Real Estate Market Bubbles Explained

By Michelle Clardie on 09/09/2022.
Reviewed by Dan Gatsby .
Real estate bubbles are a normal part of the economic real estate cycle. But they can also be a source of concern for homeowners, mortgage lenders, and real estate investors, all of whom have a vested interest in changing real estate values.

So the real estate experts here at Gatsby Investment want to answer your most pressing real estate housing bubble questions:

  • What is a housing bubble?
  • What causes a housing bubble?
  • Are there signs that indicate a potential bubble?
  • What happens when a real estate bubble bursts?
  • And what should you do when you find yourself in a housing bubble?

What Is a Housing Bubble?

A housing bubble is a temporary market condition in which home values see rapid, unsustainable growth to the point that buyers can no longer afford homes in their local market. Real estate bubbles are the result of an extreme difference between high buyer demand and low seller supply, which naturally drive prices up.

One of the easiest ways to spot a housing bubble is to compare local home prices to local household incomes. In a balanced market (where supply and demand are roughly equal), the median home price tends to be around four times the median annual household income. When the median price exceeds five times the median household income, we’re in potential bubble territory. Having said that, traditionally high-value markets like Los Angeles, San Francisco, and New York City can typically sustain prices at five times the median household income without being considered a bubble.   

It’s important to understand that an increase in home prices doesn’t necessarily indicate a housing bubble. In fact, home values are expected to rise over time, so we should see regular price increases. A housing bubble only forms when values are pushed so high that local buyers can no longer reasonably afford to own a home in their market.

While real estate bubbles may be extreme economic conditions, they’re also an example of free markets working as intended. Supply and demand drive values up, and when prices become so high that demand drops, we see a market correction in the form of reduced prices. Then those reduced prices will incentivize people to start buying again, and we see the cycle continue.   

What Causes a Housing Bubble?

There are several factors that contribute to real estate bubbles, including

  • Rapidly increasing demand. Higher buyer competition drives home values up, particularly when bidding wars become common. 

  • Low supply. Housing shortages lead to intense competition for available homes. And this competition leads to offers with above-asking purchase prices. 

  • Low mortgage rates. Low mortgage rates give buyers an incentive to buy now, while the cost of borrowing is low. So low interest rates fuel buyer demand.

  • Relaxed credit standards for home loans. Mortgage lending practices can create a bubble by allowing buyers to purchase homes beyond their means. When buyers get pre-approved for a high loan amount, they feel they can increase the purchase price to that loan limit, which drives up prices. 

  • Investor speculation. As more people see the money to be made in the hot market, speculative investors join the pool of existing buyers. This adds even more demand, tipping the scales further into a seller’s market rather than a buyer’s market.

What Are the Signs of a Housing Bubble?

There are several ways to spot a housing bubble. Not all of these signs need to be present to indicate a bubble. But the more of these signs you see, the more likely it is that you’re experiencing a housing bubble. 

  • Home prices increase faster than wages. When housing prices grow faster than incomes, homeownership becomes less affordable. 

  • Home prices increase faster than inflation. Similarly, when housing prices grow faster than the rate of inflation, homes become less affordable. 

  • Lack of affordable housing. When you see that the average would-be buyer in your market is unable to afford a home, it’s a strong indicator that home prices have become unreasonable. 

  • Increase in subprime mortgages. Subprime mortgages are home loans offered to buyers who would not qualify under normal lending criteria. Mortgage lenders are good at finding creative financing solutions to help people become homeowners. But this can lead to over-extended subprime borrowers who struggle to make their monthly mortgage payments. Subprime loans are more likely to end with a foreclosure than loans to well-qualified borrowers.

  • Rising mortgage interest rates. Mortgage interest rates are always changing. But a sudden substantial rise, particularly after an extended period of reliably low interest rates can indicate a housing bubble. 

What Happens When Housing Bubbles Burst?

A real estate bubble bursts when the market reaches a tipping point at which buyers decide that homes are no longer worth the cost of ownership. 

The build-up to this tipping point is gradual, but the shift can be sudden. As increasing home values and rising interest rates make homeownership less affordable, buyer demand suddenly dries up, leading to the most impactful result of a housing bubble burst: the temporary fall of property values.

A burst housing bubble can be a vicious cycle. As values dip, many would-be buyers decide to wait to see if values continue to decline. This leads to even lower demand. At the same time, some homeowners will owe more on their mortgage loan than the current value of the home. This can lead to an increase in short sales and foreclosures, which flood the market with additional inventory that further exceeds demand and pushes values lower.

The good news is that there will be a point at which it becomes advantageous for buyers to start buying again. Typically, the Federal Reserve will lower interest rates to incentivize buyers. This, combined with the temporarily lower home prices, can make property ownership attractive again. And then we see demand (and property values) grow.   

Examples of Housing Bubbles

Real estate bubbles are nothing new. We’ve seen them regularly throughout the history of free real estate markets. 

The Chicago Housing Bubble of the 1830s

In the 1830s, Chicago land values rose 400-fold over a six-year period, mostly because of state legislation that pushed the Bank of Illinois to invest too much money too quickly in undeveloped real estate. Property values crumbled by nearly 90% over the following four-year period.

