Keeping Track of the Joneses

By Kate Campbell

Wharton’s Christopher Mayer Maps What Makes the Ever-Unpredictable Real Estate Market Tick

While many real estate markets across the country are hearty, signs of a decline dot the horizon in places like Manhattan and San Jose, which were among the hottest markets only a few years ago, says Wharton real estate professor Christopher Mayer. The reasons for such complex fluctuations in the market vary, he says, but that does not mean they can’t be researched, defined and ultimately charted for a more productive industry. And inefficient markets, he says, often present the best investment opportunities.

“When we’re experiencing a boom market, it can make sense to price aggressively,” says Mayer, who along with colleague David Genesove co-authored “Loss Aversion and Seller Behavior: Evidence from the Housing Market” for an upcoming issue of the Quarterly Journal of Economics. “Even if your house stays on the market a little longer. After all, the goal is not necessarily to sell to the first buyer who shows up, but to the buyer who is willing to pay the most. And if you sell before many buyers have had the chance to see your house, you are missing out on potentially high bids.”

Mayer was an MIT doctoral student in economics in search of a dissertation topic when he stumbled on his true calling. While living in a cramped apartment in Cambridge, Mass. in 1990, Mayer and his wife, Melissa Bilski, began house hunting for their first home.

He recalls being stunned as he learned more about how housing markets work. While there were plenty of houses for sale in 1990, many appeared to be overpriced. The economy was floundering, but sellers were not getting the message: asking prices weren’t falling, despite slack demand. In addition, there was almost no information to help buyers make the daunting task easier.

“My wife and I were about to make the single largest investment of our lives and I wanted to know more about what I was getting into. Was this going to be a good or a bad price to pay?” says Mayer

The experience made Mayer curious about how people think about their homes as an investment, when they decide to sell or buy, and what factors they consider before making these decisions. He discovered that, unlike the stock market, the real estate market operates in a bit of a vacuum, with only outdated, often inaccessible or unexamined data to provide clues.

“Even today, with the expansion of information available on the web, investors can find out far more about the right price on a $20 stock than they can know in buying a $500,000 house. I felt like most people had fundamentally little idea of what they were doing.”

In the end, Mayer wrote his dissertation on real estate auctions.

“I was interested in how the auction functioned in getting buyers and sellers together in a room to agree on prices. It was during a time when I was trying to understand the behavior of the real estate market. Watching the market collapse in Boston, I saw properties sell really cheap at these auctions. But I didn’t have any money so I tried to convince my dad to invest with me. He wasn’t ready.”

So instead of becoming a real estate investor, Mayer took a job as an economist at the Federal Reserve Bank of Boston. But he decided to commit to studying what makes the real estate market tick and how people react to those changes. Those early, accidental days of discovery in Boston were intriguing to Mayer, and he hasn’t lost his zeal to decipher real estate markets and improve the function of the real estate industry.

“I love my job. I think of being a professor as being an entrepreneur in ideas. Generating interesting ideas is a sign of being successful,” says Mayer, an associate professor who teaches MBA and undergraduate classes in real estate finance and investment. “Being around students is wonderful. Teaching is a good way to learn, especially given the high level of talent at Wharton,” says Mayer, an avid marathon runner who runs between 20 and 40 miles a week.

Mayer and his wife, who now have a one-year-old daughter, Jocelyn, and live in suburban Philadelphia, ended up following their instincts back in those early house-hunting days. Buying in 1990, the peak of the Boston housing market, the couple moved into a three-bedroom, one-bath starter in Wakefield, a suburb 20 minutes from Boston. “We fixed it up and lived there for four years.”

Timing is everything in real estate, Mayer has come to learn.

In retrospect, the couple would have been better served to wait before buying their first house. “But at the same time, we would have still had to live in our Cambridge apartment.” Most buyers and sellers must weigh similar options of convenience and necessity when they decide to move.

“It’s a weird business,” he says. “People often seem to make systematic mistakes in selling their house. In boom markets, such as Silicon Valley or Manhattan in the last couple of years, sellers regularly under-price their homes. Properties routinely sell well above their asking price and are on the market for hours rather than days. Yet in busts, such as Boston in the early 1990s, houses would often sell 20 percent or more below asking prices.”

And many houses, Mayer says, never sell at all.

Data he collected during the Boston real estate bust shows that up to two-thirds of houses on the market were eventually withdrawn without selling. Sellers would often be better off pricing more aggressively, raising prices in booms, says Mayer, but lowering their asking prices in busts.

So why don’t sellers price their houses more appropriately?

