Why First-Time Buyers Matter For The Housing Market

As the housing recovery progresses, there is growing concern that first-time buyers – often equated with millennials – are buying too few homes. “Too few” in this context means less than the historical norm. Why should this worry us? The obvious reason is that it could indicate that the barriers to homeownership are rising, but when reporters cover the shortage of first-time buyers they usually invoke a very different reason.

One reporter phrased the go-to reason particularly well by saying that “millennials are… akin to guppies in the housing market food chain: When a first-time buyer moves into an entry-level house, it lets the sellers upgrade.”  The implication of the food chain analogy is that a shortage of first-time buyers will cause the equivalent of famine in the housing market: a slowdown in home sales and presumably also in prices. Put differently, the concern is that if millennials don’t buy enough homes, that will dampen or undo the housing recovery.

Repeat-buyers and transaction chains

What is the logic here? Most home buyers – historically around 60% – are repeat-buyers, and most repeat-buyers need to sell their old home in order to buy a new one. Now lets consider a simple mental model: suppose that home sales are organized into neat chains, in which A buys a home from B, who then buys a home from C and so on. The chain continues until somewhere along the chain, someone sells a home but doesn’t buy one. This can happen for many reasons, for example if someone moves in with someone else.

The key, however, is how chains start. B won’t be able to upgrade into C’s home unless he or she can sell their old home to A, who is a first-time buyer.  Thus, if too few first-time buyers like A instigate chains, then fewer folks like B will be able to sell, which means that even the likes of C could end up staying put in their old home despite wanting to move. The upshot is that fewer first-time buyers mean fewer home sales in the market, including ones that don’t involve first-time buyers at all.¹

Like every model, this one is incomplete. For example, it fails to recognize that people (and other entities) can own multiple homes, and that when people buy a home without selling one they instigate a transaction chain even if the home is their umpteenth property. Yet despite its flaws, the model provides a rough approximation of reality.

Market thickness and home prices

What the model does not explain is why a shortage of first-time buyers should affect home prices.  Explaining that requires some elaboration: with fewer first-time buyers there are fewer transaction chains in motion at any point in time, which in turn means there are fewer repeat-buyers in the market. Now because every repeat-buyer plays a dual role – that of a buyer and a seller – fewer repeat-buyers make for a thinner market, i.e. one in which there are proportionately fewer buyers and sellers.

The thickness of the housing market affects prices in at least two ways.  First, thicker markets offer a wider selection of homes for sale, which makes one likelier to find their dream home. As we all know, when the dream home is at stake even the most prudent buyer tends to release the purse strings. In a thin market, on the other hand, the dream home is probably not for sale.

Another way that market thickness affects home prices is by producing more frequent multiple-bid situations. It is a well-known technique for realtors to set a low asking price in order to entice enthusiastic home buyers into a multiple-bid situation, which ultimately pushes the sale price higher than it would have been otherwise. In a thicker market, in which every new listing is considered by all of the buyers in the area, simple probability tells us that more multiple-bid situations will emerge. Take them away, as would be the case in a thinner market, and prices won’t rise as quickly.

The effects of market thickness are not limited to a small set of highly-coveted homes – they propagate in the market. Because the sale price of one home serves as a “comparable” for setting the asking price on similar homes, buyers competing over their dream home can run up the prices of many additional homes down the line, which can then carry the effect even further when they, too, become “comparables.” Of course, the opposite is true when the market grows thinner, which is our concern here.

A distinct possibility

Whether or not cooling down the housing market seems like a troubling development or one that is welcome depends on whether you are thinking of buying or selling, and in which part of the country you live. But will too few sales to first-time buyers necessarily have this effect? That is a distinct possibility.

Notes:

¹ One might imagine that with fewer transaction chains in motion, repeat buyers would simply form longer chains and would all still manage to sell their homes, just over a longer period of time, but this is wrong. With fewer transaction chains, the challenge of matching buyers and sellers in terms of home characteristics and timing both become more complicated, ultimately leading to fewer transactions reaching fruition.