Asset Bubbles: an Application to Residential Real Estate

Abstract

Behavioural models offer new insights into why bubbles are ubiquitous in residential real estate markets. These markets are dominated by unsophisticated households who often develop optimistic views by extrapolating from past returns. Rational investors cannot easily trade against an overvaluation of housing assets because of high transaction costs and a binding short sale constraint. Circumventing the effect of the latter, the supply of housing frequently increases in response to rising prices. This helps to mitigate bubbles but often leads to overbuilding, which slows down the recovery after a bubble bursts. Models that incorporate the effects of perverse incentives and limits to arbitrage are especially helpful in explaining the bubble that developed in mortgage‐backed securities and helped fuel the recent real estate bubble by relaxing home buyers’ borrowing constraints. The literature is ambiguous about whether governments should intervene to burst bubbles, as a better response may lie in improving incentives of key market players.

Did bubbles migrate from the stock to the housing market in China between 2005 and 2010?

“…Accordingly, asset prices may contain a sizeable speculative component. For surveys of the theory of asset market bubbles, see Scherbina and Schlusche (), and for housing market bubbles, see Glaeser and Nathanson () and Scherbina and Schlusche (). In China, the dominance of unsophisticated households, binding short‐sale constraints and often costly arbitrage are common to the stock (during our sample) and residential housing markets.…”

Getting it right or getting it cursed: Auction prices in a residential real estate bubble

“…Our auctions differ from their auctions in that our auctions include both experienced real estate investors and inexperienced owner occupiers – households with scant real estate investment experience. Scherbina and Schlusche () conjecture, but do not test, that the presence of these two types of property purchaser in residential real estate markets can be expected to impact on the pricing dynamics in such markets, which can account for why ‘bubbles are ubiquitous’ in residential real estate markets. We test for a winner's curse in a sample which combines hand‐collected data on the critical winning bidder characteristic of experience (professional real estate investor versus an owner occupier).…”

Behavioural Economics and House Prices: A Literature Review

“…In housing markets, as soon as prices become too high, it becomes rational to relocate elsewhere to purchase cheaper property in a different area of the country; regional land bubbles cannot exist if perfectly rational actors invest in housing markets. However, there is evidence that regional bubbles do exist, such as in parts of rural Cheshire and London (Scherbina & Schlusche, 2012). In many nations (including the UK), the after-effects of the bursting of the house-price bubble led many people into a 'Mobility Trap', in which they could not relocate to jobs more favourable to their skill set (Stephens, 2012).…”

“…Stiglitz (1990) argued that if individuals are rational, they would foresee the date when the bubble would burst, and sell the asset before thatlowering prices; this fall in the asset price would also be foreseen; hence bubbles would not exist. Scherbina & Schlusche (2012) claim that with high levels of substitutability in stock markets, a bubble is incompatible with rational behaviour. In housing markets, as soon as prices become too high, it becomes rational to relocate elsewhere to purchase cheaper property in a different area of the country; regional land bubbles cannot exist if perfectly rational actors invest in housing markets.…”

“…The reverse of what neoclassical economists assume. Scherbina & Schlusche (2012) refer to 'feedback trading' -a chartist view, assuming stock price changes are based on previous price changes (similar to the weak form of the Efficient Market Hypothesis), allowing unnatural growth above the fundamental value of an asset. These effectively create a Ponzi process (Minksy, 1977), causing a flood of money into the housing market -forcing up prices artificially.…”