Slow decline of Home Prices

Shiller (of Case -Shiller index) wrote in The New York Times about why home prices fall slowly instead of crashing and why the prices may continue to fall. This is a great explanation of the averages and the reasons for slow decline. Two questions occur to me:

  1. Why does a homeowner start with a very high list price even though the market price (based on comparable homes) is lower?
  2. Why are homeowners willing to let go an offer only to settle later for the same or lower price?

The reason for the high list price can be attributed to endowment effect. People tend to value things they own more than the things they do not. This is nicely demonstrated in a video by Dan Ariely. There is considerable emotional connections that get translated into higher utility and hence a higher valuation. In addition to this people do not consider opportunity cost of carrying the home for longer time. This results in initial high priced listing despite the fact that comparable houses in the neighborhood have been in the market for a much longer time and are currently priced lower than this house. Unfortunately buyers do not share the same emotional value hence houses end up sitting in the market longer.

The reason for rejecting reasonable offers during the initial days only to settle for same or lower price later is due to mental accounting that ignores the opportunity cost of carrying the home longer. Opportunity cost here includes additional mortgage payments, carrying costs and most importantly lost revenue from capital tied up in the house. Even if they considered opportunity costs, homeowners overestimate the chances of getting better offer and underestimate the time they need to wait for such an offer. Due to  high initial price, a low offer will also look substantially lower.

The net result is prices not reflecting what the market is willing to pay. Hence the slow decline of home prices.

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