Mayer’s research focuses on three explanations: equity constraints, loss aversion and the poor use of information in the market. Equity constraints emerge when the value of the house falls below the mortgage amount and a seller has negative equity. “This is one of the factors that discourages people from liquidating their house in a down market. Let’s say you bought your house two years ago at $200,000 with a $20,000 down payment. But prices fall 25 percent and now your house is worth $150,000. Rather than writing a $30,000 check to the bank at closing, or defaulting on the mortgage and facing severe credit problems in the future, sellers tend to set high asking prices and hope that a buyer comes along who really likes their house,” says Mayer.

Nonetheless, even sellers with very low mortgages appear to over-price their houses in busts. To explain this phenomenon, Mayer points to loss aversion, which quite simply means that people are averse to realizing losses on their investment. ” Here I emphasize the aversion to realizing a loss. When house prices fall, all owners lose money no matter how much they paid for their house originally. However, sellers who once paid more money for their house than it is now worth are much more reluctant to sell than an owner who bought when house prices were low.”

As housing prices tumble, more owners suffer losses and thus fewer houses end up selling, Mayer’s research shows. This may help explain why so few houses sell in bust markets, when sales decline by 50 percent or more, he says.

“There’s growing evidence of loss aversion in many areas, from individual stock investors to professional traders and real estate investors, but loss aversion is even more pronounced in housing markets.” Behavioral economists attribute loss aversion to a psychological attachment to one’s own investment. And what investment could be personal than one’s home, Mayer asks.

Ultimately, loss aversion has real costs.

Sellers who choose not liquidate their home for a loss may have to turn down a good job in another city or remain in their cramped home another year as their kids grow. In addition, tearing up stakes in a down market often offers a good opportunity to “trade-up” at low prices. Owners who stay in their houses to avoid realizing a loss also surrender the opportunity to buy in a down market.

The third factor recognizes that sellers also seem to mis-price houses during boom markets, when loss aversion and equity constraints don’t apply. This is where Mayer’s research hones in on the lack of credible information on the real estate market.

“Real estate prices often seem to be based on old data rather than future expectations,” he says. “Sellers will look at comparable properties that sold six to 12 months earlier for guidance on the market value of their property.”

This could explain why asking prices dip so low during booms when prices have been rising quickly, but are so high when past prices were falling. “Yet we teach our students that asset prices should be based on expectations about the future rather than observation about the past. Stock market analysts value companies based on the expected growth of earnings in the future, not past performance.”

So just how can a seller better price their home?

For starters, Mayer says, people can adjust the prices of comparable properties to reflect changes in the market. “If a comparable property sold six months ago, but prices have risen by 10 percent since the sale, the seller should raise their listing price at least 10 percent to reflect current market conditions.”

Sellers can use price indexes to help make these adjustments in much the same way that consumers use the price index to adjust for inflation or a stock market index to measure the performance of the equities market.

But, he admits, it’s tough to find a local price index for a town or neighborhood.

Given the enormity of the real estate market, this puzzles Mayer. The Federal Reserve reports that the value of all real estate in the U.S. is similar to the value of the stock market. Yet there is very little information available about houses relative to stocks. There are a number of factors sellers can use, he says, to gauge where the real estate market is headed in the near term.

Real estate prices are often slow to adjust to changes in the overall economy. A potential seller should look at indicators such as the number of sales and time on the market. Trends including houses that sit on the market longer, and a decline in the number of sales in a neighborhood, are indicators that prices in the future are likely to fall relative to past trends. A sharp downturn in local economic conditions, he says, means sellers can anticipate lower real estate prices, but with a lag.

“At times like these, sellers should try to stay ahead of the game. The worst thing you can do as a seller is to over-price your house at the beginning of a downturn and then continue to follow the market down, with a lag each time,” says Mayer.

What else does Mayer see for the future?

“I think eventually the real estate industry will figure out how to use the abundant information about housing markets more effectively. Brokers typically do not adjust their pricing based on the profitability of their listings. This was also true of banks 10 years ago. Since then banks have looked carefully at their most profitable customers and adjusted their prices accordingly. Brokers might do the same calculation and compete for sellers whose houses have a low cost to sell or are expected to sell quickly. The industry should also use the abundant information available to them to address basic issues such as the trade-off between asking price and time on the market.”

Meanwhile, real estate markets continue to provide lots of room for future research.

Real estate occasionally lacks the sizzle of more popular fields of study, Mayer concedes. But its uncharted complexity continues to attract him.

“Housing in this country is 25 to 30 percent of the net worth of the United States. It’s a $10 trillion-plus market. And as many puzzles as there are about housing, we know even less about commercial real estate markets, worth more than $4 trillion. This is just a very important field,” he says. “For most Americans, their house is the single largest investment that they will ever make and is the primary means of saving for the future. Investable real estate represents about one-third of the value of corporations. I think it will be a long time before we really understand why real estate markets operate the way they do.

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