Breakthroughs in Modern Real Estate

"They paid too much!" versus the "get-it curve".

Every once in a while I run across something that leads to a light-bulb moment.

I'd seen demand curves thirty years ago while staying awake through microeconomics, but the one I saw recently in Economics Explained, an economics-for-dummies book written in 1982 by economists Robert Heilbroner and Lester Thurow, illustrates a truth I knew instinctively from working with home buyers over the past eleven years but hadn't been able to visualize until now.  But that eleven-year delay in "getting it" doesn't bother me:  it's a concept many still don't get.  In fact, many deny its validity. 

Heilbroner and Thurow begin their Chapter 15, "How Markets Work", with this assertion:  "Market prices interest us for many reasons, but perhaps none is so important as the rationing function that prices carry out."

Rationing?  Like World War II ration cards?  Like gas rationing during the 1973 oil crisis?  Like Soviet-era Russians lining up for bread?  Here in this affluent corner of paradise we call Silicon Valley, shining beacon to the free-enterprise system?  What the heck does rationing have to do with Silicon Valley real estate?

Work with me.  Heilbroner and Thurow claim that "there is nothing more important to grasp than this central purpose that markets serve", and since they're economists and think the rationing function is important, it must be important.

"Imagine a market with ten buyers", they continue, "each willing and able to buy one unit of a commodity, but each having a different maximum price that is agreeable to him.  Imagine ten suppliers, each also willing and able to put one unit of supply on the market, each at a different price.

"That market would look like this:

Cool.  Since they're economists, Heilbroner and Thurow are interested in the "equilibrium price", the price that brings buyers and sellers of this item—let's call  it a "widget", since economists like widgets—together in the greatest numbers and "clears" the market for widgets.  In the box above, $6 is that equilibrium price.

So we've learned something already.  But here let's shift gears, because now we'd like to know what the demand curve for widgets looks like.  So here's a chart, based on the information above, that shows the widget demand curve, with widget prices along the y axis and quantity of widgets bought along the x:

Okay.  But since this is a real estate Web site, let's shift gears once more and turn the demand curve for widgets into the demand curve for one typical "starter" home in this area, say, a 3-bedroom/1-bath home of about 1200 sq.ft. in the Midtown neighborhood of Palo Alto.

Now we're cookin'.  Of course, this is just a theoretical demand curve.  We don't really know if we could sell that Midtown starter home 11 times if we offered it at $100,000 and, because law and custom encourage us to sell one house to one buyer, we'll never know, although we are allowed to speculate that if we listed this house at $100,000 we'd get maybe 1100 offers.  But since our goal is to sell just one house to just one home buyer, rather than five widgets to five widget buyers, we don't care what the equilibrium price is, the price at which the maximum number of buyers and sellers are willing to do business.  We only care about the one price that brings one home buyer to one home seller.   

And because we only care about the top, highest point of the demand curve, the point where that one quantity of Midtown starter home sells at its highest and market-correct price point of $1,100,000, we don't care about the many other price points to the right along the demand curve.  We don't care about the also-rans to the right along the curve.  We don't even care about the buyer who came in second.

Or do we?

We do, or at least I do, because as the announcer for the old TV show sternly informed us, "There are a million stories in the naked city" (you can probably Google this) and each point along the demand curve "is one of them".  (And, no, I never got to watch, probably because I was too young, although back in the day a lot of people including me got a lot of mileage out of that line.)

And in fact, the entire real estate industry should care about all those other points to the right along the demand curve, because it graphically explains burning industry issues such as "tire-kickers" and "looky-lous" versus "real buyers", or "real buyers" versus what might be called "near real buyers".  The graph strips away the pejorative language and negative descriptors and helps us see demand more objectively and analytically.  And although we won't get into it here, the demand curve also explains "real sellers" versus sellers "just fishing" for the "one perfect buyer" who doesn't exist. 

But today let's focus on buyers.  To get the stories of the points along the demand curve, let's start at the far right of the x axis, down where those theoretical 11 home buyers are willing and able to purchase the Midtown starter home if they can nab it for a cool $100,000.  Why is $100,000 their limit?  Perhaps it's all they can afford.  But a whole lot of us could, given the opportunity, squeeze monthly payments of about $430 a month, based on an $80,000 5 percent 30-year loan, into our budget in exchange for the opportunity to own a single-family home in Midtown Palo Alto.  We'd manage, somehow.  It's a no-brainer.

