What Psychology And The Big Short Tell Us Will Happen In The Prime London Resi Market
The prime Central London residential market is frozen, and property sales in the area have stagnated. That is often not because of any particular distress, but instead comes down to a deep psychological aversion people have to selling at below their preconceived idea of fair value, even when it is the "rational" thing to do.
To understand what is happening in the market and where it might go next, it is worth looking at the field of behavioural psychology via the lens of best-selling book and film "The Big Short".
According to data from LonRes, the London residential analysis firm, in the past year more London properties have been taken off the market after being put for sale than have actually been sold.
Transaction volumes have fallen by 11% in the first half of 2017, and are down by 37% compared to the first half of 2013. And when transaction volumes fall, prices follow — down 4% across London according to LonRes, and 11% for prime markets.
The average sale is occurring after 164 days, and those who give up typically do so after 161 days.
But buyers are still asking for sky-high prices. A year ago 21% of vendors were cutting asking prices by 10% or more to achieve a sale - now that figure is more than a third.
LonRes said this showed that while people were willing to accept price cuts, properties are still reaching the market with hugely overly optimistic asking prices.
A lack of affordability among the homes being built in London is largely to blame.
But psychology also plays a big part.
Professor Richard Thaler is the behavioural economist and author of the best-selling book "Nudge", which looks at how behavioural psychology can be applied to everyday life.
He points to a paper and his appearance in the film "The Big Short" [from 3:25 onward] to show how the topic influences real estate.
“My best work on real estate was in the movie 'The Big Short,'” Thaler told Bisnow.
He also pointed to a paper by David Genesove and Christopher Mayer that looked at the crash of the Boston condo market in the late 1980s and early 1990s, when prices fell almost 40%. It found that those who had bought at the peak of the market typically listed their properties at around 35% higher than the prevailing market prices when they came to sell, meaning fewer than 30% of homes listed sold within six months, creating a big overhang of unsold homes.
“These observations suggest that sellers’ reservation prices may be less flexible downwards than buyers’ offers. This pattern is especially puzzling given that most moves are local, so that the typical seller is also a buyer in the same market,” Thaler said.
Genesove and Mayer explain this as a result of loss aversion and prospect theory. Even if the price of your condo has fallen 40%, so has everything else on the market and you are probably moving nearby, so it should not really matter if you sell at a loss because you are buying at a discount. But loss aversion and prospect theory outline how and why people are not rational like that. It argues that we base financial decisions around fixed markers — so if you bought at one price, you are loathe to sell below that, even if the house you are buying has fallen by a similar amount, because the pain of the loss is greater than the pleasure of buying at a similar discount.
And so we come back to the current situation in London. The market had an incredible bull run in the 15 or so years to 2015, with prices on average more than doubling and sometimes even tripling in most districts.
Those who have bought toward the end of this run are reluctant to sell at a loss, hence the big difference between asking prices and selling prices. Even if they have made money, it takes time for people to accept the new market reality. That is making the market sluggish, even though people want to do deals.
“There are large numbers of people in properties they would really rather sell,” LonRes head of research Marcus Dixon said.
And the theory is even more applicable at the level of developers and companies involved in the prime new-build market.
The prime new-build residential market has suffered even more precipitous falls in transaction volumes than the general market — new-build sales levels fell 44% in 2016, according to data from London Central Portfolio. Prices fell 9% in the same period.
“The problem is a lot of what has been built in West London and south of the river was built for an expat price point, and the interest is not there at the moment,” Apollo Global Management head of Europe Roger Orf said. “The domestic price point is about half of that.”
Here the market is stagnating less because of psychology, but instead because the developers building these units cannot afford to sell at a price the market is willing to pay. At the height of the market from 2013 to 2015, a huge number of development sites traded at prices that implied the end sales values would remain at high levels, rather than start to slip back.
The market is starting to see some distress. Receivers were appointed to a company undertaking a development of 80 flats in the St. John’s Wood area of London in November after a fallout between the developer and its lenders. It is one of the first such appointments since the financial crisis.
The developer of the huge Battersea Power Station scheme has said that falling sales prices and rising construction costs have cut its profit margin from 20% to 8% in the past four years.
But so far, in the main the developers of such schemes are managing to avoid the need for rescue capital, even though there are plenty of opportunity funds in the wings waiting to invest. Such deals usually mean that the price at which the units can be sold is rebased and brought into line with market sales prices.
"The issue is sellers are looking backwards, and people like me are saying the price needs to be much lower for me to take on the risk,” Orf said. “It’s about whether a lot of these developers have the capital structure to wait it out until we have more visibility over Brexit.”
For developers the issue is on the balance sheet. For individuals selling, it is in the mind. Either way, the prime Central London resi market is going nowhere fast.