Sometimes what looks irrational to an observer is actually very rational to the principal

A question is raised about why small residential real estate holders don't always do what appears to be in their self-interest -- i.e. sell after the property has appreciated and there is an imbalance between its rate of return as income property and what it would fetch on the market for an owner-user -- and take their profit. It's true; people who own real estate do not always appear to act like rational economic actors.  Here's one theory:

The only reason my landlady would want to not take advantage of the decline in the rent/buy ratio (i.e., the fact that demand for home purchasing in the neighborhood is increasing faster than the demand for home rentals) is that she anticipates the ratio will fall further in the future, thus making a 2004 sale a bad deal in light of the fact that she can continue to obtain rental income in the interim.

Well that's possible; and there are a variety of reasons why people do not sell even when the market has risen dramatically and it is "rational" to sell. But a prime answer is "What would they do with the cash?"

Real estate is a very much a mom-and-pop business. Real estate is not a fungible commodity. Once sold, real estate investments are hard to replace and there are very high transaction costs, as well. So in fact it is entirely rational for small-holders to resist selling even in the face of huge gains because they have thought long and hard and have faced the question: "What would I do with the cash?" How, after taxes and commissions and escrow etc etc and etc, would they reinvest? Could they do better than what they already have, even recognizing that they have a low rate of return compared to their untapped equity. Not being professional investors -- or even if they are -- they often decide to just hold on and accept what is now actually a very good return based on their initial investment rather than sell and be faced with reinvesting a wad of cash.

I have dealt with this question at somewhat great length in It's a mom-and-pop market.

Comments

[JRoth]

One point I want to add: although the landlady certainly (seems to) meets the "rationality" threshhold for a well-functioning market, the other things you identify are precisely what keeps real estate from operating in a manner particularly close to the textbook "free market." High threshholds of entry and exit, non-fungible commodity.... Anyone who would expect real estate to consistently respond effectively and efficiently to incentives doesn't understand either the real estate market or the free market.

None of which is to say that it's not a functioning market, merely that it is very, very far from the model markets that are held up as Hayekian paragons of superior information processors.