What is a housing bubble and how does it work?

A housing bubble arises when demand for real estate exceeds supply, leading the average price of available houses to grow, which is frequently at an excessive rate. 

Additionally, when the trend develops, it can have an impact on home buyers and sellers as they decide if now is a suitable time to buy or sell a home.

In contrast to the stock market, where consumers are aware of and accept the possibility that prices would fall, sometimes dramatically as certain changes occur.

Many people who purchase a property do not believe that the value of their home will ever decline significantly.

When compared to other asset types, the housing sector has typically been unaffected by price bubbles.

This could be a result of the high transaction costs involved when buying a home, as well as the ongoing expenditures of owning and maintaining a home, all of which discourage speculative activity.

However, housing markets do occasionally experience periods of irrational exuberance, with prices rising rapidly before returning to normal.

What is a Housing Bubble?

An economic bubble, according to the Bureau of Labor Statistics, occurs when “trade is in high volumes at prices that are considerably at variance with intrinsic values.”

When that term is implemented in real estate, a housing bubble is defined as a sudden increase in demand for houses combined with limited supply and rampant speculation.

A housing bubble, also known as a real estate bubble, is a rapid rise in home prices caused by demand, speculation, and reckless expenditure that eventually bursts.

Housing bubbles are typically characterized by a spike in demand in the face of constrained supply that takes a long time to replenish and increase.

Speculators pump funds into the market, thus pushing up demand. Demand falls or grinds to a halt at a particular stage as supply rises, leading to a rapid fall in prices, and the bubble eventually bursts.

A housing bubble is also described as an unexpected increase in demand for real estate and housing, as well as a spontaneous or unusual increase in home prices.

Housing bubbles differ based on how long they endure and how harsh the consequences are when they pop. In a summary, housing bubbles appear to do more economic damage than good, at least for the short term.

The bright side is that housing bubbles are usually only ephemeral, what this means is that, the housing market and the economy can still recover.

Every bubble is usually only there for a short time. According to the International Monetary Fund (IMF), while equity market bubbles are more frequent, housing market bubbles can last much longer, up to several years.

How a Housing Bubble works, looking at a past scenario

The phrase “bubble” is not new nor exclusive to real estate. Indeed, one of the first bubbles occurred in the 17th century in Holland, when trade in the tulip markets surged, then collapsed, wiping out wealth quickly.

Housing bubbles have happened numerous times in American history, but the one that peaked in 2006-2007 is undoubtedly the most notorious.

The increase of subprime mortgage loans was a major driver of the bubble in that case. To put it another way, very many borrowers were permitted to obtain mortgage loans that they could not manage.

Because more people purchased homes, demand increased, leading to more speculation. Between 2004 and 2006, the Fed raised rates to help control inflation.

Affordability problems plagued subprime borrowers who had taken out adjustable-rate mortgages. Delinquencies caused foreclosures, which in turn led to falling home prices, causing the housing bubble to collapse and the market to tumble.

The housing market meltdown had far-reaching consequences for the whole economy, causing a recession.

Among the most serious consequences were:

• 8.7 million jobs were lost.

• 8 million homes were lost to foreclosure

• 95 million homes lost their equity.

• 500 community bank closures

Causes of a Housing Bubble

Housing prices, like the prices of any other item or service in a free market, are determined by supply and demand.

Prices rise as demand rises and supply lowers. Prices rise when demand outpaces supply trends in the absence of a natural disaster that would reduce the immediate supply of dwellings.

Considering it requires a long time to construct or repair a house, and because there isn't any additional land to build on in heavily populated areas, housing supply can be slow to respond to increases in demand.

Therefore, if there is a quick or continuous surge in demand, prices are guaranteed to rise.

Once it is proven that an above-average spike in home prices is caused by a demand shock, we need to figure out what caused that surge in demand.

There are numerous possibilities which are:

• An increase in the number of people entering the housing market, or in the demographic portion of the population that is joining the housing market.

• An increase in overall economic activity and wealth, which provides consumers with more disposable income and promotes homeownership.

• A cheap, general level of interest rates, particularly short-term interest rates, that renders homes more inexpensive.

• Potential risk mispricing by mortgage lenders and mortgage bond investors, resulting in increased loan availability for borrowers.

• Mortgage borrowers’ lack of financial awareness and excessive risk-taking.

• Short-term interaction between a mortgage broker and a borrower in which the latter is occasionally persuaded to take unnecessary risks.

Factors that may burst the Bubble

When excessive risk-taking becomes prevalent throughout the housing market, and prices no longer reflect anything near to fundamentals, the bubble finally bursts.

This will occur while the housing supply continues to rise in response to the previous demand surge.

To put it another way, demand falls while supply rises, resulting in a rapid drop in prices as no one is left to pay for even more properties at even greater prices.

What should be done if the Housing Bubble bursts?

If there is a housing bubble and it bursts, home values will plummet. You might discover that your home isn't worth the amount you owe. Being affected by such may make it more difficult to sell and relocate without incurring a loss.

The smartest thing you can do right now is avoid being trapped in a mortgage that you can't afford. Use a mortgage calculator to figure out how much you can pay before buying a property.

Also, stay away from high-risk loans. First-time homebuyer mortgage lenders can help with the process and help you choose the right loan.

Those homeowners who were capable of keeping up with their monthly mortgage payments during the last housing market meltdown saw their home value rise and their equity return.

Not everybody had a good time with the crash. Speculators who bought properties with interest-only loans assumed that the home's value would improve over time, giving them equity.

The assumption was that they'd be able to refinance or sell the house before the loan reverted to a higher principal-plus-interest payment.

Unfortunately, when the market fell, some of these people were unable to make their payments. To make matters worse, they were unable to sell the house for the sum due.

Conclusion

Housing markets, while not as susceptible to bubbles as other markets, actually do exist. 

Long-term averages are an excellent predictor of where home values will wind up after periods of fast appreciation followed by periods of stagnation or decline.

The same is valid for times of price growth that are below average.

If you're an investor, you should be aware of how a housing bubble might impact your portfolio in the short and long term.

If the reasons for a housing bubble are not directly tied to the stock market and the consequence does not spark a bigger recession, the effects on day traders may be limited.

However, if you're worried about a bubble forming before a recession, you could want to add defensive securities to your investment portfolio to help reduce risk.