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What Is a Housing Bubble?

This is how investors should handle housing bubbles.

[Updated: Feb 04, 2021] Oct 23, 2020 by Tara Mastroeni
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Now that we're more than a decade past the 2007 financial crisis, housing prices are once again on a steep rise. This price inflation has many wondering whether we're in a housing bubble and, if so, what they can do to leverage their investments. With that in mind, below is your guide to housing bubbles. Read on to learn what a housing bubble is, how it works, and how you can use the presence of a housing bubble to guide your investment strategy.

What is a housing bubble?

The term "housing bubble" is used in the real estate industry to describe a period of time where housing prices rise to a level of instability. In this case, the price of housing is usually driven up by an outside force like a surplus of demand during a time of limited supply. However, once that happens, speculators like outside investors also enter the market in search of sizable returns and drive up prices even further. Eventually, prices will rise to the point at which they no longer reflect the true value of the asset.

Over time, the demand spike begins to decrease as supply continues to rise. When that happens, the bubble starts to burst. Suddenly, there's an excess of supply compared to the demand. As a result, prices will decrease sharply to compensate for the sudden surplus, leaving those who bought during the housing bubble underwater and many struggling just to pay their mortgages.

Notably, housing bubbles occur less frequently than other equity bubbles. However, when they do, they tend to last longer and have a broader effect on the economy as a whole. Once the bubble bursts, many people will have borrowed more than their home is worth and will struggle to keep up with their housing payments. This leads to increasing numbers of foreclosures and a sizable loss of savings and financial stability across the board.

Understanding how housing bubbles function

Now that you have a better understanding of what a housing bubble is, the next step is to take a closer look at how they function. With that in mind, we've laid out more specifics for you below. Read it over for an in-depth understanding of how bubbles work and what can be done to prevent them from occurring in the future.

What causes housing bubbles?

At their core, housing bubbles are caused by an excess of demand compared to the current supply. However, this mismatch between supply and demand can come from a variety of factors. In reality, the cause of a housing bubble could be a mix of any of the following:

  1. The fact that it takes a long time to build a house, which makes supply generally slow to respond to demand at any time.
  2. General economic growth, which causes people to have more disposable income and to be more likely to seek out homeownership.
  3. A sudden increase in the population of a particular area.
  4. A lack of space for new construction, which drives up the prices of existing housing.
  5. Low mortgage interest rates.
  6. Less strict underwriting standards, which causes more borrowers to be able to enter the mortgage market.
  7. New mortgage products, particularly those offering the opportunity to make low introductory payments.
  8. A general lack of financial literacy on the part of mortgage borrowers.
  9. Increased amounts of house flipping.
  10. Speculative behavior on the part of buyers and investors rooted in an unrealistic idea of price appreciation.

Why does the bubble eventually burst?

Eventually, after months or years of prices rising up to a level where they no longer reflect the fundamental value of housing in the area, the real estate bubble will begin to burst. Again, this occurs when the supply of available housing starts to outpace the demand. That said, once again, the decrease in demand can be due to a variety of factors, including:

  1. Demand can simply become exhausted over time.
  2. An economic downturn, which results in increased numbers of job losses or disposable income.
  3. A sharp increase in mortgage rates, which may put homeownership out of reach for some interested parties.

Housing bubble example: The 2007 financial crisis

It's almost impossible to talk about housing bubbles without mentioning the 2007 financial crisis, which is the most memorable housing market crash in recent history. In this case, the financial crisis happened on the coattails of another equity bubble: the dot-com bubble in the late 1990s.

When the dot-com bubble burst, many investors decided to move from investing in the stock market to investing in real estate. At the same time, as a result of a mild recession that occurred because of the dot-com bubble and the economic uncertainty surrounding the World Trade Center attacks, the federal government lowered interest rates, which led borrowers to flood the market. Over the next few years, housing prices continued to rise substantially.

Meanwhile, in the mortgage market, lending standards were becoming increasingly less strict, leading to an increase in subprime mortgage lending. Unfortunately, many of those subprime loans were also adjustable-rate mortgage products, which meant that the interest rates would adjust in just a few years.

By the time they did, housing prices had risen to a level of instability. The stock market had also recovered, which meant investors were no longer interested in buying houses at incredible premiums. As demand dropped, housing prices began to fall dramatically. Many of the subprime borrowers found themselves underwater on their investment and unable to afford their new housing payments.

Soon, the number of home sales grew, which drove down housing prices even further and led to a massive sell-off in the mortgage-backed security industry. Unable to get out from under their investment once the housing bubble burst, millions of those subprime borrowers succumbed to foreclosure.

How to prevent housing bubbles

Ultimately, preventing future housing bubbles has a lot to do with monetary policy. Following the 2007 housing crisis, many new regulations were put in place to prevent the same increase in subprime lending. In addition, though, economic modeling is key to identifying any potential boom and eventual bust that may occur as a result of ongoing market trends.

How investors should handle a housing bubble

As an investor, you're likely most interested in advice on how to handle an emerging housing bubble. To that end, we've laid out our best advice for that situation below.

Short the housing market (but proceed with caution)

Many investors have designs of shorting the housing market and making millions. In investing, to "short" something means to bet against it. Essentially, you can short real estate by betting that housing prices will fall. However, in this case, you need to do it through buying and selling real estate investment trusts (REITs), or shares of companies within the real estate industry.

That said, keep in mind that it's not enough to simply guess correctly that housing prices will fall in the near future. It's also important that other investors not realize that prices are about to fall, leaving the underlying asset inherently overvalued.

Then, if housing prices fall in the way you suspected, you'll make money off shorting the market. If not, you'll lose money on the deal. With that in mind, every investor needs to evaluate the risks of taking this position on a case-by-case basis.

Buy in the downturn, not at the peak

If shorting the market isn't for you, the other option is to wait until the bubble bursts and then buy in the economic downturn. If you do this, you can often get more property for your money, which will lead to better returns overall.

It can be tempting to buy when interest rates are low, which gives you more opportunity to leverage your funds, but the "buy low, sell high" adage holds true here.

The bottom line

If there's one thing we know for sure it's that housing bubbles come and go as part of the real estate cycle. To that end, investors who make it a point to stay on top of their current market trends can use its fluctuations to guide their investing decisions. However, in addition to keeping tabs on how your current market is fairing, it's a good idea to also consult a financial professional before making any significant money moves.

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