Economists are odd people in many ways. In addition to using the words supply and demand far more frequently than normal humans, we also spend a lot of time thinking about elasticity. As I found out in college, the abstract concept of elasticity can make the difference between wealth and poverty.

Once a house has been built, it is not particularly easy to convert it to something else. Thus the supply of real estate is relatively inelastic. That means that the supply of housing changes only slowly. In contrast, some­ thing that is elastic can respond quickly to changes.

What about housing demand? Barring some sort of tragedy, the number of people who need trading housing is also unlikely to change quickly. Does this mean that the demand for housing is also inelastic? No. Housing demand fluctuates far more rapidly than population.

In tough times, people are remarkably flexible in their living arrangements. A recent college graduate, for example, with a good job can't imagine living at home. If unemployed, however, the same person becomes much more tolerant of her or his parents. In good times, there­ fore, demand for housing rises far more than population growth, and in bad times, people find ways to economize.

Thus the housing market is characterized by inelastic supply and rela­tively elastic demand. So what? These sorts of markets have the interesting characteristic that price can change very rapidly.

I learned this lesson when I was in college at the University of Michi­ gan . Doug, the millionaire surfer, made a good living each Saturday scalping tickets at football games. My friend Scott and I decided to get some of this easy money. We hit upon the following strategy. Go to the student dormitories farthest from the stadium. Find students groggy from Friday night drinking and offer to buy their tickets for $1. Then ride our bicycles down to the stadium, sell the tickets for more, and collect our profits. 206 Applying Science and Art to Bonds, Stocks, and Real Estate

We did this one bright Saturday morning and managed to make about $100 in a couple of hours. I remember our first sale. A couple was walk­ ing away from a BMW. I approached the man and asked if he needed tickets. He asked, "How much?" Scott responded with "face value" of $12. The man instantly agreed, and we had $22 in profit!

The following Saturday, Scott and I were up early aggressively buying tickets. Buoyed by our success, we purchased more than 60 tickets, each for $1. As we rode our bikes to the stadium, however, we saw people offering to sell huge batches of tickets. We soon began selling tickets as fast as possible. The going prices started low and then plummeted. One buyer wanted six tickets. I offered six for $0.25 each. A competing scalper undercut me by offering all six tickets for a total of $1. Scott and I lost almost all of our investment.

What happened? We learned that like housing, football games have inelastic supply and elastic demand. While both games that we worked were against similar quality opponents, the forecast predicted rain on the second Saturday. The supply of tickets was a constant of just more than 100,000 seats (the University of Michigan 's stadium is known as the "big house"), but demand was slightly lower the second week.

In markets with inelastic supply and elastic demand, prices can move very rapidly. As game time approaches there are either more buyers or more sellers. A relatively small shift in demand makes the difference between too many buyers and too few. This translates into the difference between high ticket prices and almost free tickets. On our second week­ end of ticket scalping, Scott and I ended up throwing away dozens of tickets.

The housing market has inelastic supply and relatively elastic demand. There is no equivalent of kickoff time when supply becomes worthless so the rental effects are not as extreme. Nevertheless, the real estate market is subject to relatively large changes in rents for relatively small changes in demand. Importantly, the supply of U.S. housing has been growing far more Real Estate 207 rapidly than the population. Figure 9.3 shows the relative growth between the 1970 and 2000 census.

Over the last three decades, the growth in housing units in the United States has exceeded the growth in population. As discussed, this does not imply disaster. Over this time period, the United States has become far richer. As we have become richer, it is reasonable to expect that we would have more houses. Nevertheless, the fact that supply has grown so much more than population is a clue. If times get tougher, it is possible that demand for housing could drop enough to put significant pressure on prices.

Clue #3: Vacancies Are on the Rise

For the next clue, Figure 9.4 shows the U.S. rental vacancy rate.

The U.S. residential rental vacancy rate is at the highest level on record. This is obviously good news for renters who have more power in their negotiations with landlords. On the other hand it is unambiguously

Source: U.S. Census Bureau

bad news for landlords. It is also bad for homeowners who are not land­ lords. Potential buyers of homes are constantly evaluating the alterna­tives of buy or rent, thus the prices of all homes are influenced by the Irrational market s

Clue #4: Mania-Like Behavior in Some Areas

Irrational markets are at least as much psychological as they are eco­ nomic. The real estate market shows at least two signs of mania beyond the statistics. First, many markets show frenzied buying that accompa­ nies bubbles. Second, there is a widespread belief that real estate prices cannot fall.

My friends Tom and Florentien just bought a house in the Boston met­ropolitan area. I ran into Tom one evening and I asked how he was doing. He said, "I'm exhausted. I had to get up at 5 a.m. and take a one-day business trip. Now I've got to go make a bid on a house." I inquired further about the pressing need to make a bid immediately. Couldn't Tom go home and make a bid the next day? The answer was no.

The Boston real estate market is—as of July 2004—still in a total mania. In Tom's case, the property went on the futures market on Saturday and he knew that in order to have a chance he needed to bid by Tuesday. As soon as a reasonable property comes on the market, multiple potential buyers flock to make aggressive bids. The winning bid generally is above the asking price.

In the case of the condominium adjacent to ours, the winning bid came in above the asking price and the deal closed within hours of the unit coming on the market! Through some inside connection, the buyers learned of the hot property and quickly made the owner an offer she couldn't refuse.

This behavior is crazy. Buyers are forced to make huge decisions with very little time for consideration. The mania is not nationwide as many markets are more subdued. Nevertheless, there are many places where this buying frenzy is common. Such behavior is typical of bubbles.

The second sign of mania is the belief that real estate prices cannot fall. When people envisage bad times in real estate, they imagine a plateau for some period of time. It seems impossible that real estate prices could actually decline. In Chapter 3, we met the trustees of my condominium who thought buying more property was a "can't lose proposition."

This belief in housing price rises is shared by professional analysts. Dr. John Krainer is an economist who works for the Federal Reserve. He wrote an excellent article entitled "Housing Price Bubbles." 9 In his con­ clusion, he writes, "Following the observation that declines in nominal house prices are unusual, I hold the house price fixed at its current level." Dr. Krainer does go on to analyze the possibility that housing prices could decline. Nevertheless, it is telling that he begins by assuming that prices will not fall. When markets are at their irrational tops, people con­ sider declines to be impossible. 210 Applying Science and Art to Bonds, Stocks, and Real Estate

If it looks like a mania and feels like a mania, it's probably not a duck. The housing market shows the psychological signs of overvaluation.