When considering buying a home, buyers are more likely to be optimists who think prices will rise, making their purchase a good investment.
Pessimists, who view residential real estate as a poor investment are less likely to buy.
In more liquid markets, like stocks, pessimists participate by selling short. This means they anticipate that the price of a stock will drop, so they pay to borrow it from someone who owns it but thinks its price will stay high, then they sell the borrowed stock at the current price. If their expectations are right, the price falls, the pessimist buys it back, returns it to the lender, and keeps the difference.
Do you know of anyone who has ever done this with a house?
I’m sure your answer is no. And what that means is that the market for primary residential real estate is composed mostly of … the optimists. Not surprisingly, they can bid up the price to unrealistic levels.
And, when asset prices get bid up, this is the same thing as bidding down their rate of return. Residential real estate has very low levels of return, which is why most people are thrilled that they can buy houses on margin: it’s not much different from laying odds on a craps table.
Read the whole thing now, or in a forthcoming issue of the Journal of Economic Theory.
Via Kids Prefer Cheese.