Robert Shiller was awarded a nobel memorial prize in economics in 2013. He teaches courses in Financial Markets and Behavioural and Institutional Economics at Yale. He’s the author of the fantastic book Irrational Exuberance. He knows his stuff.
He’s said interesting things about residential housing in the past. Including pointing out that the real return on residential property in the US is not nearly as high as others think (“From 1890 to 1990 the appreciation in US housing was just about zero.”) (Oh, and I forgot to mention that he co-developed the S&P/Case-Shiller National Home Price Index.)
In a recent article published by the New York Times, Shiller gives a compelling explanation for why the housing market isn’t rational. Foremast he addresses the idea of the market being rational from the perspective of efficient markets theory.
This might sound trivial, but it’s an important point. The efficient markets theory holds that assets should always trade at their fair value, because their prices incorporate and reflect all relevant information. Consequently, if you’re buying an asset in such a market, you should be fairly confident of the value of that asset at the time you buy it. Ergo: if the housing market is rational, the price you pay for a property is what it’s worth. If the market isn’t, the property’s price and its worth might differ considerably.
Shiller begins by asserting that “the efficient markets theory is at best a half-truth, as a voluminous literature on market anomalies shows.” And in any case, “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? That’s another matter.
In the article, Shiller gives two primary explanations:
- “most investors find it difficult to understand how housing supply responds to changes in demand.”
Shiller, citing Edward L Glaeser of Harvard University, mentions that “real estate investors have repeatedly made the mistake of neglecting the supply response to rising prices.” He explains that “Developers and builders will, one way or another, exploit overpricing, increasing effective supply, in that way bringing real estate prices down.”
Think of it this way. If someone expects property growth to be 10% each year for the next 10 years, they are saying a $1 million property will be $2.6 million at the end of this period. If we assume 3% inflation, the real value (or cost in today’s dollars) would be about $2 million – a doubling in the value of the property.
If there’s a way for smart money to profit in the real estate market, “It is to build new houses and sell them before prices fall”. If a return of this nature was up for grabs, consider the supply response. Savvy developers would find a way, even in light of regulatory restrictions.
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- “In housing, the smart money has relatively little voice.” Specifically, “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”
Here, Shiller explains that “Efficient markets require the possibility of selling short”. This “helps prevent bubbles from forming”.
If someone sells short, they are making a bet that asset prices are overvalued, and can benefit from downward corrections. This is possible in the stock market, but isn’t possible to nearly the same degree in the residential real estate market.
As a consequence of this, ” 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.”
More baldly, he says: “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.”
What is Shiller’s take away? “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” [ie, “market prices”] to judge that the price is fair. The market isn’t efficient enough for that.”