Housing Market Still Isn't Rational

35 Replies

Some salient quotes:


"In housing, the smart money has relatively little voice."

"Developers and builders will, in one way or another, exploit overpricing, increase effective supply in that way bring real estate prices down".

"Markets without the possibility of making these negative bets will be inefficient. If it is not possible to short, the smart money can do no more than avoid holding an overpriced asset."

"There is a way for smart money to profit from an understanding of high prices. It is to build new houses and sell them before prices fall."

"In San Francisco we found that while the median expectation for annual home price increases over the next 10 years was only 5%, a quarter of the respondents said they thought prices would increase each year by 10% or more. That would mean a net 150% increase in a decade. These people are apparently not thinking about the supply response that so big a price increase would generate. People like this could bid prices in some places so high that eventually the local market will collapse."

"You may want to buy a house if you love it and can afford it. But remember that you cannot safely rely on “comparable sales” to judge that the price is fair. The market isn’t efficient enough for that."

As long as the asset cashflows well enough in a stable area and I don't get trapped unable to refi in the middle of a brrr i wouldn't mind another down turn for access to more deals. 

@Brian Adams Burke, @Eric Baum, @Jay Hinrichs,

You might find this interesting...

My question would be when is it ever rational? People buy based on emotion then justify with reason.

yes @Byron Bohlsen I'm hording cash for that.  That said, I don't expect another crash like in 2008,9,10.

Sound like he's advocating for some mechanism for shorting real estate to create a more efficient market, but outside of stocks in what other assets do you have the ability to short? Almost seems like it's implied that all other asset classes have some shorting mechanism and therefore efficient markets with real estate being the exception. Somebody school me on some economics.

Originally posted by @Chad Ballard :

My question would be when is it ever rational? People buy based on emotion then justify with reason.

Thanks Chad. I think that's a bit of a generalization, but likely true for the most part as SFR home purchases often is emotionally driven versus MF. That's also a benefit for SFR investors.

Originally posted by @Edward Barnes :

Sound like he's advocating for some mechanism for shorting real estate to create a more efficient market, but outside of stocks in what other assets do you have the ability to short? Almost seems like it's implied that all other asset classes have some shorting mechanism and therefore efficient markets with real estate being the exception. Somebody school me on some economics.

 I think he's saying that shorting helps minimize property price bubbles (or minimize peaks) as savvy investors are betting prices drop and by shorting it helps them drop.  He also mentioned, and I agree, that it's not easy to short property prices...unless you're shorting a REIT or something, but that's ineffective.  He mentions this to support his argument that real estate markets are innefficent.  

Though I don't plan on it....If you believe prices are at their peaks, the next best thing to do if you can't short is sell.  If a large % of owners sold, prices would drop.  

He's right. If savvy investors could easily short it would minimize real estate price volatility, as they would begin shorting as markets head into a peak.

So, anyone have any ideas on how an investor might short a SFR, MF, or other type of real estate directly?

I'm thinking getting property assigned to you through a master lease then sell at price P, with an option to buy back at anytime within next 5 years at the appraised value..then once property  price drops by back at a lower price.

@Jon S.

I am a big fan of Robert Shiller, and I agree with most of what he has to say here. I think property markets are largely inefficient because of retail buyers, and this (generally false) belief that 'Your home is an investment.' 

I also agree that REITs are more likely to track with the stock market than housing, directly, as I have seen that in my own portfolio.

A direct short is a hard thing to figure, but maybe you could modify your strategy a bit by focusing investment on the businesses that benefit from a bad real estate market: Moving companies, discount retailers, waste disposal companies.

Here is a good list of businesses that do well in recession. Just a thought.

yes @Trevor Ewen I like the 99c chains.  I have a good friend who owns retail centers with Dollar Store as the anchor. They did very well throughout the recession.

I am not saying the rationalization is not correct in the case of an investment, but at its core the decision to buy anything is based on some emotion.

A master lease would not give you the right to sell though would it? The trick would be finding someone to let you "borrow" their property to sell right away and then pay them back later. Some type of seller financing with a balloon linked to the appraised value? Value of the property goes up then you loose money if it drops then you have a gain.

Strange to think how common this is in the stock world. Sounds kind of crazy when applied to real estate.

Originally posted by @Chad Ballard :

I am not saying the rationalization is not correct in the case of an investment, but at its core the decision to buy anything is based on some emotion.

