BENTLEY UNIVERSITY, PROFESSOR HALL, PS328

The Psychology Behind the Housing Market

(Rogers) Brett Bisesti 4/28/2011 The housing market is in a rut it cannot climb out of. Since the burst of the bubble in 2008, housing price have been declining and new and existing home sales continue to struggle. Even though in recent months the economy in the United States seems to be turning around, housing remains steady just above recession lows. But why is this? Through the application of heuristics, behavioral psychology, behavioral economics, and behavioral finance, this paper will attempt to use aspects of psychology to explain why this market remains low, and it will offer solutions to help ignite future growth.

Part I: Heuristics role in the real estate market The real estate market, considered by many to be the backbone of the American dream, is one of the most complicated and daunting markets in the United States. Whereas with equities and stock option traders have easy access to buying, selling, researching, and Q&A forums, in most cases real estate trading investing requires large sums of money, lawyers, banks, credit-rating agencies, and real estate agents (just to name a few). The hoops that people have to jump through to rent, purchase, or even sell a home are numerous, costly, and in many cases confusing. Thus the heuristics behind the real estate market stem from these variables. Specifically the psychological factors behind most of the tensions in the real estate market come from loss and risk aversion. Just as people hate feeling cheated when they buy consumer goods, they also hate the feeling associated with losing money on real estate, especially with the higher expense associated with real estate prices. These factors, while mostly associated with consumers in the real estate market, are also present within the professional circle. These sentiments can be seen in a forum run by InmanNews, a Real estate/technology news source, called, Real Estate Predictions, and Wish List for 2011. In this article real estate professionals spanning from but not limited to investors, analysts, and brokers discussed their predictions for 2011. Many of these professionals, stating that they would LIKE to see growth in the housing market, didnt believe that it would happen. An exemplary pessimistic quote comes from Louis Cammarosano, General Manager at HomeGain in CA. He writes:

Predictions: More of the same. In many areas there is nothing on the horizon to indicate an improving real estate market. The second round of quantitative easing ("QE2") will prove to be another flop orchestrated by an inept Federal Reserve, and cause more damage to the economy and further damage the value of the dollar. (News) Although there were several more optoimistic views in this forum, the general feeling towards the real estate market in 2011 was a negative one. But with increases in the equities markets and a general increase in population sentiment, why isnt the real estate market improving too? As stated earlier, the main reason why this market is not taking off is that people are not psychologically willing to believe that the market will improve. They believe that if they buy now their investments will only lead to losses, thus loss aversion. And just as Louis Cammarosano wrote there are no indicators to show that the market will improve: risk aversion. People are not buying into the market because they are afraid that it will crash again, and they are trying to minimize losses. Yet if professionals arent actively participating in the movement of real estate because they are afraid of losing out, then what would the general public feal? Speaking about home-equity loans, Tara-Nicholle Nelson writes in A tougher mindset for the new real estate reality, Homeowners who have equity dont see it as easy money anymore, even though they didnt have to work for it. They see their home equity as part and parcel of their home itself, the asset, and the place where they live. They see it as untouchable. Its their most precious asset. No, seriously.

And many wont do anything not borrow, nor spend to further burden it, to subject it to the risk of loss. (Nelson) In this quote Tara-Nicholle states that people arent taking out home equity loans as much anymore because after the recession they do not want to play with their, greatest asset, and, subject it to the risk of loss. This concept this heuristic as it relates to homeequity loans is similar to that of home loans in general, and from the examples above we can see how risk and loss aversion have led to a stagnation in the housing market. Part II: Behavioral Psychology There are also many aspects of behavioral psychology that weigh in on why the real estate market is underperforming, but for this paper we will focus on only three of these aspects, the consequences behind affective decision making, exchange theory, and social influence. In terms of making decisions, real estate related ones are much more difficult to make for many reasons. Not only are they much more complicated than many of the other financial decisions we make, they also involve a lot more of our hard-earned cash. Therefore even though making a decision about a complicated issue which you may know very little about is difficult, adding on the extra financial burden certainly does not help alleviate stress levels much. Thus in this way affective decision-making techniques play a large role in the health of the real estate market, because as written about earlier, if people inheritently feel that they would not be benefiting from purchasing or renting a new home, they will be less likely to take on the stress associated with this type of transaction.

Yet incurring a loss is not only an affective decision, it also branches into exchange theory. Due to exchange theory, in order for someone to want to take a deal they must feel that there is an even exchange. Thus in this case people buying or renting homes must feel that what they are paying for is worth at least the amount they are shelling out, but in many instances this is not the case. In many areas with housing prices declining people are not looking to move real estate because they feel that they would be losing out on the deal. People looking to buy houses are not doing so because they feel that they will not be able to afford the climbing interest rates on loans while the market continues to fall, where as people looking to sell feel that their houses are undervalued. Thus neither of the requirements are met on either side of the real estate equation and due to this there will continue to be a depression in the market for real estate. Even though buyers dont feel that they would be receiving an even exchange for their money, it still doesnt mean that they arent looking to upgrade their housing situation. This has to do with social influence. Due to the social needs of people, we are always comparing ourselves to those around us. Due to this need people are always looking to live in better homes or improve the ones they live in. Its this need for improvement that leads to home loans and equity loans and what had caused the original recession. Over the course of the last decade banks and other financing institutions were giving out loans freely. They rarely did background credit checks or verified that the people applying for these loans had stable employment. Thus many of these institutions were handing out loans to people who would never be able to pay them back. This led to many people defaulting on their payments and a meltdown in the financial system. The original loans helped to create the housing crisis.

