Are You Buying Into a Bubble?

Charlie Nathanson, Prof. Kellogg School of Business at Northwestern, explains how to tell if you are buying a home at bubble pricing.  Consider the motivation of last years’ buyers to assess this possibility, and keep an eye on sales volumes – if they suddenly tail off, prices may be about to fall.

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Past performance is not a guarantee of future results...

This boilerplate disclaimer is standard wording for just about any financial investment, but when it comes to buying a home, as sensible as this pithy phrase may be, it is often disregarded.  Home buyers tend to be driven by the idea that because prices went up last year, they must go up next year.  Their belief in future price rises is often driven by watching past performance of the market, and buying is motivated by a belief in anticipated future price appreciation.  Same goes for speculators who, seeing a steady upward trajectory in house prices, assume that this is also a guarantee of future increases in value.

To be sure, there are some fundamental factors that drive price increases, but without being specific about what caused last year’s price rises, how can the buyer be so sure that that prices will go up next year also?  Or the year after, or the year after that?  or, indeed, that prices won’t go down?

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Buyer Motivation

In order to understand what is going on with recent house price increases, we need to know what prior buyers believed when they bought their houses.  If they bought under the assumption that prices were going to rise, then their decision may have been irrational and so, possibly, pushed up prices disproportionately to market fundamentals.  One way to measure this is to assess what proportion of those increases were driven by house flippers.  Brokers should be able to give a sense of this in their own geographical areas.  If they are reporting a preponderance of such activity, this might be indicative of being in the later stages in the cycle.

Also compelling is the idea that transactional volume alone is a precursor to where pricing is likely to go.   Finding data for transactional volume should not be too difficult, and if one sees a tailing off of volume, it may be the first sign that pricing is also about to stop rising and may be on the way down.

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