend’s father purchased his house for $370k a long while back and the house next door is under contract in the eights. Wow!
  • After that house sale closes, Zillow will undoubtedly value the father’s house in the eights if it is not already valued for a similar amount. If Zillow says the house is worth in the eights, then it is economic law. After all, isn’t Zillow using inscrutable AI?
  • However, what if everyone on the same street listed their houses for sale at the same time? An increase in housing supply would drive a valuation decline, but by how much?
  • We propose that given a sufficient supply, the residential valuations would find an equilibrium as defined by some multiple of an average salary in the area. Notably, this multiple would certainly reflect mortgage rates, with higher rates translating into lower multiples and vice versa.
  • So, the question is: should homes be valued by supply/demand dynamics or by financial fundamentals? Well, it depends on whether you are a buyer or a seller…
  • In any case, we can see from the chart below that current home prices are trading for over 6x median household income levels. Even Zillow’s AI can recognize that this is not sustainable…
  • House price equilibrium will eventually be achieved as salaries increase (hopefully), but more likely when mortgage rates start to decline & new builds start to ramp-up. 

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