HOT AND COLD MARKETS IN RESIDENTIAL REAL ESTATE
The study originated when one of the co-authors entered the residential real estate market to buy a home and started became aware that there seems to be a regular cycle during which there is more activity in the summer when prices are higher than in the winter months when prices are lower. This is a puzzling scenario because it begs the question: Why would people enter a market during a period when it is known that prices will be higher? Why do they not wait until the winter when they know that prices will be lower. And on the flip side, why do sellers sell during the winter season when they know that prices will be lower?
The pattern of higher prices and more activity in the summer, and lower prices and less activity is so ingrained in the market that In the US the FHFA produces two house price indexes; one that is the actual price and the other that is seasonalized. This means that the FHFA is reporting housing prices as though the cyclicality of the seasons does not exist.
The study looked at how big was this seasonal impact by looking at the raw data and not the seasonalized data to determine what is the difference between the summer and winter months for house prices. They found that the difference between the summer and the winter months is around 4.5% – a significant difference in pricing between the seasons – and that this difference has remained consistent for at least two decades.
The study found international differences in the seasonality with the UK having higher price differences summer over winter, and found that there were regional differences. For example, major California cities experience an 8% variance from winter to summer seasons. This is a very significant price difference, one season over another.
Similarly, the seasonality impacted the transactional volume with summer months experiencing over two and a half times more transactional volume than the winter months i.e. a 150% increase in volume.
The study thus put specific numbers on this known seasonality in the market, and then set out to explain why this was happening – why would anyone buy in the summer when prices were higher, or sell in the winter when prices were demonstrably lower. To answer this question the researchers considered the motivation for participants in the housing market. Typically, these are people who wish to live in the house that they buy – not always, but for the most part this is true. On average in the US and the UK, people tend to live in their homes for around ten years. [This trend is increasing in the US and has been discussed previously by economist Jordan Levine of the California Association of Realtors in a prior podcast].
The process of buying a house is costly on many levels. It is time consuming, stressful, and, of course, costly in financial terms, so when buyers look they tend to pay a lot of attention to the process and to take care in ensuring that the house they choose is one in which they will likely be happy to live for up to a decade. The extent to which a house suits a particular person is very specific to that person – one person might love a house for a number of reasons that another person might not. The result of this differentiation is that for someone who likes a specific home, they may be willing to pay more than the person who likes it less.
This concept that the same home can enjoy different valuations depending on the individual’s perception of that home is what the researchers called the ‘match quality’ of the home. If a person likes the home they will be willing to purchase the home for a price higher than other people might. This is the first building block of the theory underpinning the study.
The second building block of the theory is that where you have a market where the match quality is important – like, perhaps, the jobs market or the marriage market – when things are so specific to the pair, then what you want is that naturally in an environment where there are more choices around it will be more likely that the buyer will find a better match. This is called the ‘thick market effect’ where in a market with more choices you are likely to find something that you really like. In the case of a house, as perhaps with a job or a marriage candidate, when you find the right match you will be willing to pay more for it primarily because you like it that much more.
Likewise, as a seller, if you sell in a market where buyers are going to like your house more, then you will have the expectation that you will get a higher price. This is the second building block of the theory.
When you put everything together, consider the circumstance when there is a small amount of people who want to buy a house in the summer. Perhaps because of the school calendar, or because summer is a better time to look for houses because there is more light, or because people get married in the summer. Whatever the reason, even this small amount of people entering the market triggers other people to come in because it means that there will be more choices for them as well.
So what we see is higher prices in the summer because the quality of the match between buyer and the homes that they find is higher and so they are willing to pay more, and also they are more likely to find that perfect match because the number of available options is also higher. This now brings us back to the question why is it that buyers, knowing that prices are lower in the winter, why do they not buy in the winter? Well, if the buyer cares about the quality of living in the house then they value having more choices. If they wait until the winter they may not have same choices and so may not be able to find the home that best suits their needs.
CONCLUSIONS AND RECOMMENDATIONS
As a buyer, if you are picky about what you are looking for and are looking for something very specific, then you should wait until the summer when there is more choice and be prepared to pay more for that perfect home. If not so picky, then wait until the winter season when you can get a better price on something that may not be quite perfect for you, but that might offer better value for money.
