Rafi Mohammed

The Home Seller's Prisoner's Dilemma...Why the Housing Market is Destined to Crash

Posted on March 1st, 2007 (1 Comments)

Where’s the housing market headed? Is it going to crash? These are questions that everyone seems to be asking these days. With yesterday’s announcement that new home sales suffered their largest percentage drop in 13 years, it’s a good time to discuss where I think housing prices are headed.

After enjoying a joyous upward sprint, the housing market is taking a breather these days. What’s clear is that buyer sentiment has changed in the last 12 – 18 months. Perhaps it was the non-stop press coverage of an impending bust or concern whether generous annual appreciations could be sustained…but the green light of home buyer euphoria has changed to a yellow shaded tint of caution.

While we are used to consuming products that lose value over time (e.g., cars, computers), we view housing differently. It’s an investment…we want prices to appreciate. With uncertain future prices and Alan Greenspan’s recession red flag…this home buyer caution is understandable.

The future of the housing market – whether it crashes or soft lands – lies in the hands of home sellers. If sellers lose confidence in their home’s value – the market will crash. If they hold tight – the market will land softly.

In addition to today’s buyer reticence, new potential pricing strains are on the horizon:

  1. Thanks to creative financing, a significant portion of some buyers’ incomes go towards their mortgages. A temporary blip in their job situations could result in pressure to sell quickly.
  1. While I doubt the Fed will further raise interest rates. ARM and short term balloon mortgage holders are facing higher monthly payments. Similarly, taxes and insurance are increasing homeowner costs. These higher carrying costs could trigger selling pressure.
  1. With little hope of a turnaround, frustrated real estate investors (a significant portion of the market) may throw in the towel and dump their real estate investments onto the market.
  1. Finally, many boomers are counting on the generous rise of their home equity to finance their retirement. With uncertainty over future prices, it may make sense to cash out while the going is good.

Let’s be realistic…the odds are at least one of the above listed potential “strains” is going to cause prices to further dip. The key question is will sellers hold steady or lose confidence?

The panic that could occur in the housing market is akin to what I experience in buying tickets from scalpers at a rock concert. A few minutes before the show starts, even professional scalpers lose their cool – vigorously competing against others, they drop their prices in an attempt to monetize the rapidly declining value of their tickets. This results in drastic price drops. What does rock concert ticket scalping have to do with the housing market you may be wondering…one concern is that much like ticket scalpers, sellers will aggressively discount their homes (to lock in profits or minimize losses) before they further decline in value. This will lead to even more supply and lower prices.

Of course, there is the possibility that sellers will hold tight in this adverse market. A friend of mine lives in a luxury building on Boston’s Charles River. While prices at surrounding buildings have dropped, sale prices at his building have remained enviously stable. The reason for this stability, I believe, is because his building is inhabited with Boston Blue Blood money. These condo owners aren’t under tremendous pressure to sell…they’ll wait for the right price.

Home sellers in today’s market truly face a prisoner’s dilemma. While the market would be better off if individual sellers do not panic, it’s probably in each seller’s best interest to avoid the uncertainty and discount to cash out their profits today. The result of this prisoner’s dilemma behavior is that with everyone discounting, they all lose even more. Of course, some markets will fare better than others. With New York investment bank profits at record highs, strong demand will keep prices rising in Manhattan. Conversely, in areas like Bel-Air California, where sellers can afford to hold out for the right price, valuations will remain stable. But for the remainder of the country…hold on tight….

My sincere thanks to the following for both their insights and serving as a sounding board for this blog: Donna Drejza, Betsy Whittemore, Dr. Vinay Kapoor, and The Wise Greek Sage.

Please feel free to send me any questions or comments. I update this blog two to three times a week – please consider signing up to be notified by e-mail of a new blog post. Thanks for taking the time to read my blog.

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Readers' Comments on This Blog Entry

From Jeff on August 7th, 2007
Although I do not disagree with you that "sellers panic" causes them to take a lower price for their goods, you are missing a vital point. Sellers that hold out right now are not going to sell at all...period. With the creative, or shall we say irresponsible, lending practices of the last few years, people were able to mortgage properties way out of their league. Stories of people on $14K a year incomes in $700k houses are not that uncommon. What are these people to do when these loans reset in the next few months? In addition, how can someone on a median income now afford that house with a traditional loan? These "creative" loans no longer exist. That puts that $700k house in a $4500-$5500 a month payment. Most of middle America cannot afford that. So, yes, I agree that the market will come down, but the chances of a soft landing are very slim. In all reality, this is inevitable and necessary. Houses do not appreciate, they just maintain their value adjusted for inflation. Research your housing market over the last 30-40 years, you will see that I am right. So we are due for a correction back to 2001-2002 numbers