Finance & Accounting Apr 6, 2015

Let the Buy­er Be Aware

A com­mon error naïve home­buy­ers make helps explain hous­ing boom and bust cycles.

Yevgenia Nayberg

Based on the research of

Edward Glaeser

Charles Nathanson

What accounts for the ten­den­cy of hous­ing prices to steadi­ly increase for sev­er­al years — and then steadi­ly decline?

That decep­tive­ly sim­ple ques­tion may have a new answer, based on the research of Charles Nathanson, an assis­tant pro­fes­sor of finance at the Kel­logg School.

Few eco­nom­ic sto­ries get more con­sis­tent press cov­er­age than the hous­ing cycle. The media reg­u­lar­ly report on hous­ing starts,” or the num­ber of new home con­struc­tions, along with the aver­age cost of new homes and swings in sup­ply and demand. Near­ly every­one agrees that the health of the hous­ing mar­ket is crit­i­cal to the economy’s prospects.

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But for all that, there are few cer­tain­ties about pre­cise­ly what dri­ves the hous­ing cycle, espe­cial­ly the kind of extreme boom and bust that hap­pened in the ear­ly 2000s. Sub­stan­tial research into the ques­tion has not yield­ed a clear pic­ture of the hous­ing crash. Researchers are also strug­gling to come up with ways of iden­ti­fy­ing — or pre­vent­ing — bubbles.

The chal­lenge is that so many vari­ables — like fluc­tu­at­ing inter­est rates and con­struc­tion costs — affect the work­ings of sup­ply and demand. One thing is cer­tain though: sell­ers even­tu­al­ly over­shoot, buy­ers will not pay the ask­ing prices, and the boom becomes a bust.

How do buy­ers decide what they are will­ing to pay for what will like­ly become their most valu­able asset?”

Nathanson and his coau­thor, Edward Glaeser of Har­vard Uni­ver­si­ty, sug­gest that an error buy­ers make in assess­ing the future val­ue of a house helps to explain the ups and downs of the cycle. The error, which involves fore­cast­ing future home prices based on past and cur­rent ones, is small but wide­spread and con­tributes to momen­tum toward high­er hous­ing prices. When prices reach an unsus­tain­able lev­el, the momen­tum swings in the oth­er direc­tion, and prices return to the pre­vi­ous level.

One Deci­sion, Two Types of Buyers

For most peo­ple, buy­ing a house is unlike any oth­er pur­chase, and one with which they have min­i­mal expe­ri­ence. We usu­al­ly think of peo­ple as bet­ter at things they do repeat­ed­ly,” Nathanson said. Buy­ing a home is not one of those things for most peo­ple. More­over, a home pur­chase typ­i­cal­ly requires the buy­er to take on debt that she expects to pay back over the span of decades. Many buy­ers expect to sell their house at a prof­it before the loan is paid off. A house is an investment.

But how do buy­ers decide what they are will­ing to pay for what will like­ly become their most valu­able asset?

When you buy a house, you’re prob­a­bly going to sell it at some point,” Nathanson said. How much you pay for the house depends on how much you think you can sell it for in 7 to 10 years. That’s a dif­fi­cult prob­lem. To fig­ure that out, you’re going to look at past house prices and say, Are house prices in this area going up?’”

To be fair, pre­dict­ing future prices based on past prices is a very rea­son­able thing to do,” Nathanson said. But the prob­lem is that it is hard to do this cor­rect­ly. In fact, buy­ers fall into two dis­tinct groups when it comes to fore­cast­ing house prices: those who con­sid­er all the rel­e­vant infor­ma­tion, who behave in a way that max­i­mizes prof­it, or whom econ­o­mists label ratio­nal” actors; and those who make assump­tions based on lim­it­ed infor­ma­tion, or naïve” buyers.

How do these groups behave when it comes to gaug­ing home prices?

Ratio­nal buy­ers know that prices are not a pre­cise reflec­tion of sup­ply and demand. They rec­og­nize that beliefs and expec­ta­tions are baked into the num­bers, and they fil­ter out the psy­cho­log­i­cal fac­tors that inflate home prices, focus­ing instead on items tied more close­ly to demand. Accord­ing to Nathanson, they look at things like how strong the local econ­o­my is, how many peo­ple want to live in that neigh­bor­hood, and how good the local schools might be in the future.”

Naïve buy­ers, on the oth­er hand, believe their infor­ma­tion is bet­ter than it actu­al­ly is. Con­scious­ly or not, they use a rule of thumb that past and cur­rent prices accu­rate­ly reflect demand. They see prices went up five per­cent and assume demand to live in that area went up five per­cent,” Nathanson said. This kind of buy­er may look at a house list­ed for $200,000, see that oth­er homes in the area have sim­i­lar prices, and assume the prices accu­rate­ly reflect demand. That makes them will­ing to pay the list price or even a lit­tle bit more if com­pet­ing with oth­ers. Then you get these things that look like hous­ing bub­bles,” Nathanson said.

