This article reports on the effect of sticky prices on real estate prices.
Now that the housing price bubble has burst, we need to know more than ever about the economic factors that cause real estate prices to decline quickly or slowly. Also important is whether those factors affecting price can help us predict the speed at which different segments of the California real estate market will recover.
When Japan’s real estate market collapsed in 1991-1992, prices dropped in both residential and commercial real estate, and continued to drop for a decade, dragging government supported banks (e.g. improperly supported banks) with them. However, when Japan’s commercial real estate prices fell, they dropped dramatically faster and farther than prices for owner-occupied residential real estate. If the Japanese crisis-reaction precedent is the track our government stays on, we can expect similarly dilatory results in our own real estate market.
In a recent report entitled “Asset Price Declines and Real Estate Market Illiquidity: Evidence from Japanese Land Values”, John Krainer of the Federal Reserve Bank of San Francisco makes an effort to explain. He lists two factors he calls “price persistence” and “illiquidity.” Price persistence is the tendency of listed prices in owner-occupied real estate to resist change, staying high even when the market for resale homes has dropped, a condition more commonly called sticky prices, downward price rigidity, or money illusion. Illiquidity refers to the corresponding inability to cash out on the sale of property, one factor in a vicious circle which causes price stagnation and prohibits recovery from a crisis. Greater liquidity, when buyers and sellers can easily obtain and get rid of property at agreed upon prices, leads to a more volatile market, for better or worse.
In the case of a market collapse, according to this report, home prices are unable to stabilize—bottom out—until property pricing comes to reflect cash values. On the other hand, price persistence (sticky prices) can cause property values to remain artificially inflated long after a collapse has occurred. This phenomenon has occurred in the coastal communities of Southern California, and what is about to happen to prices is likely to be vicious.
The reluctance of prices to adjust quickly to financial conditions (reality) in the real estate market is attributed to two causes. First is the difficulty of finding a property through a gatekeeper such as a broker, agent, or builder, and then agreeing to an appropriate price, called “search frictions.” In the hunt for a home, these frictions make it far more difficult for properties to change hands and prices to adjust to current markets—preventing deals from being made. Thus, these frictions hinder the speedy resolution of a financial crisis, and work to the future detriment of the multiple listing service (MLS) environment.
The other cause of enduring recessions is “debt overhang,” the crippling load of debt that underlies so much home ownership, and makes leaving a property (for those who must relocate) more difficult. Excess mortgage debt on a property forces buyers and sellers to ascribe distorted values to the real estate. Restabilization of real estate market pricing and sales volume, to meet the current economic reality, a prerequisite for the commencement of a recovery, becomes almost impossible until the mortgage debt overhanging property owners can be matched to, or reduced to less than, the property’s value in a loan cramdown.
Ultimately, given time, negative equity homeowners are forced to become more financially rational. The study indicates that if a shock to real estate fundamentals occurs, such as the artificial increase in homeownership funded by the recent subprime mortgage boom, then the steepness of the initial homeownership drop in the recession and the speed of homeownership’s eventual recovery both depend upon the prices brokers choose to set for a property’s dollar value. When brokers can broadly agree upon an appropriate price, property values will reset constantly to their basic worth—cash values—without prices and sales volume rocketing to the artificial heights of a housing price bubble or the artificial lows at the bottom of the bubble’s collapse. Thus, the historical (long-term) trend line of property prices will be more closely maintained from year to year; boring, but better for all involved.
However, the combination of search frictions confronting perspective buyers and mortgage debt overhang make property owners reluctant, or simply unable, to sell for the property’s fundamental value (the “true cash value” of the property at any given time), especially in owner-occupied residential real estate. Instead, sellers keep their homes on the market longer, hoping to avoid default, fishing for the rare buyer who might be willing to pay a higher price. Listing agents in high-end properties tend to pander to these instincts. This leads to price stagnation, in which rise and fall of prices is unnaturally prolonged: not a good thing, since it can greatly extend the length of a market collapse, as it did in Japan in the 1990s (and Mexico in the 1980s).
Japan’s financial crisis of 1990 included a collapse in both commercial and residential property values. Income property prices were especially volatile throughout the collapse, ultimately falling faster and deeper than owner-occupied residential prices, and bottoming sooner. Owner-occupied residential real estate, which had a much higher variety of pricing and a greater burden of debt, also eventually fell catastrophically, but less dramatically. It seems that income producing real estate is more easily evaluated (by cap rates, income flow, and replacement costs) and typically less burdened by high LTV debt ratios, making it easier for buyers and sellers to agree upon an appropriate price; thus providing the owner with the ability to cash out—greater liquidity.
The relative ease of income property evaluation makes that part of the real estate market a more exciting and less predictable field, as capitalization rates can change dramatically, altering market values in a moment. Conversely, owner-occupied residential property moves slowly and steadily with sticky pricing, not reacting to the market forces existing at the time. This information indicates we should anticipate a quicker recovery for income-producing real estate in our California market as prices stabilize, followed by a slow but persistent rise in sales volume, and eventually, prices. Reaction from the single family residential sector will follow.