As a seller, if you have a house that has a lot of special features then you should sell in the summer season because there are more people around looking for a home and you are going to be more likely to find someone who values those many features and will be willing to pay for them. If you house is, for example, a new build surrounded by homes that are very similar or otherwise does not have particularly special features, then there is no need to wait.
The central bank of a country is tasked with changing interest rates and changing the money supply to try to smooth out economic fluctuations to prevent runaway inflation and to keep employment at full growth. Their task is to stabilize the national economy and the way that they do that is by moving around short-term interest rates.
Until recently central banks have had a very strong reluctance to have negative interest rates and from an intuitive perspective this would make sense yet during the great recession that started some ten years ago, the federal funds rate were lowered to next to zero. This left very little maneuvering for the Fed as it tried to stimulate the economy. Attention, therefore, started to drift away from short term interest rates which were at close to zero percent, towards how to lower longer term interest rates that you might see on long term treasuries at around four percent or mortgage rates around four to five percent.
That is harder to do because the way that the Fed controls short term rates is it changes the rates that it charges banks trying to get overnight loans from the federal reserve. To influence long term rates, the federal reserve entered the market and became a voracious buyer of long term debt. During QE1 (the first round of quantitative easing), the Fed signaled that it was going to buy long term (30 year) mortgage backed securities. This has the effect of bidding up the price of the bonds which in turn pushes down the yield on the bonds which will be passed through to the corporate sector, and to the household sector. The economy would thus be stimulated by the fed’s acquisition of ten year treasury bonds and Fannie and Freddie mortgage backed securities, because long term investment decisions such as whether to purchase a house or build a multi-family apartment building or a factory will be facilitated as a result of having lower long term interest rates.
But the question is, does this really work and if it does, how does it work exactly because without seeing the full scope of consequences of such monetary policy there may be unexpected consequences that are more damaging than the problem we were originally attempting to solve. At Berkeley university there is a vast database of anonymized data on properties, on mortgages, and on refinances that is used to assess the impact of these policies on the market.
Palmer looked at who was refinancing, who was taking advantage of these lower interest rates, who is purchasing homes, and what kind of refinancing is going on in what volume, and link those behaviors to monetary policy to see what kind of effect the various QEs were and are having on the economy. Palmer looked at the effect of QE1 where the Fed was buying mortgage backed securities, and QE2 where the Fed looked at buying ten-year treasuries, and then at QE3 where there was a return to acquiring mortgage backed securities in addition to treasury debt. This left the question was one of these strategies more effective than another and if so why.
Quick aside. Fannie and Freddie buy and guarantee residential mortgage loans that meet several criteria. The loans must have at least 20% down payment, for example, it has to be below the ‘conforming’ loan limit which is in the neighborhood of around $500,000. If it a loan is higher than the defined conforming limit, it is ineligible for purchase by Fannie or Freddie. The Fed is restricted to buying loans guaranteed by Fannie and Freddie so for those communities where house prices are substantially higher than the conforming limits, then the mortgage amounts will be higher also so the theory is that these communities would not directly benefit from the QEs which were restricted to only buying conforming loans. They would not see interest rates come down nearly as much as those communities where loan sizes fell within the conforming loan limits. This allowed Palmer and his colleagues to compare the behavior of communities directly affected by the QEs, i.e. those communities with a predominance of conforming loans, with those less directly affected, i.e. those communities with higher home prices and consequently non-Fannie and Freddie loans.
What they found was that the reason that QE1 was so effective was that it was able to inject capital into the household sector by enabling people to refinance their homes at lower interest rates. QE2 was not nearly as effective because the Fed was only buying treasury debt and so could not drop liquidity into the household sector with nearly as much effectiveness as when buying Fannie and Freddie debt. When, in QE3, the Fed returned to buying mortgage backed securities it was not nearly as effective as it had been during QE1 because the economy, in some sense, did not need it quite as much as it had.
Going forward there is less likelihood that the Fed will continue with quantitative easing. As mortgages are paid off because someone sells their home or otherwise pays down their debt, the Fed reinvests the principle that is paid back by buying more Fannie and Freddie debt. One way to taper off the QE stimuli to slowly increase long term interest rates is to stop buying back Fannie and Freddie loans with principle that is paid back. As this happens, the long-term end of the yield curve will start to see an uptick in interest rates and consequently pricing will start to soften and cap rates will go up.