Saturday, June 02, 2007

 

Sticky Deals

Price stickiness in a slower real estate market.
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As markets are decelerating, there is an anxious face-off between sellers and buyers of real capital assets as expectations of big profits fade away just as well.

In economic terms, the slowdown that we are witnessing today in many real estate markets is actually welcome news since allowing the economy to cool off through a reversal of real capital appreciation while at the same time allowing real wages to catch up is exactly the tonic needed to consolidate market wealth achieved thus far, eliminate the 'froth' by reducing speculation and, in ultimate analysis, keep bubbles away.

But then, of course, not all of us are economists - at least not my own clients.

The house party had to end eventually, even if many sellers still refuse to believe it. In fact many sellers remain defiant to the point of delusion, demanding one more drink at the housing bar. ‘Stickiness' is a noun used in Economics to describe a situation in which a variable is resistant to change. Price stickiness, therefore, reflects the fact that asking prices of interests in land remain high and even increase at a time when demand lowers.

Sales of existing homes, both new and resale, are down 7 percent and 6.6 percent nationwide respectively in the United States and Canada in the first quarter of 2007 compared to one year ago. Buyers are taking their time, leery of overpaying and taking on too much debt, and yet particularly in the United States the National Association of Realtors reports that in the first quarter of this year listing prices of single-family detached units not only failed to match the decline in demand, but in fact in eighty-two metropolitan areas they actually increased compared to a year ago.

Experts in market psychology say stubborn sellers suffer of a classic case of denial. When it comes to financial-making behaviour, people would rather gamble and hope that prices come back. They tend to ignore information suggesting that prices are dropping. It is the same mentality that leads blackjack players to double down in a losing streak. This explains sellers' reluctance to cut down prices, and in fact several academic studies also suggest that frustrated sellers take their homes off the market rather than accepting lowball offers. Conversely, when investors see prices rise they get overconfident - much like the hot-hand bias that leads folks to think a basketball player will sink his fourth shot after making the prior three, even though probability says the odds are the same for every shot.

Price stability certainly is the utmost desire of central bankers, in any market. In fact, many a central bank have it, more or less. Consumer-price inflation hovers to 2 percent in America, 2.2 percent in Canada, 1.6 percent in the Euro Zone and 0.6 percent in Japan. One might argue, therefore, that because the overall price level is not changing a lot, nor are individual prices - but this is not necessarily a rule of thumb.

How often prices move is an important question. Shifts in prices are like the traffic lights of an economy, signalling to people to buy more of this and less of that, to spend or to save, or to find new jobs. If the lights change readily, resources can be redirected smoothly. If they get stuck, so does the economy. In particular, if neither prices nor wages shift easily, the cost in output and jobs and, ultimately, the cost of reducing inflation can be high. Sticky prices also mean that an inflationary shock - an increase in oil prices, for instance, like the one that is happening this very moment - can take a long time to work its way through the system.

Price stickiness in any market, but especially in a big-ticket market such as Real Estate, is responsible for and reflects some confusion that exists between nominal and real values and gives rise, moreover, to a particular phenomenon known as the ‘Money Illusion'. Money illusion does influence people perceptions of outcomes. Experiments have shown that people generally perceive a 2 percent cut in nominal income as unfair, but see a 2 percent rise in nominal income where there is 4 percent inflation as fair, despite the fact that the two situations are almost rational equivalents. The same happens in Real Estate, where the trend is for asking prices to remain high or even increase when selling prices are dropping.

Luigi Frascati

luigi@dccnet.com
www.luigifrascati.com

Real Estate Chronicle

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Comments:
Great Topic. The real estate problems are just starting to heat up here on the west coast. The 2010 Olympics have put a wrench in the decline.
 
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