Or is it?  Let's move left along the demand curve to the next point, where 10 persons are willing to buy the house for $200,000.  By moving to the left we've left behind the eleventh buyer.  Why?  Maybe doubling the price to $200,000 priced him out, but it's also possible that he'd turn down the house even if he could still afford the payments.  Maybe he's one of those people who'd be happy to point out that the expenses of owning the home don't stop with mortgage payments.  We're looking at insurance and property taxes and regular maintenance costs plus the hassle of maintaining the home and the yard and maybe that home was built in 1947 and updated in 1971 with avocado green laminate countertops and orange shag carpeting and who could live in that, aside from a lot of homeowners in this area and most renters?  So throw in $100,000 for hardwood and granite and all the other finishes essential to 21st century living, and you've paid too much, at least by his thinking.  And besides, home-buying is a blend of risky business and conspicuous consumption and only Yuppie scum buy in Palo Alto and he's just a regular guy who doesn't put on homeowner airs and doesn't go around thinking he's better than the next guy and homeownership is just a hype job foisted on the public by the National Association of Realtors® and he might get transferred and he doesn't want the commitment and...

Admittedly, his is an extreme view, although if you wanted you could find more than a handful on the radical fringe of the movement who really think this way.  They wouldn't take the house if it was tied up with pretty ribbon and left on their doorstep.  More plausible, however, are the people immediately to the left along the x axis, from points 10 to, say, 6.  Because as we move left along the demand curve, the price of the home goes up sharply, excluding still more potential buyers and making the trade-offs involved progressively less appealing to those who could afford the home if they cut back on other forms of consumption:  vacations, eating out frequently, a nice car. 

Not that some of these folks won't drop in on the occasional open house.  Not that some of these folks won't occasionally email a listing agent.  Not that some of these folks won't occasionally post an insightful, witty comment on the real estate market on their favorite blog.  Because even though they've never been in an agent's car, let alone made an offer, let alone successfully gone through the homebuying experience, some of these folks know a lot about real estate.

It's only speculation, of course, but I suspect that as you approach point 5 on the demand curve you start running into people who really would buy that Midtown starter home, or any Midtown home, or any Palo Alto home, if they could snag it for $700,000.  Remember, it wasn't that long ago, maybe seven years or so, when you could get into Palo Alto for $700,000.  That's an eternity in market years, but well within the memory of many who live here.  Let's say that the people at point 5 were, like so many, drawn here in the late 1990s by the dot-com boom, loved the area and loved the money and thought about buying a home, but wondered why all these other techies flooding the area kept bidding up the price of that scarce resource housing, so they backed away because everyone knew that real estate was overheated and prices were about to pop.  And when prices did pop, back in 2001, well, everyone knew that they'd keep going down for three or four years at least, just as they had in the early 1990s, and everyone knew that Silicon Valley was just a one-trick dot-com pony that was either finished kaput or stuck in a ditch for years, so there was no big rush to buy and, besides, they had a really cool landlord who never raised the rent (or fixed anything) and, besides...

...buying a home really wasn't important to them.  Then or, most likely, now.  Sheesh not at these prices.  But tell me if you find a 3-bedroom home in Midtown for $700,000.  Here's my email address.

Of course, it's okay if buying a home isn't important to you.  Some people simply have no interest in homeownership.  And it's okay if you are interested in buying a home, but not interested in paying $1,100,000 for a dumpy 61-year-old home with only 1200 sq.ft. and barely one bath.  Hey, I watch those home-buying shows on HG-TV too, and I know what even $700,000 will get you almost anywhere else in the country:  an entire city block, or maybe even a small county .  Or maybe you don't think you'll be here long enough to get through that inevitable first downturn in the market without having to sell.  Yes, the rationales for preferring renting to homeownership in this volatile and extremely expensive area are entirely defensible, even if the rationalizations aren't.  Here I'd like to point out that that's one of the beauties of the demand curve:  even though it's theoretical, it suggests that lots of people feel the same way you do.  Maybe even most people.  Certainly most people posting on the Internet.

What isn't okay, of course, is questioning the intelligence and sanity of the progressively smaller group of people to the left on the demand curve who are willing and able to shell out big bucks for little house because said house is in a city known nationally and even internationally for its quality of life.  And, unfortunately, there's a lot of that questioning going on, and much gleeful rubbing of hands whenever it appears that shudder some people may have paid too much!  Which would be all the time, according to them.

We'll talk about this more in a moment.  For now, let's continue our journey leftward along the x axis.

Along about points 3 or 4 you start meeting folks who'll tell you they're in the market.  Some, maybe many, are working with agents, getting daily listing alerts, going to open homes weekly, regularly following real estate online and in the mainstream media and through friends and co-workers.  And, every once in a while, writing an offer.  I can just about guarantee that if you had more than six offers on a Midtown starter home, before the stock market crash a definite possibility with a well-priced well-prepared home, one of those offers would come in $150,000 or more below market.  Particularly if the buyer's agent was from out of the area.  In fact, there's probably a verifiable negative correlation between the distance of the agent's office and the amount of the offer.

Now we've reach a milestone, the point at which we stop calling the line on the chart a "demand curve" and start calling it a "get-it curve".  Because anyone who thinks a $1,100,000 house will sell for $950,000 with eight offers and wastes his or her time and everyone else's pursuing that naive belief doesn't get it.  Heck, we might have called the line a get-it curve a few minutes ago, but now there's no doubt.  It's like high-diving into three inches of water and then complaining when the paramedics don't show up right away.

