• Real estate bubbles are sharp price increases caused by a temporary increase in demand that is not rooted in basic fundamentals.
  • Fundamentals are determined by factors that affect supply and demand, such as home construction costs and changing demographics.
  • Although experts often disagree that a real estate bubble exists, you can consider housing prices relative to rents and incomes as a good indicator.
  • Read more stories from Personal Finance Insider.

In the 1990s and early 2000s, lax lending standards and subprime mortgages led to a housing bubble that devastated families across the United States, especially middle-class ones. House prices are now higher than they were at the peak of the housing bubble, but experts disagree on whether this price spike can be considered a bubble.

While a spike in prices in the real estate market does not necessarily indicate a real estate bubble, what is a real estate bubble and how does it form?

What is a real estate bubble?

A real estate bubble is a sharp increase in prices in the real estate market following a sudden and temporary increase in demand caused by external factors. According to Housing Wire senior analyst Logan Mohtashami, housing bubbles occur when “prices are disconnected from fundamentals and the demand that is driven by housing is speculative in nature.”

Housing bubbles are defined by their ability to “burst”. Eventually, whatever is driving demand will collapse, and suddenly there will be no demand, which means housing prices will start to fall rapidly.

Consider an example: the housing bubble in the mid-2000s. At that time, lending standards were incredibly lax and it was easy to get a home loan, creating an unsustainable demand for housing. When credit standards tightened, demand fell and prices fell.

Compared to other economic bubbles, real estate bubbles are rare. This is mainly because housing is so expensive and therefore not prone to much impulsiveness.

“It’s very difficult to have a massive marketing campaign that goes viral, that makes everyone want to suddenly change that fundamentally huge decision in your life that has so many steps and so many interactions with credit, loans and banks,” says Skylar Olsen. , senior housing economist at Tomo, a digital real estate company. “It’s not like Beanie Baby madness.” Maintaining a home is also costly and time consuming, which discourages speculation.

What causes a real estate bubble?

There is no single cause for a housing bubble – it varies from bubble to bubble. However, they are always caused when the housing market deviates from the fundamentals on which it is based, usually due to temporary external pressures in the housing market which stimulate demand.

The real estate bubble that drove down house prices in the 2000s was the result of subprime mortgages or loose lending practices, what Mohtashami calls exotic lending debt structures. These risky loans were granted to borrowers who would not have been able to buy a house otherwise, opening up the possibility of home ownership to a whole section of the population. Unfortunately, many of these borrowers were unable to make their mortgage payments, so they lost their homes due to tightening credit standards.

“We no longer have exotic loan debt structures in the system,” Mohtashami says. “As a result, we have created the best homeowner loan profiles in our history.”

Speculation can still push the housing market away from fundamentals, although it does not have the strength to create a housing bubble on its own. When real estate prices start to climb, speculators might see an opportunity to ride that wave and buy into the real estate market. These real estate investors are limiting the supply of homes and raising prices even higher and further from fundamentals. Speculation drives housing construction, which aggravates the crash when the bubble bursts creating excess supply, further devaluing homes.

In debates about a current housing bubble in 2022, a housing bubble is said to be caused by the

Federal Reserve

Advice boosting the economy during the pandemic. “If you’re discussing a bubble right now, what you would say is the Fed was something artificial,” Olsen said. “They had boosted the economy too much, too hard, and now they have to pull back. This is the process that could potentially burst the bubble.”

What are the fundamentals of the real estate market?

If the market moves away from the fundamentals causes a real estate bubble, this raises the following question: what are the fundamentals of the real estate market?

Like all markets, the housing market is driven by supply and demand. Housing supply can be influenced by factors such as construction prices, land availability, and even new construction technologies. Housing supply is considered long-term elastic, meaning it can adjust to meet demand over a long period of time. However, this is less and less true.

Supply may also be affected by the destruction of housing. “I think it’s worth talking about, especially as we approach climate change,” Olsen says. “You can lose a bunch of houses in a hurricane or a storm surge.”

On the other hand, housing demand is largely determined by the demographics of people buying homes. This includes the age of people buying homes and the income of those people. Demand is also influenced by the type of job and where people want to migrate. “Big job booms or industrial booms in a metropolitan area will attract better paying jobs. Higher income eventually increases people’s ability to pay in the marketplace,” Olsen said.

Demand will also be affected by the location of the housing market. Looking at something on a smaller scale, like a city, demand can be affected by school districts and crime rates.

How to determine if we are in a bubble

While it’s easy enough to define a bubble and its potential causes, determining whether we’re actually in a housing bubble is tricky. Housing experts often disagree on whether a price spike is caused by a change in fundamentals – so not a housing bubble – or something that is completely separate from those fundamentals.

Economist-researcher Luis Torres writes in a Texas A&M study that “rapidly growing house prices are not in themselves conclusive evidence of a bubble.” Instead, these price increases “are not based on economic fundamentals, particularly if price increases for that region do not reflect overall historical price trends.”

Additionally, since fundamentals change over time, “there is no sure way of knowing what prices should be,” Torres writes. There is no way to determine when the market is acting abnormally, because there is no normality to compare it to.

However, it may be useful to compare other economic trends to housing prices, such as the cost of rent. If rents rise in parallel with housing prices, it may be that a wave of migration is moving towards a certain area or that the demand for housing is only increasing. Olsen says “there could be something inappropriate about house values ​​if they’re rising so much faster than rents, couldn’t there?”

In addition, another worrying indicator is whether house prices are rapidly outpacing incomes. The demand for housing increases when income increases because people have more disposable income for a down payment on a house. If incomes are not rising, but house prices are, then something other than purchasing power is pushing demand.

The housing bubble of the mid-2000s explained

The housing bubble that burst in 2008 was the culmination of several bad practices in the housing market that took place over several years.

Securities backed by mortgages: Mortgage-backed securities (MBS) were a type of investment that pooled mortgages and sold them to investors in the secondary market. They are only as safe as mortgages themselves, which in the 2000s meant they weren’t very safe, but investors had no idea because the risk was not properly priced.

When MBS entered the primary market, which meant investors were buying directly from lenders, “you had a bunch of

mortgage lenders

who have found it easy to lend because they have this flow of money,” says Olsen.

Adjusted rate mortgages: Low mortgage rates increase real estate demand by making homes available to more people who might not otherwise have been able to buy a home. In the 2000s, a large portion of mortgages were adjustable rate mortgages. These attract people with a low initial mortgage rate that increases after the initial rate period expires. Olsen says households who took out an adjustable-rate mortgage either didn’t understand or weren’t told exactly how their mortgage rate was changing. “They got a loan they couldn’t really repay,” she says.

Rising mortgage rates caused a wave of foreclosures, which doubled from nearly 720,000 in 2006 to 2.3 million in 2008. Six trillion dollars was lost in wealth as a result of the housing crash.

Credit is now incredibly tight. “Getting a loan to buy a house has never been so difficult,” says Shah. Therefore, we are unlikely to see a real estate bubble caused by these same circumstances. If we want it to stay that way, Mohtashami says “the best thing for America is to never relax lending standards from what they are now, and you’ll be fine.”