In February of 2011, I wrote my column in these pages about the macroeconomic principle of fear versus greed and how this relationship was, at the time, impacting market conditions in the commercial real estate sales market.
Since my days at the Wharton School in the early 1980s, I have been fascinated by the various illustrations economists use to explain how economics works and how the relationships between various objects, or emotions, provide insights into the way markets work. Some of these illustrations are quintessential, have been used for decades and will continue to be used for future generations.
For instance, in macroeconomic theory, the “guns versus butter model” is an example of a simple production possibility frontier that demonstrates the relationship between a country’s investment in defense and civilian goods. In this example, a nation has to choose how to spend its finite resources between two options. It can decide to invest in defense/military by buying guns or investing in the production of civilian goods by buying butter or a combination of both. This model provides an analogy for choices between defense and civilian spending in more complex economies.
Another favorite is the “diamonds versus water paradox” that illustrates the apparent contradiction that, although water is essential for life, diamonds command a higher value in the marketplace. Economist Adam Smith is often considered to be the classic advocate of this paradox. In his classic, An Inquiry into the Nature and Causes of the Wealth of Nations, he discusses the concepts of “value in use” and “value in exchange.” These rules determine what he called the relative, or exchangeable, value of goods. Counterintuitively, the things that have the greatest value in use have frequently little or no value in exchange; on the contrary, those that have the greatest value in exchange have frequently little or no value in use.
Greed and fear represent two of the three main emotional motivators that impact the ebb and flow of business behavior and market cycles (herd instinct is the third). While the relationship between fear and greed is most commonly used relative to stock markets, they go well beyond that. The phrase, traditionally used by traders and television commentators, has become a central topic of broader economic research about investor cognitive and emotional biases. These irrationalities contradict, or at least moderate, the efficient market hypothesis.
More than two-and-a-half years ago, it was clear that the commercial real estate sales market in New York City was transitioning from one in which fear dominated to one in which fear and greed were somewhat equal with greed building momentum. So where are we today?
The best way to look at the battle between these factors is to check in on some of the many historically proven truths relative to the cyclical nature of the commercial real estate market:
“When money is easily accessed by borrowers, sellers are those who receive the benefits, not the buyers.” Today, money is not quite as easily accessible as it was in 2006 and 2007, but it is flowing much more easily than it was four or five years ago. As lenders get “greedier” and the competition to put out money increases, money will become easier to access. Certainly, loan-to-value ratios are increasing, meaning that greed is setting in.
“When everyone believes a paradigm shift has occurred and the markets will never fall, it is about to.” While we are not quite at that point, an overwhelming percentage of market participants believe we will have at least several more years of “up markets,” meaning greed is on the rise.
“Any rapid change in market conditions that is attributed to demographic changes must be wrong, as these changes move through the market at glacial speed.” Property values have appreciated rapidly, far outpacing enhancements in underlying fundamentals. Clearly, our extraordinarily low interest rate environment has impacted these increases. However, far too often, we hear that the number of folks moving into New York City has pushed demand drivers and exerted upward pressure on values. It would appear greed is impacting this dynamic more than demographics.
In the current battle between greed and fear, greed appears to have the upper hand by a large margin. With so many speed bumps on the horizon, it is surprising that fear can barely be seen in the rear view mirror. Fortunately, from a sales broker’s perspective, as Gordon Gekko famously said, “Greed is good”—at least until fear sets in once again, as it inevitably will.