Showing posts with label 05-HousingMarkets. Show all posts
Showing posts with label 05-HousingMarkets. Show all posts
Wednesday, February 6, 2008
Tuesday, February 5, 2008
Housing Markets
Housing markets are interesting to consider as a contrast to retail markets because there are so many economic factors where the two are different; yet in spite of these differences we believe the model of supply and demand applies to both. Let's begin by listing a few of these factors and contrast them to the retail market case. Then we will get into each of these a little deeper. After that we'll consider some other factors and repeat the process.
First, let's note that homes are expensive items and for most people the decision to buy a home is a major purchase that involves much planning and effort, a lot of investigation of what housing is available, and perhaps also a lot of soul searching before a decision is made. As a fraction of total income the price of most retail items is small, so many of these are purchased without near the amount of forethought.
Second, in many respects each home is unique and buyers and sellers respect that uniqueness. We say that housing is a differentiated product market. Retail items, in contrast, are much closer to the ideal of a homogenous product market. One 18 box of Wheaties is viewed the same as another, one package of Pampers for a toddler between 20 and 25 pounds is viewed the same as another, etc. In other words, if you narrow the category enough for retail then beyond that you have homogeneity. With housing, the heterogeneity can survive down to the individual unit.
Third, and this is really a consequence of the first two, with housing you have to be careful to distinguish between list prices (the price mentioned in an advertisement or other listing), and transaction prices (what the house actually sells for). The two are usually not the same. In retail, the list price and the transaction price are usually the same.
Census FAQ on Housing
American Housing Survey
House Price Data
Realtor.com
According to the U.S. Bureau of the Census, the median home price in the U.S. is not quite $124,000 (see the first link above) and there is substantial variation in pricing around that (take the House Price Data link and then scroll down to the table Value@12). To get a feeling for what explains that variation let's look at a few individual "list prices." Go to the realtor.com site, choose a location and a price range, and look at a few listings. What factors that are overt in these ads differentiate one house from another?
First, let's note that homes are expensive items and for most people the decision to buy a home is a major purchase that involves much planning and effort, a lot of investigation of what housing is available, and perhaps also a lot of soul searching before a decision is made. As a fraction of total income the price of most retail items is small, so many of these are purchased without near the amount of forethought.
Second, in many respects each home is unique and buyers and sellers respect that uniqueness. We say that housing is a differentiated product market. Retail items, in contrast, are much closer to the ideal of a homogenous product market. One 18 box of Wheaties is viewed the same as another, one package of Pampers for a toddler between 20 and 25 pounds is viewed the same as another, etc. In other words, if you narrow the category enough for retail then beyond that you have homogeneity. With housing, the heterogeneity can survive down to the individual unit.
Third, and this is really a consequence of the first two, with housing you have to be careful to distinguish between list prices (the price mentioned in an advertisement or other listing), and transaction prices (what the house actually sells for). The two are usually not the same. In retail, the list price and the transaction price are usually the same.
Census FAQ on Housing
American Housing Survey
House Price Data
Realtor.com
According to the U.S. Bureau of the Census, the median home price in the U.S. is not quite $124,000 (see the first link above) and there is substantial variation in pricing around that (take the House Price Data link and then scroll down to the table Value@12). To get a feeling for what explains that variation let's look at a few individual "list prices." Go to the realtor.com site, choose a location and a price range, and look at a few listings. What factors that are overt in these ads differentiate one house from another?
Housing Markets - 2
Some of the factors are age of the house, square footage, total number of rooms, number of bedrooms, number of bathrooms, specialty rooms, hardwood floors or not, fireplace or not, number of garages and whether attached, deck or porch or not, fenced or not, style of the house (colonial, tudor, etc.), lot size, nearby amenities such as a park or lake, exact address (which also acts as a proxy for local public good services, such as quality of the neighborhood schools), and date of the listing.
Note that most buyers of homes are also sellers of homes. When a family moves into a new home, it moves out of the old home (unless this is a first time home purchase or a purchase of a vacation home). Thus many of the factors which influence demand for homes also influence supply. Some of these include one or more of the breadwinners in the family getting a new job and needing to relocate, a significant change in wealth (for example a major promotion, a loss of a job, or an inheritance) that makes alternative housing more desirable, and change in the number or health status of family members that makes the current house unsuitable.
For these reasons, and some other reasons too, buyers of homes, even those interested in purchasing the same house, are different from each other in some relevant respects. In other words, a seller might prefer to deal with one buyer over another. It is not just the properties that are differentiated. It is the people too. Can you think of some other factors that might differentiate the buyers?
Note that most buyers of homes are also sellers of homes. When a family moves into a new home, it moves out of the old home (unless this is a first time home purchase or a purchase of a vacation home). Thus many of the factors which influence demand for homes also influence supply. Some of these include one or more of the breadwinners in the family getting a new job and needing to relocate, a significant change in wealth (for example a major promotion, a loss of a job, or an inheritance) that makes alternative housing more desirable, and change in the number or health status of family members that makes the current house unsuitable.