Part III: Behavioral Economics This name, the Housing Crisis is known as superficial scapegoating. This is part of a psychological branch called, behavioral economics. This as well as the factors of recency bias, anchoring, and impulsivity play a large role in the real estate market. Real estate and market analysts do far more damage than they realize when they refer to the housing market crash in 2008 as the Housing Crisis. By naming this issue as such, these professionals are giving the economic downturn a negative connotation. This nuance not only affects the minds of real estate professionals, but it also affects the buying and selling habits of general consumers. Thus because the United States population believes the housing market is in a crisis they are less likely to participate in this form of trading, and the crisis spreads. Yet even after the worst of the crisis is over people will continue to doubt its strength because of recency bias. Examples of this bias being used in the financial world would be technical analysis tools such as The Moving Average Convergence-Divergence which measures the shift between bullishness and bearishness in equities. While this technical can be used for stocks, the concept can also be applied to the housing market, where people will consider purchasing or selling their homes based on what has happened in the markets recently, which can be shown in terms of a time-series graph. Thus if major voices in the industry state that the market is in crisis, a couple of months later unless those same voices begin to change their views the general public will continue to feel that the market is not in a strong place.

This concept of recency bias also goes along hand in hand with the idea of anchoring. In terms of the real estate market now, many people are making their decisions based on their anchored beleifs about the market gathered from the recession rather than making impulse choices. While most home buyers or sellers wouldnt make impulese choices regarding such a costly and psychologically draining process anyways, it would also make sense that more people would make their decisions based on upheld beliefs taken from the recession years, especially due to the concepts of superficial scapegoating and recency bias. Thus due to these behavoiral economic concepts, following the recession people have a less than optimistic view on the real estate market. Part IV: Behavioral Finance Behavioral finance also plays a strong role in why the housing market is in the state it is now. This is mainly due to the collective state of pessimism which has built up since the recessino due to factors associated with behavioral psychology and behavioral economics. This pessimism is almost entirely due to the burst of the housing bubble which had been built up from a housing surge within the last decade. Thus because of the excessive exuberance in the early 21st century, when this excitement fell, it dove into the pit of recession. This drop in the real estate market due to heuristics, behavioral psychology, and behavioral economics helped to create the collective state of pesimmism we see in the real estate market now. And although this cynicism will continue, there is a solution to the beleaguered real estate market.

Part V: Solutions While due to behavioral finance people are in a collective state of pesimmism concerning the real estate market, what really needs to happen is cautious optimism. This would lead to slow, steady growth. Just as the economy as a whole does not want to move quickly and drastically between recession and inflation, the housing market shouldnt either. This can be attained through a couple of different psychological changes. For one, people need to begin to believe that the economy is growing stronger. This confidence would be created through job growth and a drop in the foreclosure rates among other factors; because as people began going back to work, there will be more people earning regular wages and they will once again be able to afford mortgage payments. This would lower foreclosure rates which in turn would increase confidence in housing because fewer people would be losing their homes. Thus while this example we would need unemployment to drop, but is this attainable? Federal Reserve chair Ben Bernanke stated that it may take four to five years for unemployment to reach pre-recession levels. (Press) Therefore based on one of the most respected economic advisors of all time the United States has several more years to go to reach pre-recession levels. Yet while this may be true, is it not also true that in order to reach these levels the economy must grow over the next few years? It may be true that it will not grow quickly or at a very steady pace, but the fact of the matter is that it will grow. Thus if people were willing to take this optimistic view and translate it to housing this market will have the potential to move in a positive direction over the next few years. If buyers and sellers began to have a more upbeat view on the real estate market they might be able to swing prices and mortgage rates back into areas which promote more trading. As Tara-Nicholle Nelson writes, The headline then might

be, Is Prosperity Contagious? It's certainly an outbreak worth trying to start. (Nelson, Foreclosure and Debt: Contagious?) Part VI: Conclusion In this way heuristics, behavioral psychology, behavioral economics, and behavioral finance played a role in the rise, flattening out, and decline in the real estate market. Yet if we were to try and change some of our views about real estate, we may be able to set the market on a path of future growth.

Works Cited
Nelson, Tara-Nicholle. A Tougher Mindset for the New Real Estate Reality. 5 April 2011. 28 April 2011 <http://www.rethinkrealestate.com/http:/www.rethinkrealestate.com/a-tougher-mindset-for-the-newreal-estate-reality/>. . "Foreclosure and Debt: Contagious?" 5 October 2009. InMan News. 3 May 2011 <http://www.inman.com/buyers-sellers/columnists/tara-nicholle-nelson/foreclosure-debtcontagious?page=0%2C1>. News, Inman. "Real Estate Predictions, Wish List for 2011." Inman News (2010). Press, Associated. "Bernanke: It may take four to five years to reach normal unemployment levels." 8 January 2011. 3 May 2011 <http://www.gazettenet.com/2011/01/08/bernanke-it-may-take-four-fiveyears-reach-normal-unemployment-l>. Rogers. Gingerbread House Picture. Pittsburgh Post-Gazette. Pittsburgh Post-Gazette. Pittsburgh, 2007.