A master lease would not give you the right to sell though would it? The trick would be finding someone to let you "borrow" their property to sell right away and then pay them back later. Some type of seller financing with a balloon linked to the appraised value? Value of the property goes up then you loose money if it drops then you have a gain.

Strange to think how common this is in the stock world. Sounds kind of crazy when applied to real estate.

 Chad,

I'm not sure I agree.  I do believe in investors using intuition, which is involved in my final step of each purchase, but intuition and emotion are not the same thing.  I believe that emotion doesn't get involved in my investment process.  That said, humans are emotional creatures, so it's difficult to remove entirely.

The assignor would assign because they believe the value of the property will increase, while the person taking the assignment would bet the opposite.

thanks @Trevor Ewen @Chad Ballard

I just emailed Robert directly.  We'll see what he thinks about it. 

I think he'd be a good guest on BP.

Disagreement is what makes the world interesting. I reserve the right to change my mind based on any future comments.

Originally posted by @Edward Barnes :

Sound like he's advocating for some mechanism for shorting real estate to create a more efficient market, but outside of stocks in what other assets do you have the ability to short? Almost seems like it's implied that all other asset classes have some shorting mechanism and therefore efficient markets with real estate being the exception. Somebody school me on some economics.

 He had one but I haven't heard of it since right after it premiered a few years ago.   

The prior run up was fueled by easy loans.  The prices just kept leap frogging from sale to sale and refis. I don't think lenders are doing that this time around. My sense is that without the easy loans, there won't be a great run up. I think sellers just want to get back to what they had in 2007. But are buyers and lenders really going for this?

I think one day we will all forget those lessons but I don't think it will be this soon.

Building/reno materials market used to be reasonable/rational 10 years ago. Flash forward 10 years and most every building block of a home re/construction seems around TWICE the price it was just a decade ago. 

Average maintenance fee for just 1 condo alone in a huge Manhattan building i sold in recent years was and is around $5,000/month. As materials and services get more pricey, so does maintenance and repairs and sellers' expectations; who wants to buy a house for 400k spend 100k on needed repairs over the next few years then be expected to sell for the same 400k?

just remodelling a bath nowadays around here costs 25k easy. didnt use to be that way. so i 'blame' home depot and contractors (and wholesalers!); not so much developers or fix and sell flippers.

Trying to use efficient market hypothesis analysis that has roots in securities analysis isn't going to work well.  As he points out in the article the EMH is only a half-truth anyway because the math implicit in it makes numerous simplifying assumptions, many of which are simply not true in the real world.  

Real estate also isn't a financial instrument to most of the bidders for smaller density housing.  People are looking for a place to live and are not really considering it as strictly an investment.  They're nowhere near "smart money" and have no idea how to do a discounted cash flow analysis.  They're also not basing their purchasing decisions on a NPV or any other financial metric.  They're trying to find shelter with good schools and access to the labor market with a reasonable commute.  

The government is also intimately involved in the real estate market.  Housing permitting an policy is generally controlled at the local level be politicians who are not well-versed in finance.  They make suboptimal decisions based on their heuristic analysis of what will win them favor during the next (generally short) election cycle.  Austin's permitting and housing policies rival the leftist cities like San Francisco in their lunacy.  Each new mayor promises to come in and clean it up like every new regime at the federal level promises to clean up the tax code.  What happens?  It becomes WORSE and more complicated with each regime.  

At the national level GSEs and government policy distort the price of money used to purchase housing.  "Ownership society" policies also dominate the national political landscape to win over voters and present various other non-market-based inefficiencies.  

So yeah....it isn't exactly earth-shattering news that the housing market isn't efficient.  There are also very large transaction costs on both sides of the purchase (explicitly or implicitly) and large organizations with political ties to maintain the cartel for real estate commissions.  Good luck getting anything approaching a liquid securities market out of this with all of these current challenges.  

Yeah - the real estate market is NOT efficient and at times is irrational.

Thank God for that - because if the market is truly efficient, there's no need for real estate agents, real estate wholesalers and there won't be any real estate investors either. Sellers can easily sell their properties as buyers will agree perfectly with sellers' assessment of value and there's no need for transactional help from brokers, wholesalers and investors.

Profit is made when smart investors create value or recognize value that the inefficient market does not see or does not know how to create.

On the other hand, the efficient market hypothesis does not even work in the stock market either. Warren Buffett said if the stock market is truly efficient, he would never be a billionaire as he bought stocks of companies the market grossly undervalued.