Small Error, Big Effects

The error naïve buy­ers make in fore­cast­ing future prices based on the past may seem small, but it can snow­ball. When the results of a mod­el sim­u­lat­ing ratio­nal behav­ior are set against a mod­el sim­u­lat­ing naïve behav­ior over sev­er­al years, the effects are striking.

Nathanson and Glaeser found that over time the error leads naïve buy­ers to over­es­ti­mate the actu­al lev­el of hous­ing demand — and thus over­val­ue homes. Future buy­ers, in turn, make the same error. This becomes a sequen­tial and self-rein­forc­ing process, and the gap between prices and demand grows ever-wider.

Inter­est­ing­ly, though naïve buy­ers expect prices to rise, they actu­al­ly under­es­ti­mate the near-term rise in the val­ue of homes dur­ing a boom. This is true for the same rea­son that they err when look­ing to past prices for guid­ance. They do not con­sid­er the fact that future buy­ers will update their beliefs.

Naïve buy­ers don’t real­ize that oth­er buy­ers are learn­ing from prices, too,” Nathanson said. So if I’m think­ing about buy­ers in the future, I know prices are going up today, but I think that buy­ers in the future aren’t going to learn any­thing from that. But in real­i­ty, they will look at the ris­ing prices, and that will increase their opti­mism.” Thus, when cur­rent buy­ers fail to take the per­cep­tions of future buy­ers into account, they under­es­ti­mate the val­ue of the house in question.

This error is key to under­stand­ing the hous­ing market’s momen­tum — or the ten­den­cy for prices to con­tin­ue on their cur­rent path with­in a giv­en swing of a boom and bust cycle. The gap between naïve buy­ers’ expec­ta­tions (what they think the house is worth) and real­i­ty (that it is worth more than they think it is) sur­pris­es them. It pro­vides a psy­cho­log­i­cal push, real­ized as momen­tum, that keeps prices ascend­ing over the short run.

Past the five-year time hori­zon, how­ev­er, buy­ers’ expec­ta­tions out­strip the actu­al growth in prices. The same process, work­ing in reverse, then pulls prices back down. Naïve buy­ers now over­es­ti­mate the true lev­el of demand and are sur­prised when homes are worth less than they think they are, cre­at­ing momen­tum fueled by sequen­tial under­valu­ing. And that con­tributes to a bust.

Curb Your Exuberance

As Glaeser and Nathanson note, this is only one pos­si­ble mod­el of semi-ratio­nal­i­ty in hous­ing mar­kets. Many oth­er forms of irra­tional­i­ty may exist.”

But even if they do not pro­vide the final word on the sub­ject, the authors do offer an expla­na­tion for some­thing that is typ­i­cal­ly assumed but not proven: the psy­chol­o­gy, or irra­tional exu­ber­ance,” that shapes the hous­ing cycle.

One of the sto­ries is that peo­ple just got over­ly opti­mistic some­how,” Nathanson said. And that the bust was pre­dictable,” once buy­ers start­ed to believe that hous­es were overvalued.

We actu­al­ly have a the­o­ry for why peo­ple would con­sis­tent­ly be too opti­mistic dur­ing booms and too pes­simistic dur­ing busts,” Nathanson said. In sev­er­al oth­er papers about hous­ing cycles, includ­ing my own work, this opti­mism and pes­simism is just assumed.”

Ulti­mate­ly, the aim of under­stand­ing the ups and downs of the hous­ing cycle is to help leg­is­la­tors and insti­tu­tions cre­ate laws and poli­cies that pre­vent the kind of dra­mat­ic swing in prices that hap­pened from 2000 to 2006. The bust that fol­lowed inflict­ed dev­as­ta­tion across the econ­o­my and played a crit­i­cal role in the broad­er finan­cial cri­sis that began in 2008.

As Nathanson and Glaeser write, the eco­nom­ics of real estate bub­bles is still in its infan­cy,” and it is too ear­ly to make pol­i­cy pre­scrip­tions with any confidence.

But if their the­sis holds up, the les­son is that peo­ple are learn­ing from prices the wrong way,” Nathanson said. So the ques­tion is: Is there a bet­ter way for peo­ple to fore­cast future prices from past prices — one that peo­ple can use, and that’s not ter­ri­bly com­pli­cat­ed?” That is some­thing Nathanson is explor­ing in cur­rent research.

As he point­ed out, the prac­ti­cal impli­ca­tions of such fol­low-on research could be valu­able: There might be some very sim­ple rules that peo­ple can use, that won’t lead them astray. If we can actu­al­ly dis­cov­er some sim­ple rule peo­ple could use to avoid booms and busts, we could edu­cate peo­ple about what that is.”

About the Writer

Theo Anderson is a writer and editor who lives in Chicago.

About the Research

Glaeser, Edward and Charles Nathanson, “An Extrapolative Model of House Price Dynamics.” Working paper.

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