Market Information >

Be It Ever So Illogical:
Homeowners Who Won't Cut the Price

March 26, 2008

In 2005, Randolph Harrison and his wife, Pamela, decided to move north from Silicon Valley, over the Golden Gate Bridge into wooded Marin County to be closer to her new job. They found a six-bedroom house that seemed ideal except for the price, $1.875 million. The current owner, they knew, had bought the house a year earlier for $1.475 million.

So the couple, who both have finance jobs in the technology industry, told their real estate agent that they wanted to offer $1.575 million. He told them that the owner wouldn’t even listen to such a low bid. The owner’s attitude was “we’ll just stay here until we sell it for 1.875,” the agent said, “even if it takes years.”

Three years ago, when the real estate bubble was still inflating, this sort of standoff was the exception. It’s the norm today. Overall home sales have fallen a remarkable 33 percent since the summer of 2005. Home prices, on the other hand, continued to rise until 2006 and are now only 5 to 10 percent below where they were in mid-2005, according to various measures.

In most other areas of the economy, this combination of plummeting sales and stable prices would not happen. When demand for airline tickets drops, the airlines cut their prices until they have sold their seats. When stocks become less appealing, share prices fall, sometimes sharply.

Just try to imagine stock prices staying roughly flat over a three-year period while sales volumes sank because investors considered the market overvalued. Bear Stearns is still worth $150 a share, and I’m not selling until someone pays me $150!

Real estate, though, is different. For both economic and psychological reasons, there is no asset more conducive to hopeful overvaluation.

That means real estate slumps tend to grind on for years, until sellers submit to reality and reduce their prices. This week’s batch of economic reports suggest that the adjustment is finally starting to happen. The decline in house prices is accelerating, especially in some of the big metropolitan areas covered by the Case-Shiller index released Tuesday, while the number of home sales has recently risen a bit.

But prices still have a ways to fall. Relative to the economic fundamentals — like incomes and housing supply — the average price nationwide seems to be about 10 percent too high. (This, of course, hides a lot of variation. In Texas, prices look sensible, while in much of Florida and Arizona, they are probably about 25 percent too high.)

The slow unwinding of the real estate excess, in turn, means that the turmoil in the financial markets and the country’s broader economic problems also aren’t anywhere near their end. Ben Bernanke, the Federal Reserve chairman, recently told Congress that the stabilization of prices was “what we’re looking forward to.” That is, the end of the real estate slump is the only thing that can get the economy back on solid ground.

Until house prices stop falling, it won’t be clear how many more people will default on their mortgages. Even homeowners who stay current on their mortgage payments will be affected. With the value of their largest asset dropping, many will decide to spend less and save more, aggravating the economic slowdown.

On Tuesday, the Conference Board reported that Americans were more pessimistic about the economy’s direction over the next six months than at any point since the bad old days of the 1973 oil embargo.

In many ways, it would be better if the housing correction would happen more swiftly and sharply. The pain might be worse, but it would be over quickly. We seem to understand this principle when we’re removing a bandage. Why, then, is it so much harder with housing?

Because houses are almost perfectly engineered to trick owners into overvaluing them.

For starters, people have an obvious emotional connection to their house. After you have raised a family or enjoyed long meals with friends there, you are naturally going to place a higher value on it than a dispassionate buyer would. It’s your home.

In normal times, buyers and sellers can still come to an agreement because inflation allows sellers to feel that they have made a nice return on their house. People don’t sell houses frequently, so the sale price of a house is almost always higher than it was when the current owner bought it, just as the price of food, haircuts and everything else tends to rise over a five- or 10-year span. Because of leverage — the fact that people buy houses mostly on credit — these inflation-driven price increases turn into true investment gains.

In the wake of the biggest housing boom on record, it’s understandably hard to accept a new reality. Robert Glinert, a real estate agent in the Los Angeles area, said he has recently been saying no to almost half the sellers who have asked him to represent them. Their initial asking price is just too unrealistic.

“People say, ‘I don’t care about the market — my home is still worth what I paid for it in 2006,’ ” Mr. Glinert told me. “And I say, ‘To you. Only to you.’ ”

Doing what Mr. Glinert is asking sellers to do — dropping the asking price below their purchase price — is especially difficult. It’s tantamount to admitting defeat.

David Laibson, a leading behavioral economist, categorizes this sort of behavior under the heading of “the principle of the matter.” His point is that people often go to great lengths to avoid taking a loss — or simply having to acknowledge one. “Even a small loss evokes a sense of frustration,” said Mr. Laibson, a professor at Harvard. “There’s something magical about ‘at least breaking even.’ ”

Often, this hurts no one so much as it hurts the would-be sellers. They stay in homes where they no longer want to live, rather than accepting their loss and moving on. Or they move but endure the hassle of renting out their old home, waiting, usually in vain, for the mythical buyer who understands its charms. All the while, their money is tied up in the house, and inflation is eating away at its real value.

Back in 2005, after Mr. Harrison and his wife couldn’t find a house they considered fairly valued, they opted to rent instead. They pay $3,250 a month for a four-bedroom home, which is a bargain relative to what their mortgage payments would have been.

And that six-bedroom house listed for $1.875 million? The last Mr. Harrison checked, it still hadn’t sold.