In a recent New York Times opinion piece, Robert Shiller, the Nobel Prize winning economist at Yale University, suggests strongly that the housing market is a riskier place to invest than securities markets, as housing market prices are less likely to be rational and efficient. He proposes two reasons that may seem rather technical, but are in fact pretty easy to understand:
- Most housing market investors don’t think deeply about how housing prices develop, and the market responses that are likely to follow.
- Housing market investors are unable to sell housing “short,” which makes it much more difficult to express a view that the market is overpriced.
To Shiller’s arguments, I would add a third:
- The market for residential real estate is relatively thin, the trading volumes are miniscule, and transactions occur very infrequently.
Let’s examine each of these points in turn, and extract their implications.
Most housing market investors don’t think deeply about how housing prices develop, and the market responses that are likely to follow.
A large number of very active stock market investors make their livings by buying, selling and trading stocks. They are vitally interested in the determinants of stock prices. They study the companies whose businesses the stocks represent: products and services, suppliers and customers, and competitors and market trends.
In contrast, people who buy houses most often do so primarily because they need a place to live. They do not participate actively in the housing market unless they are “in the market” to buy their next home or sell their current abode. They think about the housing market in terms of the neighborhoods and streets that interest them. For the most part, they don’t think about all of the homes in their city or town, let alone those in neighboring areas. They consider mostly other buyers who are like them – similarly situated in age, income and family status. They are unlikely to think much about broader demand forces or the potential for homes to be added to or withdrawn from the market.
In summary, there is a shortage of active and knowledgeable market participants in the housing market relative to the stock market. The housing market is likely to be less efficient in the sense that the prices at which houses change hands are likely to be higher or lower than they would be with the more complete information that more active participants would provide.
Housing market investors are unable to sell housing “short,” which makes it much more difficult to express a view that the market is overpriced.
In the stock market, an investor can borrow a stock and sell it, profiting from the drop in the stock price.This is a much more profitable way of expressing a view that the price of the stock is too high than simply choosing not to buy it, and it has a much greater impact on the market.
In housing markets, this type of behavior is not possible. Those who believe that prices are too high can choose not to buy, but they can’t borrow houses to sell them. There is no market mechanism for them to profit even if they are right.
This difference produces a bias toward (incorrectly) higher prices in housing markets relative to securities markets.
The market for residential real estate is relatively thin, trading volumes are miniscule, and transactions occur very infrequently.
In the US stock market, there are approximately 5,000 stocks traded on exchanges. In public stock markets, many stocks trade daily, and some trade many times per minute. Many market participants are full time investors who compete to identify the “right” price. Investors can realize the benefit (profit) for being right easily – the stock market is very liquid, and there are many potential buyers
In contrast, there are approximately 70 million detached single-family homes in the US. This doesn’t count the 35 million or so attached houses and apartments, nor does it count the nearly 9 million mobile homes. In many selling situations, the number of potential buyers is under 10, certainly under 100. The market is local and limited, not national and public as the stock market is. Rejected bids are not public (for the public stock markets, unfilled bid prices and offer prices are not only public information, but they are posted electronically).
Individual houses trade much less than once per year. In 2015, the annual rate of home sales was about 5.5 million (implying that houses trade once every 15 to 20 years).
So houses trade much less frequently than stocks, it is much harder to discover sale prices and unsuccessful bids, and the range of potential buyers is much smaller than for stocks.
This makes it much less likely that the sale price of any particular house will be “efficient,” reflecting all the relevant information about the supply of and demand for similar houses. Many buyers will pay too much, and many sellers will receive less than they would if transaction prices reflected market information more fully.
What does it all mean?
Buying a house is a big decision – it’s likely to be the largest single purchase of your life. And, you could make a lot of money at it.
The thinking in this note (summarizing and extending Shiller’s op-ed) suggests that you should approach home buying cautiously. Houses are likely to change hands at prices that are higher or lower than the prices that would obtain with more complete information, both because there is a shortage of active and well-informed traders, and because trading occurs infrequently. That is, you might dramatically overpay, or you might get a great deal, and you won’t know for a long time. However, there is a bias toward paying too much (prices that are too high) because short selling isn’t possible.
If possible, consider a broad range of alternatives – towns, neighborhoods, streets. It also makes good sense to compare buying to renting. Bringing more information to bear on your behalf will help you make a more efficient purchase for you and for your family. Finally, recognize that fevers can erupt. Prices won’t keep rising forever, even though conventional wisdom says they will.
Whether you get it right (paying less than you would if market information were fully reflected) or wrong (paying more), it’s perhaps best not to think of your house as an investment, but simply as the place you live. Adding the investment profit potential to your thought process can encourage you to pay more than you should, and more than you can afford.
