I Don't Know the Economics Term for This

While I sometimes get grouped into economics blogs, I actually don't have a degree in the subject.  I have an MBA, some practical experience, some hobbyist reading, a few undergraduate courses, and, as my wife can attest, a willingness to pretend I know what I am talking about.  Unfortunately, that is not enough in this case.

Over the last 6 months, I have observed an interesting phenomena in the Phoenix area, one which I am sure I am not the first to discover, but I don't have enough background to put a name on it.  Here is what is going on:

Over the last year or two, the Phoenix real estate market has been red hot.  This has caused a lot of individual investors to make local real estate investments (I discussed more about this here).  The preferred type of investment seems to be to buy an old house on valuable land, tear it down, and sell the new house for a profit.

All fine and normal so far.  The interesting part comes when the investor chooses the style and appearance of the new home.  Remember that these are typically highly leveraged investments.  Investors take out a large mortgage, and that mortgage has to be paid every month that the investor cannot sell the home.  It is critical, then, that the investor build a home that is designed in a way to be most likely to sell.

Let's imagine that the pool of possible house buyers have the following preferences (I am making these numbers up):

  1. Tuscan / Mediterranean style, 40%
  2. Santa Fe style, 25%
  3. Santa Barbara style, 20%
  4. New England style, 10%
  5. Ultra modern style, 5%

With only limited information on what is going on in the market around them (ie what others are planning to build) all of these investor-builders pick the most popular style on the list, thereby apparently maximizing their ability to sell the home.  As a result, every tear down / rebuild / remodel I see in our area is a new Tuscan home.  So, while 40% of buyers (or whatever the number is) want Tuscan, 100% of the supply is Tuscan.  By the way, the same thing apparently happened in the last big Phoenix real estate boom back in the 1980's, since nearly every house in our neighborhood that was built in the early eighties was built in what we call the "santa barbara" style.

This is obviously some type of market failure, but I don't know what it is called.  I might call it the "variety failure".  To a large extent, this dynamic is made possible by the fact that many of the investors in the real estate market are only entering the housing market for a single transaction, and are not well informed of the actions of other sellers in the market.  In most other industries, investors need to make money over multiple transactions over many years, which mutes this effect.  For example, there are always farmers who try to plant this year what was earning good money last year, but these players in the market are usually weeded out over time as last year's shortage leads to this year's glut and financial losses.  Also muting this failure nowadays are changes in manufacturing techniques, which allows low cost production of greater variety, as well as expansion of specialty retail space (e.g. category killers like Petsmart or Borders), which allows display of more product variations.

  • Don Lloyd

    The question arises as to just who the investor expects to be selling to. If it is another future investor, then choosing the most popular style represents a lower risk because the market being sold into will be deeper. Building a unique or relatively unpopular house is likely going to limit the population of potential buyers. It is both unlikely and risky to try to build a house that will command a premium price in the future from actual homebuyers, if you have no special expertise in that area.

    Regards, Don

    BTW -- The comment preview displays as black text on dark green, completely unreadable.

  • Earl

    As an economist finishing an undergraduate degree, I'd call it either an information failure (asymmetrical information) -- ie, there exists different information between the sellers and purchasers WRT the desires of the purchasers. This typically refers to the seller having more information than the buyer, such as used car vendors, etc. However, I think that you could use the term in this situation.

    Alternatively, it could be called transaction costs/information costs. The latter being the great failing of libertarians.

    Earl

  • Tom

    Earl said: "Alternatively, it could be called transaction costs/information costs. The latter being the great failing of libertarians." Please elaborate about the "failing of libertarians."

    My take: If all of this is being done by private actors who aren't substantially subsidized by taxpayers (some subsidization is inescapable given differential tax treatment, zoning, etc.), there is no failure. Mistakes are the price we pay for liberty. Those who prosper in the long run are those who, other things being the same, learn from their mistakes.