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What’s the value of a home? Of course prices change over time, but there should be a standard formula for determining the value of a home. It turns out that like anything else, it’s related to the benefits that come with it. The physical characteristic of the house aren’t the deciding factor in price, or homes in Georgia would command the same prices as homes in San Jose. To a large degree, it’s related to availability of jobs. People will buy homes near good paying jobs. Their income determines how much house they can afford. Even within a metropolitan area, homes with shorter commutes to employment centers command higher prices. Logically, there should be a way to calculate a home’s value based on its location. Economists have come up with such a formula, and it turns out that prices do tend to move in the direction of the correct value over time.

If this is true, we should be able to do the math and go out and buy a home for its actual value? Right? Not exactly. In the near term prices fluctuate with other factors, like availability of funds and buyer and seller expectations.A few years back, lenders were making stated income loans left and right. If you could afford the teaser rate, you could buy a house. The increase in demand drove prices up above the realistic values. No one worried about what would happen when the rate increased. They assumed that prices would continue to rise and mortgage financing would be available. But of course artificially inflated prices can’t last forever. When mortgage payments on those subprime loans increased, it all started crashing down.

A market correction was definitely in order, but as we often see, it went too far. Lenders didn’t just stop lending to buyers who can’t afford the payments. They made the requirements so stringent that even buyers who could qualify during ‘normal’ times couldn’t get a loan.And a flood of distressed properties and forclosures drove prices well below their values.Now potential buyers want to wait until prices have bottomed out. But when will that be?

Time and time again, history shows us that the market will overcorrect. Just as we got carried away with optimism when prices were increasing, fear will drive market value too far the other way. When will it stop? A few smart buyers won’t be able to resist the bargains any longer.  If you can buy something for less than it’s worth, you come out ahead – even if someone else gets the same thing for a dollar less the next day. Once it starts, then more buyers will join in and the prices will start increasing. Most of us won’t know that has happened until months after the fact.

Economists are starting to tell us that residential real estate is undervalued in many, but not all, cities. Which markets, you ask? The areas that saw unrealistically huge price increases are now suffering the largest declines. In a review of Southern California real estate prices, Global Insight said that real estate in Los Angeles is 6.4% undervalued, Orange County real estate is 10.9% undervalued, homes in Riverside-San Bernardino are 15.7% undervalued, and San Diego homes are 21.2% undervalued.

Does that mean you should rush out and buy a home in San Diego or Riverside?  It depends.  Even within a geographic market, the situation is different in various market segments. There are still a lot of distressed properties and foreclosures on the market, mostly starter homes. At the same time, move-up homes are in short supply. If you’re looking for a condo, you might want to wait a little longer.  If you’re looking for a move up home, there are some great bargains.  And right now interest rates are at historic lows and the government is offering tax incentives to home buyers in an effort to get the real estate market moving again.