The Housing Market Still Isn’t Rational

Originally published in the New York Times on July 24, 2015.

Home prices have been climbing. They have risen 27% nationally since 2012, even more in places like San Francisco. But why worry? If you accept the efficient markets theory—and believe that real estate is an efficient market—then these prices are based on “new information,” even if you don’t know what that information is.

The problem with this kind of thinking is that the efficient markets theory is at best a half-truth, as a voluminous literature on market anomalies shows. What’s more, even that half-truth is grounded mainly in the stock market, which attracts professional investors who sometimes do make the market behave efficiently.

The housing market is another matter. It is far less rational than even the often irrational stock market, for a couple of important reasons. First, most investors find it difficult to understand how housing supply responds to changes in demand. Only a small minority of people think carefully about such things. Second, it is very hard for the minority of smart-money investors who do understand such matters to bet against bubble-level prices in real estate markets. In housing, the smart money has relatively little voice.

For the first point, in “A Nation of Gamblers: Real Estate Speculation and American History,” a presentation at the 2013 American Economic Association convention, Edward L. Glaeser of Harvard University reviewed real estate booms and busts. He showed how real estate investors have repeatedly made the mistake of neglecting the supply response to rising prices. In the Alabama cotton farmland boom of 1815 to 1819, for example, high cotton prices seemed to justify high prices for cotton land. What most investors failed to see at the time was that these cotton prices would induce new farmers around the world to begin to grow cotton. That same failure to anticipate how supply can respond to demand applies to many forms of real estate today. Developers and builders will, one way or another, exploit overpricing, increasing effective supply, in that way bringing real estate prices down.

For the second point, in 1977 Edward M. Miller pointed out in The Journal of Finance something that should have been obvious: Efficient markets require the possibility of selling short. In the stock market, for example, with short-selling, people who think the market is overpriced and headed for a fall can borrow shares and sell the borrowed shares at the current high price. If share prices do indeed fall, they can buy the shares back at a lower price and repay the loan, with a profit.

Short-selling helps prevent bubbles from forming, but such negative bets cannot easily occur in the housing market. You can’t routinely borrow a house and sell it, promising to buy back the same house later to repay the loan.

Markets without the possibility of making these negative bets will be inefficient. That’s because if it is not possible to short, the smart money can do no more than avoid holding an overpriced asset. Canny traders are forced to sit on the sidelines, and watch in futility as prices decline as they expected. Without short-sellers, there is nothing to stop a group of ignorant investors—who get some ill-conceived idea that a certain investment is just terrific—from bidding up prices to extravagant levels. In the housing market, that poses an enormous problem.

Suppose that you are convinced housing prices are too high. How can you profit from this insight? You might consider shorting the residential real estate investment trusts (REITs) that invest in residential properties and are themselves traded on stock exchanges. However, REIT prices do not have a consistent correlation with housing prices, and tend to resemble stock prices instead. For example, the housing market declined in the two years after the March 2009 bottom of the stock market. The S & P/Case-Shiller National Home Price Index fell 6% over this period. But, over that same time interval, the S & P 500 Residential REIT index tripled in value. Clearly, shorting this index would have been a bad move, even though a bet that housing prices would decline was spot on.

During the financial crisis, some professional investors did manage to profit by correctly forecasting home price declines. They used mortgage derivatives such as collateralized debt obligations to place their bets. John Paulson of Paulson & Company is well known for very successfully profiting from his prediction of trouble in the housing market. But mortgages are not homes, and he and others like him did not beat down the emerging housing bubble before it grew out of proportion.

In 2006, in collaboration with several colleagues and me, the Chicago Mercantile Exchange set up a futures market for single-family homes in 10 United States cities. This market is still going today, but it is not very active and it can be used to place only a small bet that home prices will fall.

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. This is a time-consuming process but it is what we are starting to see now, as housing starts and permits data show.

Still, despite rising prices, at present, exuberant investors do not dominate the domestic housing market over all. The Pulsenomics survey of household heads in January showed that national home price expectations are modest: on average increases of only 3.7% a year are expected for the next 10 years.

Extravagant expectations do lurk in parts of the market. In the 2015 Yale School of Management survey of recent home buyers that Karl Case of Wellesley College, Anne Thompson of Dodge Data and Analytics, and I direct, our preliminary results confirmed the overall Pulsenomics conclusion yet found that some people have strikingly unrealistic expectations.

In San Francisco, for example, 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. Yet the smart money can’t find a profitable way to correct such errors today.

The bottom line is that there is no reason to assume that the real estate market is even close to efficient. 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.