Ask most financial experts and they will tell you that real estate markets tend to move much more gradually than stock markets. The reasons given are usually along the lines of “less liquidity” and “higher transaction costs”, which basically means it takes longer and costs more to trade real estate than stocks.
While this is perfectly true, what I have never seen mentioned is the fact that in large residential real estate markets, such as Toronto, there is an inherent “hedge” that slows down the speed at which prices change. I call this the “I have to live somewhere” effect. For example, everyone who lives in Toronto is forced, whether they buy or rent, to take part in the real estate market. Even renters are in a sense “buying in” to the market by paying rent to their landlords. When demand for rental properties increases, rents increase and this attracts more investors to the real estate market, which in turn pushes up real estate prices.
This does not apply to stocks. If someone does not feel stocks are a good investment at the moment, they can simply invest in something else or sit on the sidelines and not participate in the stock market at all (they’re not forced to “rent” stocks). This is a key difference between stock markets and real estate markets which is often overlooked, but it helps explain why stock markets can change overnight, while real estate markets tend to change a lot more gradually and a lot less drastically.
To put it another way, if as many people felt the same way about the TSX as they do right now about the Toronto real estate bubble, the TSX index would lose 30% of it’s value tomorrow. One of the reasons why this won’t happen to Toronto real estate, despite widespread speculation about a bubble, is because people cannot simply “opt out” of the real estate market – they have to live somewhere.
While we saw some dramatic changes in certain parts of the US real estate markets (in 2008/2009), this is very unlikely to happen at a time when the majority of people are EXPECTING a crash. The reason for this is simple – if most of the people who live in a city are expecting its real estate market to crash, there will be a lot of “pent up demand” (that is, a lot of people who want to buy, but are currently renting and just waiting for prices to come down). So what happens when prices do actually start to come down? People from the”pent up” group start buying. Some of them buy right away, at the first sign of a price decrease, some wait a bit longer, depending on each person’s circumstances, but the overall effect is that prices will drop a lot slower that they otherwise would have. This is why big changes are more likely to happen when the majority of people are NOT speculating about a bubble and there is no pent up demand. In the US market example I mentioned above, there was almost no one waiting on the sidelines to buy when prices started to come down. This is partially because through the magic of interest-only,
no-income-required loans (endorsed by the ever-so-generous US
government), anyone with a pulse already owned real estate!
Sarcasm aside, there is also a reverse effect at work when prices are on the rise. Both of these effects combined give real estate markets in big, developed cities an inherently gradual temper that stock markets will never have.