For these reasons, and some other reasons too, buyers of homes, even those interested in purchasing the same house, are different from each other in some relevant respects. In other words, a seller might prefer to deal with one buyer over another. It is not just the properties that are differentiated. It is the people too. Can you think of some other factors that might differentiate the buyers?
Housing Markets - 3
Since all else equal the seller wants to get the highest price possible for the house, one obvious differentiator of buyers is the maximum they are willing to pay for the house. A factor related to this is the buyer's ability to obtain financing, which depends on income, credit rating, and tangible assets. Another important aspect is timing. When does the buyer want to close the deal (and then move in)? The nearer that is to when the seller wants to close, the better. Sellers also might be concerned about the likelihood that the buyer will walk away from the deal. Usually a buyer is required to put up "earnest money" once a tentative agreement has been reached. In a seller's market (excess demand) a buyer might put up earnest money on a house that is next best rather than most preferred, because too many other buyers are bidding on the better alternative. If that other house happens to become available then the buyer might go for that and surrender the earnest money. Similarly, in a buyer's market (excess supply) the buyer might plan to buy the new house assuming the old house will be sold. If that proves difficult, the buyer might chicken out and surrender the earnest money rather than risk having to finance two homes over an extended period of time. (And it should be noted that the buyer faces a like risk, particularly in a seller's market when another buyer may step in and outbid the current best offer. Still another factor is just how flexible and easy to deal with a buyer is. Normally, it is easier to do business with someone who is flexible.
We conclude that there are legitimate reasons for why a buyer may want to buy a particular house and for why a seller may want to sell to a particular buyer. In this case they will almost certainly negotiate about price (and other things too such as the close date and whether repairs will be made on the house prior to closing). The bargaining can itself be a source of price variation. We can't predict precisely how it will turn out. It won't always be like we assumed in the "Trade" worksheet of the S&D Updated workbook, where the price was right in the middle between the buyer's value and the seller's cost. But we do know that it will be determined somehow so they both make out from the deal.
What is your personal experience with bargaining? Have you ever been in a negotiation where you swapped something for something else or bought or sold something at a garage sale or bazaar? If so, can you recall whether it turned out just as you thought it would before the process started?
We conclude that there are legitimate reasons for why a buyer may want to buy a particular house and for why a seller may want to sell to a particular buyer. In this case they will almost certainly negotiate about price (and other things too such as the close date and whether repairs will be made on the house prior to closing). The bargaining can itself be a source of price variation. We can't predict precisely how it will turn out. It won't always be like we assumed in the "Trade" worksheet of the S&D Updated workbook, where the price was right in the middle between the buyer's value and the seller's cost. But we do know that it will be determined somehow so they both make out from the deal.
What is your personal experience with bargaining? Have you ever been in a negotiation where you swapped something for something else or bought or sold something at a garage sale or bazaar? If so, can you recall whether it turned out just as you thought it would before the process started?
Housing Markets - 4
In a bargaining situation there is generally more unpredictability the less you know about the person you are dealing with. If you know the other person very well, you can better predict the compromise solutions that will obtain as the outcome of the deal.
In any case, you can always walk away form the deal. What you can net in excess of what you expect to achieve by walking away is a "surplus." One way to think about competitive markets is that the surpluses for buyers and sellers are small, bordering on negligible. In that case, the price variation that is observed must be a consequence of the variation in the qualities of the goods and services being traded.
Let's turn to another very interesting aspect of housing markets --- the prevalence of intermediaries to facilitate transactions. The key point is that unlike sales people who work in retail, these intermediaries are not employed by the buyer or the seller but are instead contracted out to provide their services to facilitate the particular transaction.
One type of intermediary is the real estate agent or broker. An aspect of the agents' job is to provide information to the client. For example, if a potential buyer is considering purchase of a home, the agent will provide information about available housing. Can you think of other ways that the buyer might get this type of information? What sources would be consulted?
In any case, you can always walk away form the deal. What you can net in excess of what you expect to achieve by walking away is a "surplus." One way to think about competitive markets is that the surpluses for buyers and sellers are small, bordering on negligible. In that case, the price variation that is observed must be a consequence of the variation in the qualities of the goods and services being traded.
Let's turn to another very interesting aspect of housing markets --- the prevalence of intermediaries to facilitate transactions. The key point is that unlike sales people who work in retail, these intermediaries are not employed by the buyer or the seller but are instead contracted out to provide their services to facilitate the particular transaction.
One type of intermediary is the real estate agent or broker. An aspect of the agents' job is to provide information to the client. For example, if a potential buyer is considering purchase of a home, the agent will provide information about available housing. Can you think of other ways that the buyer might get this type of information? What sources would be consulted?
