Finance Weblog: Real state prices in Spain and bad decision making

John Authers a journalist from the FT described the Spanish consumers as bad decision makers in terms of their real state buying decisions. He grounded his appreciations on arguments from behavioural finance widely discussed by Robert Shiller in his book Irrational Exuberance. Though Irrational Exuberance dealt with the dot com boom instead of the real state boom, the same principles apply. According to Shiller, traditionally the trend on housing prices has moved closely with that of rents, as any asset pricing valuation model would predict. But in the last years they have been diverging widely. Prices have increased by 182 % and rents have barely moved. This movement has been exacerbated in countries like Spain. Shiller summarizes the principles of behavioural finance that has led many to buy a house without much looking at any valuation model or economic reasoning as follows. First, homebuyers are affected by wishful thinking; they all believe their house is a winner. Second, the human brain filters and processes ideas in terms of stories rather that documented facts. Stories from relatives of friends blur our thinking on the value of housing. Last, money illusion. People only report their buying and selling prices. Transactions costs- notaries, taxes…-, maintenance and other costs of the investment are not generally input at the time of calculating the return of the investments.

Further arguments that justify wrong decisions making comes to mind when looking at the boom in the Spanish real sector. First, it is probably the first time in the Spanish economic history that consumer widely get mortgages at adjustable rates. Those who got mortgages at euribor plus a some basis points summing just 3,50% where really thinking that rates would permanently stay there. They engaged in adjustables rates but they never thought they would adjust. Second, people dislike renting as they believe they are throwing their money to the trash. When buying a house people hardly make the homework of calculating the return on an alternative investment (rather than the home) and whether that return is higher than the rental cost. Third, people argue fiercely that real state prices have never gone down. This is again a lot of wishful thinking. Just look back at the statistics (see graph below) . Fourth, people have very short memory. Even those who lived the period of high rates, cannot factor in the wide swing that interest rates go through. Many of the second house homebuyers, bought their house when rates were well above 15 %. This has been erased from their memories as they only remember the rates from the current business cycle.

There are too many reasons for not buying, but there are also many reasons that justify the purchase of a house today or at least a couple of years ago. I will leave it for another post.

Real House Prices for Spain
Source: “House Prices and Monetary Policy: A Cross-Country Study” (2005) by Alan G. Ahearne, John Ammer, Brian M. Doyle, Linda S. Kole, and Robert F. Martin, Board of Governors of the Federal Reserve, International Finance Discussion, Number 841

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