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What Is the Root Cause of a Real Estate Bubble?

real estate

  • What Is a Housing Bubble?

Like a sudden increase in the price of any good or service, a housing bubble often starts with a rise in demand and a shortage of available stock.

As more consumers enter the market, demand rises. When the speculators arrive, they start buying up investment properties and fixing them up to sell.

Prices must increase since there is a tight supply and a huge increase in demand.

Prices may eventually reach an unsupportable level. For the typical or even above-average buyer in such area, home prices become unaffordable.

A bubble is a transient occurrence. They develop quickly in the stock market and can explode even as quickly. According to the International Monetary Fund, a housing bubble can last for several years (IMF).

But other influences have the power to deflate a booming real estate/property market at any time. More people become unable to afford their monthly carrying costs as mortgage rates rise. An increase in unemployment during an economic downturn reduces the number of potential homebuyers / real estate customers. When they feel uneasy, investors cease looking for properties to flip.

Why Does the Housing Market Bubble Occur?

The rule of supply and demand determines how much housing costs, just like it does for any other good or service on a free market. Prices rise as demand rises or supply declines.

Real estate prices increase when demand exceeds supply when there are no natural disasters to reduce the supply of dwellings. As a result of the lengthy construction or renovation process, the housing supply can be slow to respond. In some urban places, there isn’t any more land available for construction.

As a result, prices will undoubtedly increase if demand increases suddenly or significantly.

 

Why is housing demand fueled?

  • Demand growth doesn’t happen in a vacuum. Usually, several variables are at play:
  • An increase in wealth and overall economic activity puts more discretionary income in consumers’ pockets and promotes homeownership.
  • A certain demographic group joins the real estate/home market.
  • Homes become more affordable due to low mortgage rates.
  • Home ownership is made more accessible by mortgage solutions with novel characteristics including reduced beginning monthly payments.
  • More purchasers enter the market as a result of simple finance availability, which frequently has laxer underwriting rules.
  • To meet Wall Street’s desire for high-yielding structured mortgage-back securities, lenders aim to expand their mortgage industry (MBS)
  • Easy access to mortgages is made possible by lax lending criteria.
  • Extreme risk-taking on the part of mortgage borrowers
  • Realistic and unsustainable predictions of home price rise have encouraged risky and speculative activity by investors and home buyers.

A housing market bubble may develop as a result of the interaction of some or all of these factors. In fact, the overall structure of all bubbles is the same: an increase in activity and prices is followed by excessive risk-taking and speculative behavior on the part of all market participants, including buyers, borrowers, lenders, builders, and investors.

What Causes a Housing Bubble to Pop?

When excessive risk-taking becomes widespread and prices no longer closely reflect fundamentals, a bubble eventually bursts.

This will occur in the real estate/home market when developers keep constructing in response to declining demand. In other words, supply grows while demand declines. Sales will inevitably slow down, and price appreciation will also drop.

The cycle is not over after that. The market is shaken by the realization of risk as sales decline and prices cease growing. There are several factors that could have triggered the realization:

  • An increase in interest rates makes homeownership out of reach for more potential buyers and, in some situations, puts present homeowners in financial difficulty. This frequently results in defaults and foreclosures, which ultimately increase the supply of homes on the market.
  • A decline in overall economic activity lowers disposable income, results in employment losses, and results in fewer job openings, all of which lower home demand. A recession poses a unique threat. 
  • Supply and demand are in equilibrium as a result of the exhaustion of demand, which also slows the high rate of housing price increase.

When that happens, the cycle might be finished. Prices have stabilized as a result of the balance between supply and demand. But things might worsen.

Credit requirements are tightened, demand falls, supply rises, traders exit the real estate market, and prices begin to decline as the market’s mood shifts.

How To Manage a Housing Bubble

You might be tempted to sell your home if you currently own one in a neighborhood where home prices are skyrocketing. Just keep in mind that unless you’re going to downsize, rent, or relocate to a less expensive area, you’re entering the bubble. You’ll be in a market that can be overvalued, competing with the other homebuyers.

If you’re looking for a home, you could think about delaying your search. You can end up paying too much.

                                                       

Mean reversion is a basic and crucial financial concept. Although real estate/housing markets do occasionally experience bubbles, they are less common than with other asset classes. When there are periods of fast appreciation followed by stable or declining prices, long-term averages are a strong predictor of where home prices will ultimately end up. The same is true for instances of less-than-average price growth.

https://www.investopedia.com/articles/07/housing_bubble.asp

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