Housing Markets - 5
We have already seen that the Internet can be a good source of this type of information. There are also house listings in newspapers and both of those sources are frequently consulted by buyers even if they have a realtor. For some homes on the market there will be "open houses" which allow potential buyers to take a look see. These help buyers not just to gauge that particular home but also to serve as a benchmark for other alternatives.
If the information can be found elsewhere, then why use an agent or broker? This question is relevant not just to the real estate market. Web sites as automated brokers have clearly made inroads into the travel business (e.g., expedia.com and travelocity.com) and the stock market investing business (e.g., ameritrade.com and estocktrading.net). So one should distinguish a buyer who would know which alternative to choose if the information on alternatives was available, from a different buyer who would need help to process that information and match it to some more abstract categories that are guiding the buyer's choice. The former type of buyer is more likely to use the online service. The latter is more likely to go with an agent or broker and in that sense the agent's job is as much educational as it is to simply provide information. Some buyer's in the former category may nevertheless go to an agent either because the agent might have information that is not available from other sources, or because the agent can get the information more readily.
BLS Real Estate Agent/Broker Job Description
An interesting issue is whether the agents/brokers have an affect on the transaction price. To consider why this may occur, let us look at two types of incentives that are at work on the agent. The first comes from within the transaction. Frequently, the agent's compensation is calculated as a percentage of the selling price (and frequently the rate is 3%). So for example, if the seller got $100,000, the agent for the seller would get $3,000, as would the agent for the buyer, and the buyer would pay $106,000 to cover that expenditure. If both agents get paid on this percentage basis then both have incentive to get the highest price possible that will close the deal. But there is an offsetting incentive in that the agent for the buyer also has to be concerned with generating additional business and to the extent that new business comes from referrals, the agent will want the current buyer to be happy with the transaction price. Likewise, the buyer will choose an agent in part based on the agent's good reputation.
A paper that argues the broker effect is not on price, but rather on time to closure.
ARUEA Paper
Since you may not have experience as a home buyer and may not have dealt with real estate agents (but if you've rented an apartment the experience may have been similar) let's try to personalize this issue of agent "moral hazard" by focusing on a different case that you should be familiar with. Moral hazard means the agent works in his own self-interest first and foremost. We'll ask if the student-advisor relationship has moral hazard. Consider your relationship with your academic advisor, either at present or in the past. In suggesting courses or instructors for you to take, do you think your advisor helped you find the best alternatives? Do you think the quality of that advice depends on you knowing your advisor well?
If the information can be found elsewhere, then why use an agent or broker? This question is relevant not just to the real estate market. Web sites as automated brokers have clearly made inroads into the travel business (e.g., expedia.com and travelocity.com) and the stock market investing business (e.g., ameritrade.com and estocktrading.net). So one should distinguish a buyer who would know which alternative to choose if the information on alternatives was available, from a different buyer who would need help to process that information and match it to some more abstract categories that are guiding the buyer's choice. The former type of buyer is more likely to use the online service. The latter is more likely to go with an agent or broker and in that sense the agent's job is as much educational as it is to simply provide information. Some buyer's in the former category may nevertheless go to an agent either because the agent might have information that is not available from other sources, or because the agent can get the information more readily.
BLS Real Estate Agent/Broker Job Description
An interesting issue is whether the agents/brokers have an affect on the transaction price. To consider why this may occur, let us look at two types of incentives that are at work on the agent. The first comes from within the transaction. Frequently, the agent's compensation is calculated as a percentage of the selling price (and frequently the rate is 3%). So for example, if the seller got $100,000, the agent for the seller would get $3,000, as would the agent for the buyer, and the buyer would pay $106,000 to cover that expenditure. If both agents get paid on this percentage basis then both have incentive to get the highest price possible that will close the deal. But there is an offsetting incentive in that the agent for the buyer also has to be concerned with generating additional business and to the extent that new business comes from referrals, the agent will want the current buyer to be happy with the transaction price. Likewise, the buyer will choose an agent in part based on the agent's good reputation.
A paper that argues the broker effect is not on price, but rather on time to closure.
ARUEA Paper
Since you may not have experience as a home buyer and may not have dealt with real estate agents (but if you've rented an apartment the experience may have been similar) let's try to personalize this issue of agent "moral hazard" by focusing on a different case that you should be familiar with. Moral hazard means the agent works in his own self-interest first and foremost. We'll ask if the student-advisor relationship has moral hazard. Consider your relationship with your academic advisor, either at present or in the past. In suggesting courses or instructors for you to take, do you think your advisor helped you find the best alternatives? Do you think the quality of that advice depends on you knowing your advisor well?
