City scenic from Amsterdam in the Netherlands
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From 1604-1810, Amsterdam had three real estate bubbles. House prices doubled or tripled and then fell back to their initial values. Each bubble lasted decades.
Recent research looked at possible explanations for these Amsterdam bubbles, including economic fundamentals like wages and rents, but found the top factors were; 1) An initial shift toward investing in real estate (caused by outside forces) which increased house prices, and the higher prices triggered, 2) Additional purchases justified by those past house price increases which in turn caused additional price increases, and so on until house prices were completely out of whack.
The first effect was covered in a recent post on Forbes.com. Here, we’ll discuss the second effect — self-reinforcing upward house price momentum — and we’ll end with a fascinating similarity between modern housing markets and the housing market in Amsterdam 200-300 years ago.
In a recent working paper, “The First Housing Bubble? House Prices and Turnover in Amsterdam, 1582-1810,” Ph.D. candidate Matthijs Korevaar of Maastricht University created a home price index based on 164,000 documented house sales in Amsterdam from 1563 until 1811 (when Napoleon annexed Holland and changed the real estate registration and taxation system). The word “turnover” in the study means “sales.”
200 Years Of Amsterdam Housing Bubbles
Source: Working Paper, “The First Housing Bubble? House Prices And Turnover in Amsterdam, 1582-1810,” Matthijs Korevaar, 2018.
Breaking The Law (Of Economics)
When the price of something increases, economics says people will buy less of it but that’s not true in bubbles.
When house prices increase it’s not uncommon for some potential house buyers to become more — not less — motivated to buy. They look at those past price increases and they want to buy as soon as possible before house prices increase any more.
If house prices haven’t increased much in many years, the new price increases open up a whole new reason to buy houses — short-term price appreciation instead of just long-term, predictable rental income.
The larger and longer the price increases, the more potential buyers are confident prices will continue to increase rapidly if they buy. More and more buyers focus on the potential profits from price appreciation when they sell rather than the ongoing rental income when they own.
When enough of these new investors buy enough houses, those additional sales will cause house prices to (eventually) increase which will again motivate investors, new and old, to buy more houses which will cause prices to increase even more and so on in a self-reinforcing upward price spiral.
Sensitive To Emotions
And it doesn’t take a large increase in the number of investors speculating on continued house price increases to move housing markets.
In historic Amsterdam, only around 2% to 3% of houses sold each year. That means a small increase in the percentage of investors who have optimistic price expectations can have a big impact on the value of all houses.
Speculation in Amsterdam 1714-1750 Housing Bubble
Source: Working Paper, “The First Housing Bubble? House Prices And Turnover in Amsterdam, 1582-1810,” Matthijs Korevaar, 2018.
2-Year Price Lag
The Amsterdam study found that house price increases were explained, in part, by house price increases the previous year. The study found house price increases were explained even more by house price increases TWO years earlier!
It seems when house prices have increased for the previous two years, some potential buyers feel confident the upward trend will continue, they feel it’s safe to pull the trigger and buy investment houses no matter how high prices are. They’re keying on the past increase in prices, not current prices levels or the economic fundamentals.
The More Things Change…
Here’s the fascinating part, studies of modern real estate bubbles found similar results — prices the last two or three years help determine the price this year.
Despite all the differences between the real estate markets in Amsterdam 200-300 years ago and in the United States 20 years ago, studies of both have found a big determinant of price increases was the price increases the previous two or three years.
I wonder if this is a basic human trait — it takes a year or two or three for people to believe past house price increases (or decreases) are real. Their view of the future is just a reflection of the recent past.
Bubble Economics
One definition of a bubble says when higher prices make people want to buy more, not less, of something, it’s a bubble.
Bubbles break the fundamental rule of economics that says people will buy less of anything when its price rises but, apparently, demand isn’t just based on current prices but also on expected future prices.
And in a market like houses where only a small percentage of houses are bought and sold in a year, a very small increase in the percentage of people who are convinced prices will soon increase a lot can drive up prices whether in Amsterdam 300 years ago or in California 20 years ago.