Housing Prices and Behavioral Economics

Posted by: Chris Palmeri on July 17, 2009

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In traditional finance text books, assets are always priced perfectly by the cool, rational work of markets. In the real world, human behavior has a huge influence on what things sell for, particularly houses. That’s lead to an area of research called behavioral economics—the study of how people’s emotions impact their financial decisions.

A couple of weeks ago I put in an offer on a three-bedroom, bank-owned home in Pomona, California, which is about a half hour east of Los Angeles. The house was listed at $144,500. I offered $145,000. My offer was accepted this week. I was told there were two offers above mine, including one at $180,000. How did I win? I offered to pay cash. The bank that owned the property saw less of a risk of my sale not going through. Was this rational thinking on the bank’s part? Or are they making pricing mistakes just to clear out inventory as quickly as they can?

Now let’s look at the other bidders. There were sixteen offers in all. That means thirteen offers were below mine. I offered just $500 above the asking price. This is a house that sold in 2006—I kid you not—for $400,000. Why, given that 66% discount, were more people not willing to go above the asking price? Behavioral economics. Everyone wants a deal.

Lastly, let’s take a look at my thinking. A week ago I would have been happy as a clam my offer was accepted. Every bit of analysis I did showed this was just a screaming deal. But on Monday I learned that our parent company, McGraw-Hill, might sell BusinessWeek. Suddenly my future job prospects looked less certain. From an investment standpoint this purchase made perfect sense, from an emotional one? I withdrew my offer. Time will tell if I was prudent or just chicken. You can be both, I believe.

Reader Comments

Bignumone

July 18, 2009 9:02 AM

If that picture is the house, you may or may not have made a mistake withdrawing. Where I grew up and where I live now (MI), $150K is about $60K too much. No matter where you live $400K for that size house/lot is ridiculous. I can get 40 acres, farmhouse with horse barn and track.
I just don't see the value of living in CA if you have to pay that much for a 'cracker-box' (that is what we called that type of place growing up).

Chris Broubalow

July 18, 2009 9:15 AM

Chris Palmeri just encapsulated in easy to swallow form a stratagy that I never even considered: Doing your home work and doing exactly what goes against the behavioral psychology that most people would embrace. I believe most people, after having made the deal would have reluctantly followed through with the purchase. I hope Chris was wrong on the latter. Good luck!

Ballbuster

July 18, 2009 11:10 AM

Palermi's real estate offer, $145K, for this house is a fake, made for the purpose of writing a bogus story. After claiming to be knowledgeable about real estate, especially of Southern California variety, Palmeri should have known that residential real estate in Pomona is the "Arm Pit" of LA County just slightly below City of El Monte. Pomona is characterized as a blue-collar city, located in hot as hell desert and high crime area. Abandoned by big aviation industry after WWII, today, Pomona is a mishmash of low cost housing and unglamorous factories/industries which were evicted from other parts of LA County as urban-suburban sprawl forced the "less desirable" entities into Pomona. Picturesque Pomona is not exactly your idyllic Beverly Hills or quaint Newport Coast. No one in his right mind is dying to rent a house in Pomona—except the desperados. Pomona's unofficial city motto: Give me your Refuse, Rejects, and Renegades. Contrary to Palmeri's bogus claim that his "purchase made perfect sense," the truth is that good and reliable paying renters wanting to live in Pomona are hard to find, making his "purchase from a investment standpoint" a stupid fabrication. Next, Palermi claims that he withdrew his offer because his "future job prospects looked less certain” as his employer, BusinessWeek, might be sold. With the national unemployment rate hovering over 10% and nearly 15% in California during this recession year, Palmeri's sudden concern about his job insecurity is a bit belated or in fact, disingenuous. Once again, Palmeri has shown no shame in fabricating a story for the purpose of promoting real estate sales. Regardless of his belief in his own virtue, history will expose Palmeri as both stupid and a fraud. BW readers pray that the sale of BW will result in Palmeri's departure to the arm pit of Pomona.

ADEYINKA M KOTOYE

July 18, 2009 12:23 PM

The rate at which both rents and sale of properties are increasing in Lagos is astronomical and unbelievable. A typical 3 bedroom in central Lagos e.g Yaba, Ikeja, Maryland, surulere goes for between. 700k-1m Naira.While a corresponding apartment in Ikoyi, Victoria Island, Lekki and other areas that are actually outskirt of Lagos will go for 1.5m-2.5m Naira. The critereria to appear to be the quality of people in that area as opposse to accessibility and other economic factors. For instance, while it will take you less than 30 minutes to get to the airport from ikeja and its environs. It will actually take you 2 hours to get to the airport from Ikoyi, V/island etc.It is therefore irrational in my estimation for anybody to think that unless they live in Ikoye et al thay can never live anywhere else in Lagos.
The old excuse of availability of good roads, electricity and other social amenities have been made inapplicable by the current collapse of infrastructure.Therefore it is advisable for any foreigner who intend to reside in Lagos to make appropriate enquiries as to location so as not to be pushed to those extreme part of Lagos all in the name of choice areas. What do you think.

Richard

July 18, 2009 12:32 PM

Higher offers are not always better offers. A friend of mine was bidding on a
house and was outbid. A couple of months later the house was back on the open market. Why? Because the person making the higher bid started asking for "improvements" that would have cost far more than difference between his offer and the ones not too far below it.

