Understanding Real Estate Bubbles

Virtually any market or commodity (houses, gold, stocks, coffee, oranges, oil, pork bellies) can experience periods of price bubbles from time to time. In economic terms, a “bubble” is a period of rapidly increasing prices created by artificial forces. Ultimately, the bubble “pops” and prices fall back to a rational level.

What Drives the Housing Market

Supply and demand is the law that all markets operate by, and an imbalance in supply and demand is what starts the growth of a bubble. With oranges, it’s weather that’s a big factor in upsetting supply. With coffee it may be South American politics. Houses, however, respond to their own forces affecting supply and demand.

Limitations on Supply

The supply of housing can be affected by rising prices of materials in response to major disasters (Katrina) or global economics (China’s growth). It can also be affected by local conditions such as available labor, limited land for development, or escalating costs of local infrastructure for new suburbs.

As housing prices begin to increase, the public perception of continuing price escalation takes hold. Buyers are motivated to buy homes now while prices are supposedly “cheap.” This psychologically driven demand leads to buyers overbidding one another to obtain their homes now before they become unaffordable.

Increase in Demand

On the other end of the equation, areas that attract new residents because of jobs, retirement appeal, or other factors experience a naturally growing demand for new homes. When the influx of newcomers outpaces the supply of new homes, prices begin rising.

As home prices increase, the same psychological factors involving buying before the prices become too high further spur the buying frenzy.

The Impact of Cheap Money

Mortgage interest rates also have a huge influence on demand for homes. When interest rates are low, more people can qualify for a mortgage. A drop in interest rates brings additional buyers into the market quickly, and supply can’t swell fast enough to keep up with the increasing demand. This also contributes to a buying frenzy that ratchets up the prices bid for houses.

Pouring Gasoline on the Fire

In this environment, speculators add fuel to the fire. Seeing the fast-rising prices, they begin buying homes and further limit supply to potential owner-occupants, eventually reselling the properties at higher prices as supply is constricted and values rise.

The Perfect Storm

The continued escalation in prices can’t continue at its artificially inflated pace forever. Yes, in the long run, prices for real estate will always go up. But when prices have run up quickly due to artificial forces, they eventually ratchet back down to realistic levels in what is termed a “correction,” after which prices eventually start rising again.

During a correction, supply has begun increasing in response to the higher profits for housing, while demand has started shrinking because fewer and fewer buyers can afford the higher prices. In a literal “perfect storm,” more houses hit the market just as many of the buyers drop out.

With fewer buyers available and homes going unsold, builders and home sellers start reducing their prices. Speculators realize they can’t sell their house purchases for what they paid and let the properties go back to the lender. The lender resells the homes out of foreclosure for even lower than market prices. Prices spiral downward.

As prices drop, potential homebuyers delay buying a house. They don’t want to buy until the prices stop dropping. This shrinks demand even further, forcing prices even lower.

Interest Rates at Work Again

While not always a factor in every bursting real estate bubble, what makes the storm even more perfect is for interest rates to begin rising. Now even fewer families can afford to buy and demand shrinks even more.

In a new twist on the interest rate factor, the latest adjustable rate mortgages are effectively causing existing homeowners to suffer the effects of rising rate adjustments even though rates for new loans have been relatively steady. Loan defaults among these owners lead to more “fire sales” which aggravate the downward fall of prices.

The Inevitable Rebound

There comes a point when many of those who have been putting off home purchases simply can’t put off buying a house any longer. They come back into the market helping turn the tide and stem the fall in prices.

This encourages others that the bottom may have been reached and now is the time to start buying again. Home building has temporarily stagnated and all the foreclosures have been absorbed resulting in a limited supply as demand returns. Prices begin to stabilize and the former bubble is now officially history.