The latest report on home sales is bleak:
Sales of new homes fell in June for the seventh time in the past eight months, more proof that the worst housing slump in decades is getting deeper.
The Commerce Department reported Friday that sales of new single-family homes dropped by 0.6 percent last month to a seasonally adjusted annual rate of 530,000 units following an even bigger 1.7 percent fall in May.
The decline was slightly smaller than had been expected and sales were revised up a bit for May. Even with those changes, new home sales are down by a sharp 33.2 percent from a year ago.
At first glance, now would seem like an excellent time to buy a home. In most urban areas, home prices are down at least 20 percent from their peak in 2007. Shouldn't lower prices lead to increased demand? After all, interest rates are still low by historical standards.
The problem, of course, is that people are afraid that the real estate market will only get worse. No one wants to pay interest on an investment that continues to decrease in value. This is a textbook example of loss aversion, which is the kahnemanandtversky principle that losses hurt more than gains feel good. Kahneman and Tversky stumbled upon loss aversion after giving their students a simple survey, which asked whether or not they would accept a variety of different bets. The psychologists noticed that, when people were offered a gamble on the toss of a coin in which they might lose $20, they demanded an average payoff of at least $40 if they won. The pain of a loss was approximately twice as potent as the pleasure generated by a gain.
So far, so obvious. Losing stuff sucks. But I think some recent research on loss aversion can shed some light on the real estate malaise. The problem for home buyers right now is the possibility that they might lose something in the distant future. They think about how awful it will feel to live in a home that's worth less than their mortgage. But, according to a study by Dan Gilbert and colleagues, that prediction is actually false. As Gilbert notes, loss aversion is an affective forecasting error. We think it will really hurt to buy a home that's decreasing in value, but it's actually not that bad (at least, it's not that bad until foreclosure hits). Here's the abstract:
Loss aversion occurs because people expect losses to have greater hedonic impact than gains of equal magnitude. In two studies, people predicted that losses in a gambling task would have greater hedonic impact than would gains of equal magnitude, but when people actually gambled, losses did not have as much of an emotional impact as they predicted. People overestimated the hedonic impact of losses because they underestimated their tendency to rationalize losses and overestimated their tendency to dwell on losses. The asymmetrical impact of losses and gains was thus more a property of affective forecasts than a property of affective experience.
The key to ending the housing bust, then, might be as simple as getting people to realize that their fear of buying a home is mostly the fear of a cognitive illusion. Losing something always hurts, but it doesn't hurt nearly as much as we think it will.
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A couple of thoughts. One is an observation a friend (who is in real estate) made to me, when I discussed buying a house back in 1991 (when things sucked). He said, "...but if you have to sell your house for less when you move, you will buy something else for less, too, because EVERYTHING will have gone down in price." That obviously should counteract loss aversion.
But what if you're someone buying your first house (or for whatever reason you don't own at the moment) and are looking for the right time to buy? Obviously, loss aversion plays into it then, and I think that people frequently don't calculate the cost of not owning (e.g. rent, which you are just throwing away, lost tax deductions for interest you aren't paying because you don't own). But it also seems quite reasonable, when things are utterly crapping out, to wait until the dust settles.
Of course, in many cases, when people have to move, they don't have a choice. It might not be cost-effective to move (say to a new city) and rent for awhile and THEN buy and essentially move TWICE. Moving costs, and storage costs, can be extreme.
Of course, the other -- possibly most damaging -- effect of loss aversion is that people who own homes don't sell when they should because they can't bear to REALIZE the loss in their home's value, and so they ride the crashing market all the way to the bottom, hoping everything will turn around. And if they suddenly can't pay their high mortgage on their now seemingly worthless property, they are foreclosed upon and -- all for fear of losing tens of thousands of dollars -- they have lost exponentially more.
Great point quisp. I think the unwillingness of people to realize a loss when selling their home definitely had profound implications for the market. A 2001 study, "Loss Aversion and Seller Behavior: Evidence From the Housing Market," by Christopher Mayer and David Genesove demonstrated how our irrational sensitivity to losses distorts the real estate market, causing home owners to overvalue their homes. The two economists looked at condos in the Boston area from 1989 to 1992, when the average value of of such dwellings dropped 40 percent. If condo owners acted like rational agents, then a steep drop in the market price shouldn't lead to a cessation of selling. If they really wanted to sell their home, then they should be willing to sell their home at the lower price, since that's what the market is currently offering. The potency of loss aversion, however, means that people are unwilling to sell their property at a loss. According to the 2001 study, condo owners who bought at the peak of the Boston market listed their properties for an average of 35 percent over the expected sale price. As a result, less than 30 percent of the condos sold within six months.
I see one of the challenges with this problem is the understanding that a house is an "investment". While it is something that you own (as opposed to renting), it is meant to be a place of residence. You are paying for the functionality. When buying a car, you don't expect the value to increase (unless you're buying a collectors item of course), you understand that your necessary usage of the car reduces its value. Perhaps if there was a shift in understanding, the slide would stop.
I just wish the housing prices in Canada would start droping like in the US. I'm hoping to be a first time buyer soon, but housing is still far too inflated for me to be able to consider being able to afford anything.