@Wendell De GuzmanEfficient refers to availability of information. The stock market is efficient because theoretically everyone has access to all the information at the same time. What the bid price is, what the ask price is, what is volume of sales etc. Also all information on public companies is managed carefully to assure all investors get all the information. What people DO with that info is up to them. The latter is why stocks get "undervalued" or "overvalued".  Actually the truth is at any given moment stocks are always fairly valued because thats what buyers and sellers have agreed on.

The difference between stocks and REI is that homes are not commodities. One share of AAPL is exactly the same as another share. And there are millions of buyers and sellers trading the same item. Each home is unique and each transaction has very limited buyers and only one seller. So pricing can never be efficient.

With great respect for the work of Robert Shiller, this statement: 

""In San Francisco we found that while the median expectation for annual home price increases over the next 10 years was only 5%, a quarter of the respondents said they thought prices would increase each year by 10% or more. That would mean a net 150% increase in a decade. These people are apparently not thinking about the supply response that so big a price increase would generate. People like this could bid prices in some places so high that eventually the local market will collapse."

demonstrates a fundamental misunderstanding of the function of local real estate markets, and willful ignorance of the old maxim, "Location, Location, Location." 

In physical terms, San Francisco is virtually entirely 'built out.'  Constructing new homes means tearing down old structures and building new ones.  Simple right?  You just tear down an old industrial building and build some condos, right?  

Wrong.  The San Francisco planning code, in the aftermath of the first Internet bubble enshrined for posterity industrial uses for most existing uses in San Francisco.  You can't tear down a PDR (Production Distribution Repair, fancy name for 'Industrial'.) building or EVEN CONVERT THE USE TO OFFICE OR RESIDENTIAL in most parts of the city.  

So you just build up, on  existing residential parcels, right?  No so fast.  Getting a demolition permit will take you about 3 years, even in the best case scenario.   Also, you probably won't get one.  "But my house is only 20' tall and the lot is zoned for 40' height limit!"  Tough cookies.  Your pretty little old house contributes to the architectural environment.  You can't tear it down.  

The people at the top of the food chain (picture little old ladies who paid 15K for houses now worth $1.5mm) don't want their neighborhoods to change.  They don't want more or more dense housing.  They are against new housing.  

People at the bottom (fixed income people living in rent controlled buildings) see new development as increasing the likelihood they are displaced from their neighborhoods.  They are against new housing. 

There is no natural political advocacy group for middle and upper middle class people who would like to buy or rent new housing. 

Thus, the only projects that could make a meaningful impact on supply are the massive condo and rental towers being constructed.  At the same time we are adding office space so that there will at least be one new job for every new housing unit constructed.  Most new condos aim for at least $900 to $1000 + ppsf, so even when those are sold, they do little to lower the average selling price or make available more affordable housing.   

Does this mean that prices in San Francisco can never go down?  Of course not.  We are pretty overheated and if the tech market slows down, there will be a drop in speculative energy.  But will high prices be mitigated by a rapid increase in supply.  Nope.  It's almost impossible to see enough housing being built to materially impact the market clearing price.  We would have seen it in SF already....

Originally posted by Account Closed:

Yeah - the real estate market is NOT efficient and at times is irrational.

Thank God for that - because if the market is truly efficient, there's no need for real estate agents, real estate wholesalers and there won't be any real estate investors either. Sellers can easily sell their properties as buyers will agree perfectly with sellers' assessment of value and there's no need for transactional help from brokers, wholesalers and investors.

Profit is made when smart investors create value or recognize value that the inefficient market does not see or does not know how to create.

On the other hand, the efficient market hypothesis does not even work in the stock market either. Warren Buffett said if the stock market is truly efficient, he would never be a billionaire as he bought stocks of companies the market grossly undervalued.

Good point that even the stock market isn't an efficient market.

Liquidity and transaction costs are big barriers to real estate coming close to a theoretical rational market.  Also the fact that every property is unique.  Then you have the government influence via tax policy and involvement in the mortgage market.

Maybe the art market is more irrational, but I think in comparison to most markets Real Estate will not be an efficient market.

I would add that Shiller has in the past advocated for a housing futures market with derivatives based on the prices of different MSAs that would allow people to short different real estate markets.  

This opinion piece is sort of a re-statement of his general thesis behind these futures that no one  seems terribly interested in trading.  Somehow the so-called 'smart money' has yet to see the value I guess... 

http://www.inman.com/2012/03/23/market-housing-futures-has-yet-take/

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