The prices that people expect tomorrow influence today’s demand and supply.
Economists say that “fundamental” economic factors, such as interest rates and family income, determine home prices. For some unknown reason, economists don’t consider people’s expectations of future house prices to be a major factor in determining current house prices, but they should.
Economists have done a lot of research about this general idea. Unfortunately, they call it a bunch of different things, which is very confusing. The general idea has been called: price Expectations, price extrapolation, biased expectations, adaptive expectations, diagnostic expectations, irrational exuberance, learning about prices, impulse tradeand other names.
Despite all the different names, the idea seems obvious: If you expect house prices to be higher in the future, you’re naturally less willing to sell now, more willing to buy now, and more willing to pay more. of the current market price. for a house. That expectation causes house prices to rise even faster, which makes people even more confident that prices will continue to rise, so prices will continue to rise, and so on in a feedback loop . Up to a point, higher prices lead to higher prices.
If you expect house prices to be lower in the future, you are more willing to sell, less willing to buy now, and less willing to pay current market prices for a home, creating a negative price feedback loop. lower leading to lower prices. .
It’s not just home buyers and sellers who are affected. When prices rise, lenders also tend to extrapolate rising prices and their rising profits into the future, and in turn may be more willing to lend money, leading to more money looking for homes, higher home prices , etc. in other feedback. circle.
This is the opposite of standard economic thinking. Higher prices are supposed to reduce demand. It is true that higher prices will reduce demand in the long run, but if higher prices make people think that prices will rise even more in the near future, higher prices may cause demand to increase in the short and medium term. term. The opposite happens with falling prices.
Perhaps that’s why economists don’t call price expectations fundamental: it’s too hard to explain that, with houses, the side effect of price changes (their impact on future price expectations) can sometimes temporarily outweigh their effect. of text book.
The point is, whether prices move up, down, or sideways, many people will expect the current price trend to continue into the future, and those expectations may be a large part of current housing demand. .
Mortgage rates are one of the most fundamental drivers of housing market demand. When you apply for a 30-year loan with a small down payment, changes in the mortgage interest rate have a big impact on your monthly payments. Beginning in late 2018, mortgage rates fell for two years, lowering monthly payments and driving up home prices. Changes in other fundamentals brought about by the pandemic further fueled housing demand.
Interest rates stopped falling in January 2021. Stimulus checks ended in early 2021. The work-from-home movement was also old news by then. However, house prices continued to skyrocket through May 2022.
Many investors who had made a lot of money from home price appreciation doubled down, borrowed as much money as they could, and bought more houses. Many prospective homeowners wanted to buy before prices rose further, fearing the price would put them out of the property forever.
House prices continued to rise in 2021 and 2022, in large part because people expected them to continue rising even though many of the underlying fundamentals were no longer bullish.
Many people were simply extrapolating from past price increases. We probably also had a lot of herd instinct, “Everyone is offering tens of thousands of dollars above the list price, you have to too!”.
Then, in 2022, mortgage rates skyrocketed. The music stopped and the punch bowl was taken away. House prices stabilized. Expectations of future price increases began to decline. Today, the demand side of future price expectations is much smaller than it was last spring and will continue to fade as long as prices do not rise.
The bottom line is that demand will continue to fall for many months to come, regardless of mortgage rates, because people are slowly lowering their expectations of future house price increases. Housing demand is falling along with expectations of future house price increases.
Another round of Fed rate hikes would reduce demand immediately on top of the decline in demand from falling future price expectations.
Median home prices have already started to fall in several cities, including Phoenix and Boise. If prices drop enough for long enough and enough people start to expect prices to continue to drop in the future, that would be a game changer. It would create a new feedback loop, but this time a negative feedback loop: lower prices leading to lower prices.
It seems extremely likely that the tone of many homebuyers will change from last year’s “let’s buy ASAP” to “let’s wait and see.”
Also, some potential home sellers will gradually become more interested in selling when their second home or rental property no longer appreciates more in a year than they earn from their full-time job.
The demand side of future price expectations is very likely to fade for a year or two, maybe two or three. Things would get tough if on top of that we also have a recession that reduces demand for housing.
John Estelle is an independent real estate analyst.
Opinions expressed in Fortune.com comments are solely the views of their authors and do not reflect the views and beliefs of any Fortune.
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