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Housing over-confidence

Created:

27 April 2009

Updated:

29 April 2009

Written by:

Chris Dillow

How much do you think your house is worth? If you're a typical person, now knock 10 per cent off. That's the advice suggested by research presented to the recent Royal Economic Society annual conference by Sergi Jimenez-Martin of the Barcelona's Universitat Pompeu Fabra.

He's estimated that the average person over-estimates the price of their house by between five and ten per cent. But there's variation around this average. Whereas people who bought in recessions tend to value their houses accurately, those who bought in booms are even more over-optimistic, overvaluing their properties by up to 20 per cent.

Although this finding is based on US evidence, there's no reason to suppose UK home-owners are different. Indeed, Rightmove's index of sellers' asking prices fell just 9 per cent in the 12 months to March. That compares to a fall of 15.7 per cent in Nationwide's index and 17.6 per cent in Lloyds Banking's, both of which measure prices when mortgages have been approved and a sale agreed. This suggests sellers are too optimistic here as well as in the US.

There are strong cognitive biases causing this - and not just plain wishful thinking. One is the availability heuristic effect. If your biggest exposure to housing market economics came when you bought during a boom - and of course, many more people buy in booms than slumps - rapid house price appreciation will loom large in your mind. This will cause you to over-estimate its size and frequency, and so over-estimate your own house price.

And then there are attribution biases. On hearing that a neighbour's house has sold for a low price, our reaction is often: "But our house is much more presentable than theirs." Everyone thinks they are Sarah Beeny. But they are not (a fact which suggests Richard Dawkins might have a point.)

Whatever the cause, this tendency to over-estimate our house price has some important effects. One, says Mr Jimenez-Martin, is that during the boom it led people to take on lots of debt, in the hope that house price rises would allow them to pay it off.

If people are still over-estimating prices, they won't have adjusted to reality yet. Which raises the danger that as the full extent of the housing slump finally hits people where it hurts, consumer spending will eventually fall - something it hasn't done to date.

So, far, retail sales have not been much affected by falling prices; since the third quarter of 2007 they have risen 3.8 per cent in real terms whilst house prices, according to the Nationwide, have dropped 20.2 per cent. Is this because housing isn't net wealth, and so shouldn't affect spending? Or might it be because some of those people for whom housing is net wealth are over-estimating their wealth? If it's the latter, spending could yet fall.

A further danger is that house prices will continue to fall. The main house price indices measure the prices around the time at which houses change hands. But sellers who over-estimate their home's worth will not accept realistic offers, so their house won't enter these indices. It's only when they cut their price so it does sell that the indices will measure it.

This means the house price indices are inherently upwardly biased. They exclude some properties whose price will fall. Which means the indices could drift down as sellers wake up.

History shows that house prices often fall even as the economy generally recovers. One reason for this might be that home-owners are slow to adjust to reality.