The Internet has made the real estate market less rational

Rational expectations are a basic economic theory that originated with a paper written in 1972 by future Nobel Prize-winning economist Robert Lucas. Since then, the theory of rational expectations has been continuously discussed by economists.

“The theory of rational expectations argues that people are aware and act on the information available, making more or less accurate predictions” HorwichMinneapolis Federal, 2022.

Economists have gone down many rabbit holes related with names like; rational bubbles, biased expectations, adaptive expectations, diagnostic expectations, price expectations, price extrapolation, price learning, momentum trading, and others.

At the opposite end of Lucas’ rational expectations hypothesis is “irrational exuberanceby another Nobel Prize-winning economist, Robert Shiller. Shiller’s analysis pointed out that markets are prone to fads and fads, and are often irrational.

A key element of both rational expectations and behavioral economies is “information” and how the market reacts to it. Does the market analyze all available information efficiently or is it prone to misinterpret information which can lead to irrational booms and busts?

Information explosion

Back down to earth, in the case of the real estate market, I got a front row seat to the real estate boom and bust of the 2000s in one of the most sizzling markets, Phoenix, Arizona.

At the time I was in favor of the idea that markets were rational, but I thought that prices were irrationally exploding just because players didn’t have enough information about what was really going on in the market. The problem, I thought, was that people didn’t have enough timely data to make rational decisions. They were wrong about what was actually happening in the market.

The amount of information we had about the housing market back then was a tiny fraction of the information we have today. We used to get monthly updates from the local MLS, but it was for the entire Phoenix Metro market. They didn’t even break it down by city. Zillow didn’t begin posting official sale prices for individual homes online until 2005.

We have much more real estate information today than we did last cycle. Official home sales prices can be found all over the internet, usually with tons of additional data and often with dozens of photos.

Has all the information that we have had in recent years on the real estate market made the market more rational as I thought?

No. Prices have risen faster this time. We saw eight months in 2021 and 2022 where home prices rose nationwide more than in any other month during the 2005 boom, according to the S&P CoreLogic Case-Shiller Home Price Index.

Now prices are also falling faster. Home prices peaked nationwide in June, but we’ve already had two months where home prices have dropped 1% or more in one month! We last didn’t see such a large month-long drop in prices until November 2007, which is 2 1/2 years after the March 2005 peak.

It seems that the explosion of online real estate information has made the real estate market less rational. Certainly, it seems to have made house prices even less stable.

Has all that information fueled some of the human quirks that behavioral economists talk about? Can more information make irrational exuberance more irrational? When you can see in detail what everyone else is doing in real time, does that fuel herd behavior? Apparently, yes.

In addition, the real estate market has changed direction much faster this time. Most likely it was due to all the information available on the internet. People didn’t guess like last time whether prices were going down or not. They could see it everywhere themselves online.

Information Change Markets

In 2005, I thought that people and markets are inherently rational, and if we only had more information about what was really going on in the market, the market would act more rationally, more predictably, without all the wild booms and busts. Lack of information was the problem, I thought.

It seems, however, that more information is also fueling some of the “irrational” human economic quirks that behavioral economists are always talking about.

Today I think markets are as rational and irrational as people in general. People make mistakes and sometimes the markets make mistakes too because they are only human.

Maybe I was irrational 20 years ago when I thought markets were rational and lack of information was the problem.