Why a ‘rush to buy’ is completely irrational

I was going to write a post on this, but John beat me to it when he made a great comment in the comment section of yesterday’s post.  We’ll get to that in a minute, but here’s the quote that got me thinking about the irrationality involved in rushing to buy a home in an attempt to beat the new mortgage rules:

“The mortgage changes come at the worst possible time for Guy Pearson. The Surrey resident, who lives with his wife and three children in his mother-in-law’s house, has been looking to buy a house with a suite and was pre-approved for a purchase price of $340,000. The reduction in the maximum amortization period means Pearson now only qualifies for a $325,000 purchase.

“It’s not a ton, but it’s enough for me to go, ‘Oh my goodness, I’m not going to really get what I want now,’”

The article indicates that Mr. Pearson is wisely considering waiting things out rather than rushing to buy in an attempt to beat the new changes, as some will no doubt do.

Allow me to turn it over to John for an excellent discussion of the rationality involved in such a decision:

“Further to Ben’s topic today, there has been a lot of discussion everywhere about a possible surge in sales over the next two months as buyers attempt to lock in a 5/35. But what price should buyers be willing to pay?

The general consensus forming from economists and bloggers alike, is that house prices will drop by anywhere from 2% to about 8% this year as a result of this mortgage tightening.

However, I read that many people believe the drop in prices will happen after March 18, not before. Indeed many people believe the “surge in demand” will drive prices up over the next two months and many listings will come online to take advantage of the higher prices. In other words, once again demand will be brought forward.

If prices rise over the next two months, it will demonstrate just how irrational markets can be. We have perfect information as of two days ago, that demand for housing is going to be reduced. That, after all, was the point of the announcement.

When a demand reducing announcement is made, the demand curve shifts immediately. The market has perfect information about the future. Any purchaser who is contemplating a 5/35 at price P, will in two months only be able to afford a 5/30 at price P’ where P’ < P.

Thus the class of housing that was in the sweet spot for 5/35 purchasers at price P will immediately shift to the lower price P’. It would be irrational to pay the higher price just because cash flow would allow it. Consider the possibility that prices go down 7%. That 5% down payment is gone and the house is under water.

The rational thing to do is offer P’ now, even if a 5/35 can be locked in. The windfall is taken by the buyer as “economic rents.” Otherwise, wait until the price is forced by the drop in demand down to P’. The cash flow at 5/30 may be very similar to the cash flow that would have occurred at 5/35 simply because of the lower price.

Exactly where P’ ends up will have to be determined in the fullness of time. However, it is clear that, all things being equal, P’ is less than today’s prices. Paying a premium to lock in a 5/35 mortgage today is irrational.”

I am continually impressed by the insightful discussion in the comment section of this blog.  Thank you to all commenters for your valuable insights.

Cheers,

Ben

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15 Responses to Why a ‘rush to buy’ is completely irrational

  1. Jordan says:

    It certainly is irrational — but then again, over-bidding $100k on a cramped Leslieville row-house built on an old brownfield is also irrational, yet it still happens.

    As I’ve mentioned, the nice thing here is that we won’t have to wait long to get a fine-grained look at the effect of Flaherty’s announcement on the market.

  2. ATP says:

    I doubt there will be a rush to buy over the next two months. Unlike implementation of the HST and tightening from 0% to 5% down, the announced policy changes do not result in any sizable immediate cash savings that will entice the potential buyer to buy in a hurry. Also, with the last round of policy tightening still fresh in mind, the recent announcement will give buyers the impression that the government seems pretty serious about cooling down the real estate market. I think a lot of potential buyers will take a wait and see approach this time. The ball is back in the seller’s court and the trend in listing will be interesting to watch.

  3. Aaron H. says:

    Hi,

    I’ve been following your blog for a few weeks and I just want to say that it is excellent.

    Thanks, and keep it coming!

  4. paulb says:

    The best blog out there as far as in-depth analysis goes; hands down.

  5. Diddy321 says:

    While John’s post makes a lot of sense rationally, the biggest issue with it is this statement:

    “We have perfect information as of two days ago, that demand for housing is going to be reduced”.

    Sure those closely following real estate will arrive at this conclusion, but Real Estate transactions in practice are heavily information asymmetrical. Average Joe is negotiating a house / mortgage with agents / brokers that will spin this bit of information however they want, while at the same time introducing other high pressure counter points to close the sale.

    I could imagine a conversation along the lines of “I hear these new rules will mean less people in the market, so prices should be going down, right?” To which an agent could balk back “no, I do hundreds of transactions a month in this city, this year has been crazy with rich foreigners offsetting that”. Average Joe will accept that answer, as they can’t prove otherwise, they don’t have access to that info.

    • Howdy There says:

      Awesome. See my post following with regards to micro and macro understanding of the housing market. The agent is selling micro, while the action lies with macro.

      DON’T BE FOOLED

  6. Howdy There says:

    From a micro (individual) perspective, you have to make your financing match the price. As an individual, if the price is $300K, you better find out how to borrow that much.

    From a macro (collective) perspective, prices will match the overall ability of people to borrow. In other word, if lending is reduced, prices will fall. Most people don’t understand this, as they are focussed on the para above.

    People who don’t understand that the buyer set the price (as per para 2) will rush to buy before the new rules apply. They assume prices are determined by factors beyond their control and that they need to maximize their borrowing potential to meet market prices. They are micro in their understanding of economics. To borrow from Garth, they are greater fools.

    For those that understand that agregate prices are set by the buyer (macro), they will anticipate lower prices from the new rules. By limiting the ability of people to spend their future income by 5 years, prices will fall.

    Add in that investors will flee markets that don’t provide a positive return, we can expect significant drops in prices. I predict that sales and posibly prices will increase before the new rules. This is only because people don’t understand that availability of debt and willingness to use it sets prices; they deserve the title of greater fool.

    Only when the general public understands the dynamic nature of markets (macro outlook) will we see rational markets. Agregate willingness to mortgage your future pushes prices up; agregate conservative fiscal policy gets a better price and a better future.

    Chears

    • John in Ottawa says:

      Good comment. The old adage, “The markets can stay irrational longer than you can stay solvent.” exists for a reason.

    • buff_butler says:

      to further your comment; typically with housing the supply/demand curve for the purchaser is in terms of the monthly payment not overall price. For the builder supply/demand is in terms of the overall price vs labour + materials.

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  8. Nick says:

    A head scratcher…

    There is a 3 bedroom house that was listed on our street in the fall for $638k. It did not sell. In early January it re-appeared on MLS for $569k. Since the Flaherty announcement regarding mortgage regulations it has been re-adjusted to $619k.

    Does this count as a price increase, sideways pricing or reduction?

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