Wednesday, July 11, 2007

Real Estate Prices Rarely Drop (Sort of)

A couple of weeks ago I wrote a post about the ongoing real estate bear market. In that post I made a reference to the fact that according to a presentation by a UCLA economist that I heard several months ago, real estate prices do not tend to drop dramatically. Instead, in a typical real estate bear market the volume of transactions falls off precipitously, while prices stagnate, sometimes for years. As prices remain flat in Dollar terms, rising inflation causes the real value of homes to decline, gradually.

I find this theory very interesting, and I think it is worthwhile discussing in a little more detail. If you think about it, it is not not a trivial statement. Prices in a free market are supposed to be governed by the laws of supply and demand. If demand for apples falls off a cliff, it is only reasonable to assume that the price for apples would decline as well. Why would housing not follow the same logic?

According to the professor, from the prestigious UCLA Anderson Forecast, the problem with real estate pricing is that buyer and seller are not using the same time line to evaluate the deal. In a declining real estate market, the seller uses previous deals as a benchmark for the price he is demanding for his property: "The house down the street sold for $x last month, why should I settle for less?", while the buyer is thinking about future deals: "the market is going down. I should offer less than what the previous buyers paid, or else wait a few months and get the property for an even lower price." With buyer and seller using different benchmarks for valuing the property, an agreement is difficult to reach and fewer properties are sold. So this explains why fewer deals get made, but why does price not fall?

If you think about, the same logic can also be applied to the stock market. I mean theoretically you can replace the word "house" with the word "stock" and use the same argument. So why are stock prices subject to steep declines while real estate is more stable? Quite frankly, I am not sure. However, I would guess that the answer has something to do with liquidity and the rate at which price signals are transmitted across the stock market, as opposed to the real estate market. Since most stocks are re-priced many times per minute, both buyers and sellers know and trust that the price of the last trade is the market price. Real estate on the other hand is priced much less frequently, and no two pieces of real estate are identical. This allows both buyers and sellers to more or less ignore market prices and fixate on their own perceived value of the property - the seller looks back in time, the buyer looks forward, and no deal gets made.

I think it's an interesting idea to consider.


plonkee said...

In the British property market crash of the late 80s, early 90s, there actually was a fall in value of homes. I guess thats quite rare though.

Angie Hartford said...

Y'know, I'd never really thought about why housing prices generally don't drop. If I buy rental property, I'll have even more for my retirement, and to leave my heirs. Love it!