As to pulling the offer, unless you have
the spare cash on hand or a spouse that
can pull the weight while are searching for the next job, it makes perfect sense
to not put down roots, especially when
you may need to relocate to get the best
opportunity.

I still believe housing will continue to
fall, despite the much hyped recent uptick in prices. Once commercial loans start collapsing you will have further job loses and people barely hanging on by using their credit cards will also
fall further behind. The result is an
increase in supply, drop in demand
(or at least the ability to pay for it)
and subsequent drop in prices.

Also, we have all these new initiatives
that the politicos are pushing. The cap
and trade as well as other programs will
likely increase expenses, thus
shrinking the supply of money for people
to spend on many items, further making
the business environment more unstable,
resulting in job loses. Well, you get
the picture.

Luke

July 18, 2009 12:36 PM

This article effectively summarizes the psychological push-pull that we all undergo with major purchase/investment decisions. I understand your withdrawl of offer, but remember it is at times of heightened fear that the best investment opportunities present themselves. I hope everything works out for you.

urbantrekker

July 18, 2009 12:46 PM

prices have gone down that low.. phew. Think DC region is better insulated in this market.

David Culver

July 18, 2009 12:52 PM

Your service, this blog, is in a strong growth market, the need for guidance and insight in real estate, hence I think your self doubt was unwarranted. You should have kept the property!

Russ

July 18, 2009 1:51 PM

Enjoy your deal, knife catcher. A $400K price tag based on a financial mania and/or fraud is irrelevant to current market value.

Andrew Segal

July 18, 2009 2:14 PM

The chicken probably made the correct choice here. Like many options in business and life, there are two general hurdles to cross. The first is whether it is a good deal. The second is whether one can get a better deal either close in distance or time. Unlike the fairy tale, there is good odds that the sky will really fall in California and the chicken will be right after all.

gunashekar rajaratnam

July 18, 2009 9:27 PM

Early Economic Theories often used an insightful understanding of Human behavior. In fact these theories developed even before Behavioral Sciences were established as fields of study. Psychology began and largely grew to understand Individual behaviour and more about Individuals with behavioral problems. Only later did behavioral scientists start looking at behavior of communities and groups of people. Today non-academic market researchers grapple mostly with behavioral issues. I am personally of the opinion that to understand the real world including matters of housing and buying decisions you not only need to combine economics and behaviour sciences but a whole lot of other academic disciplines along with a generous dose of common sense. Perhaps academicians will soon start publishing their papers in the new discipline of common sense. Real world problems are much more trans-disciplinary and inexplicable by academicians,

nick arguimbau

July 18, 2009 11:41 PM

You wre right if the photo is of the house involved. It was way overpriced at $400k. Trash. It will disinterate into dust efore the 30-year mortgage term of the high bidder runs out. Housing bean to be overpriced 3 decdes ago when the high-tech mortgage with no real risk assessment became the norm. As a result, millions of houses like this one tha were overpriced and oversold. When this house is down to $40k Abnout what it was in 1982) and the Dow is down to $1400 (twice what it was when the great real estate/stock bubble of 1982-2007 has deflated, we can begin to rebuild the economy on a firmer, probably greener foundation.

You lucked out.

Kitty

July 19, 2009 2:17 AM

Well, that's kind of a stretch. I would be more apt to believe that with the current state of things, people are more conscious of the fact that they may lose their job.

There is also the fact that if it dropped 66%, who's to say that's the bottom of the housing market? For all we know, the market could go to 0.

Great deal? Maybe. Depends on a lot of things.

Rodney

July 19, 2009 5:44 AM

Chris,

To be honest I think you were just chicken to withdraw your offer. However, your action confirms your thesis that human emotions and behavior influence prices and not just rational analysis of costs vs. benefits.

Anon

July 19, 2009 3:45 PM

This was an interesting story... sorry to hear about the uncertainty.

Doug

July 20, 2009 5:23 PM

"Why, given that 66% discount, were more people not willing to go above the asking price?"

The 2006 price is not that relevant today, and maybe the asking price was the fair market value.

Doug

July 20, 2009 6:17 PM

Michigan housing -- "Recently a Californian purchased 178 properties [in Detroit], mostly one at a time, and most for under $10,000."

http://money.cnn.com/2009/06/11/real_estate/investing_in_Detroit/

Anthony

July 21, 2009 1:09 AM

You chicken. These are entry level prices and there is a lot of pent up demand for homes less than 200k. You could have rented the house out and flipped it in a few years. I don't see houses in Pomona going down much more.

JimG

July 21, 2009 6:39 PM

Wait a minute. Weren't you the guy who told us that home prices had bottomed out, just about a month ago? As I recall, I and a few other readers chided you for using anecdotal evidence as the BASIS for a business story. Why has your thinking changed in such a short period of time?

Monica Gagnier

July 21, 2009 8:04 PM

Chris -- Thanks for sharing this with us. You've put your finger on the greatest threat to the housing recovery -- rising unemployment. Best regards, Monica

al

September 15, 2009 1:04 PM

I agree keep your $145k and make sure you are job secure

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About

BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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