Blowing Bubbles with Real Estate

There is no doubt that the real estate market is in a bubble. For the past few years we have heard news reports across the nation about the high prices homes and properties are being sold for. Stories of bidding wars and people flipping properties for huge profits. And we increasingly hear the worries of a deflating bubble that is sure to come, if it hasn't arrived yet. But what is a bubble, you might ask?

Bubbles Occur in Every Market

Remember the tech bubble in the late ninety's? When a market sees long term inflation in prices the activities of market participants can push the increased prices even farther. Rising prices attract investors who expect to be able to sell at even higher prices. Their buying activities push prices up which attracts more buyers who push it higher and attract even more buyers, and so on, and so on. It becomes a positive feedback loop. But it never lasts.

Prices Do Not Go Up Forever

At some point the market runs out of buyers eager to spend. And as prices rise it pulls more sellers into the market who want to receive these high prices for their goods or their homes in the case of the real estate market. The supply and demand components of the market will eventually shift. When a bubble begins to deflate you will see an increased supply, more homes for sale, and a decrease in buyers who no longer want to pay the inflated prices. This is when the bubble will burst.

Like a growing bubble, the bursting bubble creates its own positive feedback loop, or negative depending on your point of view. Prices begin to drop and more sellers try to place their homes onto the market to receive a good price before its too late. Buyers begin to increasingly hold back on purchasing real estate because they feel they may get a better price if they wait. Compounding this deflation is the interest rate market which will act to force more supply onto the market.

These rises and falls of markets are a natural function of every market and is spurred by human nature. Governments use interest rates in an attempt to slow the pace of inflation and deflation in markets. They lower rates to induce buying by making it cheaper to borrow money. But eventually it becomes too easy to use cheap credit and markets become flush with excess liquidity (too much cash). They then begin to raise rates to deter the borrowing and spending spree that has been pushing prices very high.

It may seem counter productive for governments to intervene by adjusting interest rates. Without this form of  control markets, and their eventual bubbles, are prone to rising and falling at much more extreme rates. Though they cannot completely eliminate the negative outcomes of bubbles and their collapses, this intervention does tend to smooth out the process and limit the problems associated with bubbles.

Direct intervention in interest rates are used to control economies at a larger level, and how it influences all markets, not just real estate. But real estate has some unique elements that are far more greatly influenced by interest rates than most other markets. This is due to the massive leverage that is provided by mortgages. In no other market can the average Joe borrow such large sums of money. And when rates are low they take advantage of it, sometimes over leveraging themselves, and when rates are high they can really feel the pain.

As rates rise, monthly mortgage payments increase for those who are in floating rate mortgages. If rates rise high enough these increased payments can become unaffordable for some home owners. Those that find themselves in this tight situation are often forced to sell their property to relieve themselves of the burden of big mortgage payments. This puts more supply on the market and lowers the prices of real estate. The double whammy comes when they are forced to sell at a lower price than they paid for it during the rising portion of the bubble.

At the bottom of this cycle those who overleveraged themselves tend to get flushed out of the market. It may take years to reach a bottom and amidst the doom and gloom atmosphere of declining real estate prices a bottom will indeed occur. Eventually market forces will tip the supply and demand balance into the other direction and prices will begin to rise again. Slowly at first, but surely another bubble is on the way.

Avoiding the Pains of a Real Estate Bubble

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