Irrational Exuberance

We left until later crucial questions about if and how income and value are related. Now is the time to take up that matter. All of the prior graphics implicitly assume that net income remains constant. If values are a direct function of income, value will rise with income. Capitalization rate represents the ratio of income to value and, therefore, movements in cap rate reflect relative changes in income and value.

At the end, the race is between a series of "greater fools" who transact at prices disconnected from income. The last buyer who cannot find another to sell to on the basis of "higher-prices-for-no-reason" must wait for income to rise in order to sell at a profit. If the market realizes the speculation game has ended this can be a long wait. If some sellers are financed in ways that prohibit them from waiting, sales begin to take place at lower prices. Under these conditions the bubble deflates.

We admit that there are times when the deflation of the bubble is rapid and "bursting" might be a better word. But, after all, the whole bubble metaphor is intended to describe what happens to prices when a market of frenzied buyers infected by irrational exuberance becomes superheated.

There is an important point to be made about rationality. The assumption of zero minimum XDCR represents the line between rationality and irrationality. Commodities such as tulips, Pokemon Cards and houses are traded without regard to income production. Such commodities do not lend themselves to an analysis such as this one. Whenever income properties trade like non-income producing property one begins to see tulipmania where there once were buildings.