Housing Markets - 6
Your advisor likely has a different perspective than you and may make recommendations that are "good for you" though you may not perceive this to be the case. For example, you advisor may suggest taking a hard course that has a chance to lower your GPA, because your advisor believes you will experience more personal growth from that than from taking an easier course. This is not moral hazard. That the advisor doesn't sugar coat the recommendations is part of the job and in this sense the advisor is playing an educational role. However, the advisor may project his or her own personal likes or dislikes in making a recommendation and to the extent that your talents and aptitudes don't mirror that of your advisor suggestions of this sort do exhibit moral hazard. The extent to which the advisor tells you what you want to hear rather than work through with you what makes the most sense for you in the long term may very well depend on how well the two of you know each other. Certainly, it is easier for the advisor to say what you want to hear and have you walk away quickly.
Let us turn to another intermediary, the appraiser. If the buyer is seeking to get a mortgage to purchase the new home, the lending institution will insist on having the property appraised because the property will serve as collateral for the loan. The appraisal is presumably an independent valuation of the property. Of particular interest to us, the appraiser's job is something like identifying the marginal buyers and sellers. (See the Scale worksheet from the S&D Updated module.) But of course this is much harder to do in actuality than in the textbook case because one has to find "comparables" that differ in some respects from the property under consideration and because the known transaction prices will have occurred in the past and market conditions do change over time. It is hard for the appraiser to measure short term temporal changes in market conditions. Moreover, the appraiser doesn't get evidence from nearby homes that may be quite similar to the property under consideration, if those homes have not been bought and sold recently.
It is important to note that he appraiser's client is the bank or other lending institution, not the buyer or seller or the home. The bank's profit is in part determined by the size of the loan and so in some sense the bank has incentive to have the house appraised high, because if the house appraises low the transaction price will be negotiated down and that will reduce the loan size. However, most mortgage loans are re-sold on a secondary market rather than held by the initial lender and that resale serves to discipline the appraisal and not have it overvalue the property. But one should realize there is potential for moral hazard in the appraisal process.
It is recognized that appraiser valuations vary less than actual transaction prices. Moral hazard may be one explanation for this but it might also have to do with the appraiser's need to rely on historical transactions and the tendency to average those.
Another ARUEA Paper
Since we've covered a lot of ground here let's conclude this section by having you summarize the salient points of housing markets and how they differ from retail markets.
Let us turn to another intermediary, the appraiser. If the buyer is seeking to get a mortgage to purchase the new home, the lending institution will insist on having the property appraised because the property will serve as collateral for the loan. The appraisal is presumably an independent valuation of the property. Of particular interest to us, the appraiser's job is something like identifying the marginal buyers and sellers. (See the Scale worksheet from the S&D Updated module.) But of course this is much harder to do in actuality than in the textbook case because one has to find "comparables" that differ in some respects from the property under consideration and because the known transaction prices will have occurred in the past and market conditions do change over time. It is hard for the appraiser to measure short term temporal changes in market conditions. Moreover, the appraiser doesn't get evidence from nearby homes that may be quite similar to the property under consideration, if those homes have not been bought and sold recently.
It is important to note that he appraiser's client is the bank or other lending institution, not the buyer or seller or the home. The bank's profit is in part determined by the size of the loan and so in some sense the bank has incentive to have the house appraised high, because if the house appraises low the transaction price will be negotiated down and that will reduce the loan size. However, most mortgage loans are re-sold on a secondary market rather than held by the initial lender and that resale serves to discipline the appraisal and not have it overvalue the property. But one should realize there is potential for moral hazard in the appraisal process.
It is recognized that appraiser valuations vary less than actual transaction prices. Moral hazard may be one explanation for this but it might also have to do with the appraiser's need to rely on historical transactions and the tendency to average those.
Another ARUEA Paper
Since we've covered a lot of ground here let's conclude this section by having you summarize the salient points of housing markets and how they differ from retail markets.
Housing Markets - 7
In summary, homes are a big ticket item and consequently there is a lot of effort put into their purchase. The housing market is a differentiated product market and there will be price variation both due to the variation in the housing itself and as a consequence of the bargaining between buyer and seller. There is a substantial amount of intermediation in the process of buying an selling a home. Much of this intermediation is done by real estate agents/brokers. Another intermediary is the appraiser whose job is to provide an independent valuation of the property. Intermediation may be subject to "moral hazard" and that may in turn affect transaction prices.
Please place any comments or questions on this module in the box below.
Please place any comments or questions on this module in the box below.
Housing Markets - Discussion Question
While some homes can be rented, most homes are owner occupied. Why is that? Likewise, most consumer durables (e.g. automobiles, major appliances such as washer and dryer, home theater) are owned not rented. Why is that? And when does it make more sense to have a rental market than and ownership market?
Housing Markets - Extension and Critique of Essay
Home Value = Owner Equity + Principal Owed On Mortgage
Mortgage Basics
Tax Deductibility of Mortgage Interest
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