The votes are in: homebuyer psychology drives real estate bubbles and busts

first tuesday insight

There is no question that human perceptions of price and value shape both the vicious and the virtuous cycles of the real estate market. Herd mentality is powerful, and it works both ways. Just as everyone jumps on board when prices are perceived to be low and purchasing power high, everyone jumps overboard when expectations of future values shift.

However, herd mentality is but one feature of a complex market organism. In order for violent price swings to materialize policies must be in place to either fan or dampen irrational buy/sell behaviors.

Many have argued that Congress and the Federal Reserve (the Fed) failed the real estate market at the dawn of the new Millennium. At the twilight of a 30-year period of low interest rates and financial deregulation, no action was taken to cool down what was becoming an intensely hot market. Interest rates were kept low, derivatives trading was deregulated and sub-prime borrowers were offered a blank check. Thus, the greatest asset bubble in history inflated and popped, destroying trillions of dollars in housing wealth.

The question is, is herd mentality working in reverse today, holding real estate sales and prices down due to negative perceptions of the market? Having learned the lessons of the past decade, the Fed has now exhausted every weapon in its monetary arsenal to get things moving again. But Congress is frequently slow to act.

It is true, the herd moves with great power and little rationality. What’s needed is a good cowboy to keep it from running over the cliff.