We're looking to buy our first home sometime in the next several years, but we're put off by the falling market. Why?
1) We're renting a great place at a great price, and we're investing our savings.
2) We'll probably need to move within 5 years or so.
3) We believe that there's a significant chance of substantial further depreciation. The US is currently in the middle of the worst financial crisis since the Great Depression, and if the crisis spills over into the real economy, things could get ugly. Or so the economics bloggers keep telling us...
4) A recently-purchased house is a highly leveraged investment. Even a small drop in the market could result in us losing (say) $60,000 on a $20,000 investment.
I've made some spreadsheets and run quite a few calculations. And in every case, the danger of making a highly-leveraged investment in a falling market swamps all other financial considerations.
quisp: rent, which you are just throwing away
Actually, until you're 10 years or more into a 30 year mortgage, you're gaining only trivial equity. Unless you're in a rising market, you have to hold onto a house for almost 20 years until it starts looking like a decent investment. Unless you're fairly sure that the house will go up in value, there are much better ways to invest your money.
Interesting -- I've never considered a house an investment. We moved out of Boston in 1991, at a time when people were stuck selling their houses for less than the amount they owed on their mortgages. We made a minor amount of money on the sale of our house in Michigan when we had to move for career reasons, but have not been in a hurry to buy another house, since we don't know when we'll have to move again.
Of course, people do make lots of money on real estate sometimes, but it seems to be such a crapshoot that I can't imagine buying a house except for one reason: That we want to live in it for a minimum of five years, and probably longer. I would never expect buying a home to be a way to make money. It happens, but everywhere I've ever lived, it's been all about the luck of the draw. I'd be very happy to make money on the sale of a house, but I'd never count on it.
Julie: The real danger, of course, is buying a house for $250,000 with a $50,000 down payment, and seeing the value drop to $150,000.
At that point, you've lost $50,000 cash, and you're an additional $50,000 in debt. For most families, this would be a catastrophe, especially now that it's so difficult to declare bankruptcy.
If you're buying a first house in a falling market, you can't afford not to look at it as an investment, because you could easily wipe out your life's savings and wind up in crushing debt. This is currently happening to some distant relatives of mine.
Eric wrote: If you're buying a first house in a falling market, you can't afford not to look at it as an investment, because you could easily wipe out your life's savings and wind up in crushing debt. This is currently happening to some distant relatives of mine.
This is exactly what we saw during our last year in Boston, and we declined to buy a house until after we had moved out of the area.
Perhaps it's more clear for me to put it this way: I've never expected, nor trusted, a house to be an investment. It's just too unpredictable to be reliable. The market in Boston was skyrocketing out of our reach when we were first married, and by the time it plummeted, we were on our way out of town. The house we bought in Michigan was small, and when we buy our next house, we also want a small one -- perhaps one we're in a position to pay off in a relatively short time. If we're stuck moving to a place that's too expensive for us to do this, we'll have to revisit the plan, but since we're big fans of "flyover country", that might help us make future career decisions.
Most people starting out don't have that luxury -- we certainly didn't have the money to pay cash for a house even in an inexpensive area at the time -- and I attribute our reasonably good outcome to two things. One was the savvy to prefer small cities to large trendy ones -- and the second was the sheer luck that one of us was offered a job in just such a place.
I think the real problem with rick aversion research is that it doesn't actually tell us anything about risk aversion. Rather, the research simply evidences the divergence of the value of money and the utility of money. As the amount of money increases the utility of an individual dollar increases. The $20/$40 bet discussed above (ignoring peoples poor metacognitive skills) simply displays the average of where the utility of the potential gain (+$40) matched the utility of the potential loss (-$20). To put this in better context, if i have to pay a $500 rent, then betting my rent money at a chance to win $1000 creates the effect of the potential loss would have a much greater impact than a potential win. Until you can control for the worth of effect of a gain or loss and make them equal then risk aversion is really bunk.
I was astonished almost a year ago when the author of this blog said "Given the recent bursting of the housing bubble (let's hope, at least, that we've hit rock bottom)," and couldn't believe he was so naive.
http://scienceblogs.com/cortex/2007/08/the_neuroscience_of_market_bub.p…
We don't hit "rock bottom" only a few months after the bubble bursts. People don't act that way.
I'm afraid the recent run-up in prices was due more to the fact that people were interested in making a quick buck then in the traditional way of looking at homes - as places to live.
In the past, if prices went up, it was usually due to the fact that an area was doing well - with high employment and/or desirable living conditions. People were eager to live there and new homes were not being built fast enough to meet that demand. Thus prices went up.
After this crazy period we went through, we now have too much inventory purchased on speculation. Those bets didn't pay off since there wasn't enough demand to support the higher prices people expected.
So now people are stuck with homes that they cannot unload at a price they are happy with. Eventually, things will sort themselves out as prices are lowered to the point that properties sell. In some areas this will take many, many years.
To get to the point, I think there is some loss aversion at work. However, making people wake up to that fact won't cure the problem. A better economy or a change in the dynamics of the particular real estate market in question is the only way things will turn around.
WI foreclosures are depressing right now