Sticky Prices

This article is written by Brent Bowen – author, CE instructor, and Chief Appraiser at Texas Valuation Professionals, Inc. His training webinar on Market Indexing for Appraisers: How to Master Market Condition Adjustments is coming up next Thursday, October 3rd. Click here to register.

At breakfast this morning I noticed two things: 1) peanut butter is delicious, and 2) it can be a sticky mess.

Like peanut butter, prices can be (and often are) sticky.

What does it mean for prices to be sticky? In 1936, John Maynard Keynes coined the term ‘sticky’ when theorizing how price change in terms of wages did not always respond to changes in economic conditions. He theorized that this led to unemployment and contributed to business cycles.

Wages aren’t the only prices that are sticky. Real estate prices are sticky, too. Changes in supply and demand in a market do not always result in an immediate change in equilibrium/market prices. This is often truer with falling prices than rising prices.

Consider a scenario where you have 3 homes listed for sale in a neighborhood. All three would compete for the same buyer and are priced similarly. What if conditions in the market shift and demand drops? Showings decline and none of the 3 homes receive an offer. There are at least two things in the short-run which work against prices moving toward a new equilibrium level in response to the shift in demand. These cloud the seller’s perception and prevent a change in pricing in response to the changing market:

1) Anchoring bias – The sellers all have a desire to sell their home for the highest possible price, so cognitively their perception is going to be skewed toward the higher historical prices.

2) Herd mentality – Each seller will be keenly watching the other sellers to see how they respond. It is like a game of ‘who’s-going-to-blink-first’. If the other sellers aren’t lowering their prices, then each seller perceives that they are still priced well for the neighborhood, when in reality none of them are priced well given the shift in demand.

However, disequilibrium is like a vacuum…and in the long-run markets (like nature) abhor a vacuum.

What happens when reality comes in to fill the vacuum of misperception?

In nature, pressure differentials between two spaces can build up over a long period of time. The release of that pressure on the other hand tends to happen more quickly. Think of a volcano, with the magma building pressure until it finally bursts through the surface.

While price changes are much less dramatic than a volcanic eruption, there is a similar principle at work. In this case, the pressure building is that of the disequilibrium between supply and demand. The pressure builds when there is a prolonged or increasing discrepancy between the perception of buyers and sellers regarding price. The ‘surface’ in our analogy is in large part made up of perception.

How does this perception discrepancy ever equalize? On the seller side of the equation one of two things will generally happen (in the aggregate, these tend to happen in combination):

1) Some sellers will drop out of the market as they are unable to procure a buyer. Those sellers will essentially fill the vacuum by relieving the pressure, shifting supply downward and bridging some of the gap. Sellers that weren’t entering the market out of necessity have this option.

2) Sellers will begin to drop prices, essentially filling the vacuum of misperception with reality.  Just as with the volcano, once the perception barrier is broken, the pressure differential tends to equalize at a more rapid rate than it built up to begin with.

Let’s return to our example of the 3 competing listings to see how this might play out. Let’s assume that 1 of those sellers took the first option, canceling their listing. However, the other 2 are selling out of necessity. When one of the two sellers finally “blinks” and drops their price, the other seller has an incentive to follow suit and drop their price as well so they remain competitive. The bursting of the perception barrier therefore tends to impact the entire market segment, since now both listings have price adjusted.

So, what implication does this have for appraisers?

When those ‘sticky’ prices finally become ‘unstuck’ the result is often a drop that looks like a stair-step, not a straight line.  So, this means that in sub-markets or market segments prices change in a way that cannot always be represented by a constant linear rate.

If that is true, then how can appraisers describe the rate of market change when that rate is constantly fluctuating?  More importantly, how can an appraiser support an adjustment for market condition changes when applying a single rate (like applying a rate of -.5% per month to comparable contract dates for instance) isn’t an accurate representation for all the sales?  To say it another way, if constant linear rates tend to fail, how can an appraiser adjust for market conditions in a way that accurately reflects stair-step pricing (or just plain erratic markets)?

The answer to this question is market indexing.  Most people are familiar with market indices on some level. Inflation has been prominent in our news cycle in recent years. Price indices like the Consumer Price Index (CPI) are how inflation is measured. Appraisers can use this same technique to create price indices for a subject property’s market to measure price differentials over time. This technique allows the application of market change adjustments which vary over time in a way that mirrors the market, instead of trying to apply a ‘line of best fit’ to data which may not be linear.

This technique allows an appraiser to track an erratic market where prices may have been stable, increasing, and declining all within a short period of time. If that is how the market behaved then the indexing technique allows for the appraiser to apply no adjustment to some comparables, downward adjustments to other comparables, and upward adjustments to some others all within the same adjustment grid!

What if you could extract, refine, and model your own market data to create a price index for your market that will allow you to calculate price differentials over time and even visualize those for your clients?

You can!  

Market Indexing for Appraisers is a 2-hour webinar which will teach appraisers to import data into a custom Excel workbook and instantly calculate index-based market conditions adjustments along with compelling visuals to support those in your report. A license to use the custom Excel workbook is included for every student!