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Houses are valuable because people like to live in them, or at least (as with many second homes) know that space is available for them to live in. The fundamental value-added of a house over, say a year's time frame, therefore depends on how effectively a particular structure satisfies that demand, as compared to alternative structures that existed that year.

There are two fundamental, yet universally ignored, reasons why the purchase price of a house might vary more than the flow of value-added.

First, it is rare that a structure by itself can provide living space to the highest value occupant -- other resources are also needed to accomplish this. Namely, real estate agents and mortgage bankers are usually needed to match a particular structure with a person or family who has a high valuation of its living space. Real estate agents and mortgage bankers share the value-added with the owner of the structure; in this view the purchase price of the house is the present value of the value-added minus what it costs to have real estate agents and mortgage bankers participate.

Moreover, real estate agents and mortgage bankers are much more elastically supplied in the short run than are housing structures, so an increase in the current or expected future value-added causes a less than proportionate increase in the resources spent per house on real estate agents and mortgage bankers, but (depending on the time frame over which housing structures are also elastically supplied) potentially a greater than proportionate increase in a house's purchase price.

The second source of leverage is government subsidies to the mortgage market. Through its implicit and explicit guarantees of mortgages and the banks who own them, the government injects taxpayer funds into the mortgage market when housing prices fall, but does not receive funds from the market when housing prices rise. Mortgage banking is a competitive industry, so the supply of mortgage banking shifts down when this expected subsidy is large. In particular, when high value-added (either in the present or expected in the future) temporarily raises housing prices, the expected subsidy increases (temporarily high prices = prices will fall in the future) and the supply of mortgage bankers shifts down. In this way, an increase in the demand for housing structures automatically increases the supply of resources that complement housing structures, and thereby leverage the initial demand increase.

Obviously, if you ignore these sources of leverage, you will misattribute some of the historical housing price boom to "irrationality." Perhaps more important, you will be surprised when the same fundamentals increase housing prices again.

Source: Sources of Leverage in a Rational Housing Market