The Los Angeles Housing Bubble of the 1880s

The rapid expansion of LA created a housing bubble in the 1880s when prices increased 10-fold over a six-year period, then fell by a third the following year. This is an example of a “gold rush” bubble in which many people realized the potential of Los Angeles and immediately rushed to stake their claim. Real estate values quickly grew past the price that reasonable investors were willing to pay, and they adjusted to more reasonable levels in 1889, before climbing once again.

The American Housing Bubble of the 2000s

To fully understand the life cycle of a housing bubble, let’s look at a modern example: the American Housing Bubble of the 2000s. This has also been called the Subprime Bubble or the Savings and Loan Bubble. But to most people, this is simply The Housing Bubble.

The Housing Bubble actually began with the tech revolution of the 1990s. The explosion of new tech and accessibility of websites to the general public created the Dot Com Bubble. And when that highly-speculative bubble burst, institutional investors, who had lost a fortune when tech stocks plummeted,  recognized the benefits of investing in real estate vs the stock market. So, they funneled their remaining capital into the real estate market. 

At the same time, the Federal Reserve was trying to keep the Dot Com Bubble from triggering a nationwide recession. So, to ease the flow of money through the economy, the Fed lowered interest rates to historic lows. This lowered the cost of borrowing money, which increased demand for large purchases, like homes, that generally require financing.

To meet this growing demand, home builders ramped up construction. A report from the Federal Reserve Bank of New York asserts that builders went overboard, constructing up to 3.5 million more housing units than were needed during this bubble period. 

Lenders, meanwhile, were thrilled with the increased demand from borrowers and wanted to capitalize on it by extending as many loans as possible, even to subprime borrowers who represented a greater risk of default due to credit or income issues. Adjustable-rate mortgages were used to give buyers a lower initial mortgage payment. But when interest rates increased, many borrowers struggled to keep up with their new, higher monthly payments.

You can see all the causes of a housing bubble at play here: high demand, low supply, low interest rates, relaxed credit standards, and investor speculation. The median US home price had gone from $202,900 in the first quarter of 2000 to $322,100 in the first quarter of 2007. Not only was this a housing bubble, but it was a perfect storm of a real estate bubble.

What Caused the Bubble to Burst? 

As home values rose, more and more buyers were priced out of the market. Additionally, interest rates had risen from 5.53% in July 2005 to 6.74% in June 2006, increasing the cost of homeownership. So the demand immediately dried up.

At the same time, those subprime borrowers with adjustable-rate mortgages were suddenly unable to make their new house payments. But most didn’t have enough home equity to justify selling the house. So they went into foreclosure. And since banks are not in the business of holding residential real estate assets, the banks rushed to find buyers for the foreclosed properties, flooding the market with even more unwanted inventory.

The sudden shift in supply and demand burst the housing bubble.

What Happened When the Real Estate Bubble Burst? 

By the first quarter of 2008, the median home price had fallen from 322,100 to $290,400. It would continue to fall for the next year, reaching as low as $257,000 in the first quarter of 2009.

An estimated 3.8 million homes were foreclosed on. Traditionally stable mortgage-backed securities lost value, adding to the global financial crisis that became known as the Great Recession. 

How We Recovered from the Worst Housing Collapse in US History

We recovered from the housing collapse by bringing supply and demand back in balance. The low prices naturally enticed more people to buy real estate. The Fed lowered interest rates once again to offer an additional financial incentive. Builders stopped construction to avoid adding inventory. And lenders tighten their loan practices to make sure future borrowers were well-qualified.

The recovery took several years. But by the third quarter of 2013, the median home value hit $324,400, exceeding the previous 2007 peak. Property owners who weathered the worst housing collapse in history were rewarded with continued value growth after the initial recovery. The median home price hit $514,100 in the first quarter of 2022.   

What Should You Do if You Own Real Estate in a Housing Bubble?

You don’t need to do anything during a housing bubble. Remember, housing bubbles are a temporary market condition, and you can wait them out. Home values will always come back up!  

However, if you notice a strong bubble forming, it might be a good time to sell real estate investments. Selling while prices are inflated is a good way to benefit from all that equity and free up your cash so that you have funds available to invest in new projects when real estate prices dip following the burst. 

Just understand that perfectly timing the market is largely a matter of luck. You might sell early in the bubble and watch values continue to climb. Or you might wait too long and sell once the bubble has burst, missing your chance at peak profits. Focus on the gains you realize from the sale rather than what you could have made.

Now, what about buying additional properties during a bubble? Should you invest in real estate during a bubble? 

As long as you’re playing the long game, it’s always a good time to invest in real estate. A bubble can be a risky time to invest in short-term projects like fix-and-flips because the bubble could burst mid-flip leaving you with a property that has low buyer demand and is declining in value. But, if you’re prepared to convert your flip into a long-term rental property, you could benefit from the rental cash flow, as well as the long-term appreciation once the market recovers. 

Diversify Your Real Estate Portfolio with Gatsby Investment

Real estate is typically considered to be a low-risk investment. But navigating changing economic conditions can be difficult. Especially when extreme conditions like real estate bubbles are at play. 

The best way to protect yourself against inevitable housing bubbles is to maintain a diversified investment portfolio. 

Here at Gatsby Investment, we offer a wide range of real estate investment opportunities. And because we pool funds from multiple investors, each of our projects comes with a low minimum investment amount. This allows you to spread your investment capital across multiple projects, essentially creating an instantly diversified portfolio. 

Learn more about the advantages of investing with Gatsby today.

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