By the time we reach point 2 on the get-it curve, we find a small group of decent earnest people trying their darnedest but not quite getting it.  They're the buyers who consistently come in second or third in multiple offers.  If theirs is the only offer, they never quite close that gap between themselves and seller.  Their offers are always solid and sometimes brilliant, but always the loud out that's caught on the warning track, never the home run the team needed to win.  Some start out a 2 and, after diligent effort, work themselves up to a 1.  Others remain a 2, always on the cusp, always one small demoralizing step from achieving their goal.

But look at the get-it curve and you'll understand that the 2s have something in common with the 3s and 4s and so on down the line:  the firm and usually unshakable conviction that the solitary soul in the 1 position paid too much.  But number 1 is okay with this.  Because number 1 is the only one who gets it, really gets it.  Someone's got to come in first.  Someone's got to step forward and "pay too much", whether prices are at their peak or in a trough, and it might as well be him.  Because the alternative isn't acceptable.

What can I say, what praises can I sing, about number 1 as he looks down from his lonely vantage point on the mass of people to the right along the curve who know, just know, he paid too much?  I can call him committed.  Motivated.  Aggressive.  Focused.  Disciplined.  Impervious to what the also-rans think.  I can also call him new homeowner.  Someday the others may also be as committed, motivated, aggressive, focused, disciplined and impervious.  Some, but not all, are capable of it.  If they want to be.  If they decide that the very real benefits exceed the very real risks—that not just the risks are real but also the benefits—that the short-term sacrifice will be worth it in the long run.

Notice that I didn't mention "wealthy" among number 1's sterling qualities.  Sure, anyone who can afford a $1,100,000 house isn't wondering where his next meal comes from, but $1,100,000 isn't Steve Jobs territory in this area.  Silicon Valley's high level of compensation means that a relatively large group of people could buy that Midtown starter home if they wanted, really wanted—if they were geared for battle like number 1.  But for each house that sells, there's only one number 1. 

What would economists Heilbroner and Thurow think of this huge weeding-out process, this chain of homebuyer evolution, that involves us all?  "Note that the market is in this way a means of excluding certain people from economic activity, namely, customers with too little money or with too weak desires..."  And, yes, this applies even to sellers, since the market excludes "suppliers unwilling or unable to operate at a certain price," the market price.

But is the problem really that so few people have sufficient commitment, motivation, aggressiveness, focus, discipline and imperviousness at any one point in time?  Isn't this thinking nothing more than stark social Darwinism?  Isn't the problem really that there's a shortage of Midtown starter homes for deserving buyers, even if not all those deserving buyers are all that committed, motivated, aggressive, focused and disciplined to the idea of homeownership and impervious to what people further down the demand curve think they should pay?  Not so, according to Heilbroner-Thurow.  "When we say that there is a shortage of housing [for buyers towards the right of the curve] the everyday meaning is that people cannot find enough housing.  Yet in every market there are always some buyers who are unsatisfied."  For example, "all buyers who could not or would not pay six dollars [for a widget] had to go without".  No one calls this a shortage, "even though there are always buyers and sellers who are excluded from it".

"What about the situation with low-cost housing?  Essentially what we mean when we talk of a shortage of inexpensive housing is that we view the outcome of this particular market situation with noneconomic eyes (italics mine) and pronounce the result distasteful...[by "shortage"] we imply that we do not approve of the price mechanism as the appropriate means of allocating scarce resources in those particular instances.  Our disapproval does not imply that the market is not as efficient a distributor as ever.  What we do not like is the outcome of the market-rationing process...it clashes with other standards of the public interest that we value more highly than efficiency".

So we're back to rationing, and number 1 has all the ration cards, and some and perhaps many would say that that's not fair.  More of those to the right along the demand curve should get to be number 1, they'd say, and perhaps everyone on the curve, even number 11 nursing his grudge against homeownership.  They'd side with the young woman who a few years ago in one of those person-in-the-street "how does that make you feel?" TV news interviews opined, "I do think that everyone here is entitled to their piece of that dream and that is whether to own a condo, or an apartment or a house—to be able to afford something."  (I wonder if she ended up buying a bank-owned home, Everyman's ticket to homeownership?)  She'd move us from rationing and social Darwinism in the real estate marketplace to social engineering and a great leveling of the marketplace.

Which approach you prefer probably depends on where on the curve you fall.  But I wonder how those to the right of number 1 would feel about this leveling if it were applied to other fiercely competitive areas of life.  How would they feel, for example, if everyone in their workplace, not just the committed motivated aggressive focused disciplined impervious ones, but even the uncommitted unmotivated passive unfocused undisciplined timid ones, were equally rewarded?

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