Understanding Real Estate Bubbles

Real estate market bubbles are marked by rapidly rising home prices, sales and financing activities beyond the ‘normal’ range of periodic up turns and down turns. While housing markets have been noted to demonstrate these ‘cyclical’ patterns historically, it becomes economically unstable when these trends are excessively volatile. The signals of a real estate bubble bursting are the following economic patterns:

  • Numerous mortgage banks bankruptcy filings
  • Significantly lower Home valuations nation wide
  • Lower month over month home sales
  • Considerable depreciation of both new and old homes
  • Decreased home construction
  • Devaluation of mortgage backed securities in capital markets
  • Reduced earnings in housing industry companies

Causes of Real Estate Bubbles:

In the case of the U.S. Real estate market bubble of the middle 2000’s, several different causes led to the steep rise and eventual burst of the bubble. These variables all contributed to a bigger rise and fall of the housing market than if only 1 or 2 of the following factors occurred.

  • Housing trends tend to be cyclical by nature
  • Liberal Bank policy and loan loss precautions
  • Excess sub-prime and Alt-A type mortgages
  • Adjustable Rate Mortgages (ARM’s) heavily in default or foreclosure
  • Lack of State and/or Federal capital regulation

International housing markets are not all regulated the same way and therefore may not be as prone to bubbles as the United States and the United Kingdom. Both the United States and the United Kingdom have experienced a rapid increase in home valuations in recent years. In the United States that bubble has burst, but as of fall 2007, the British housing market has not ‘burst’. If the housing market in a particular country has stable appreciation of approximately 1-3%/annum and loan practices are more heavily regulated via stricter credit policies and higher bank borrowing rates it is less likely that country will experience a housing bubble.

Tips to Avoid Real Estate Market Risk:

The reality of housing is that a large amount of peoples net worth is tied into the value of their homes. Thus when the home values appreciate as in a housing bubble, the net worth of homeowners also rises. This leads to consumer confidence especially when interest rates are favorable for refinancing, and purchasing bigger and better homes with the increase in net worth. To avoid the negative effects of real estate market bubbles the following techniques may prove helpful.

  • Purchase a house as close to a tax assessed value as possible
  • Finance using an affordable fixed rate loan with low closing costs
  • Choose a reputable loan corporation to finance your home
  • If a home price has appreciated more than 10-12% in 2 years think twice about buying
  • Be aware of national and regional housing trends that influence home prices

When buying a home within a real estate bubble, it is important to know that the house value may not continue to appreciate in value, and may even decline in price. When a bubble is bursting it is also important to know that home prices may not stabilize where they are expected to i.e. the market may ‘bottom out’ lower than previously thought. In both cases one’s capital investment may be lost and thus financial prudence is of good measure. With a little research and analysis of current economic conditions, real estate market risk can potentially be avoided.

To summarize, real estate market bubbles are not everyday occurrences, if they occur at all. Just because a housing market is rising or falling does not always mean it is a bubble or bursting bubble. International housing markets all have unique influences, regulation and trends that may affect them in different ways to more familiar markets. There are several ways to identify, understand and avoid a real estate market bubble. By considering the information in this article one may be better prepared for future housing bubbles and/or adverse conditions in the housing market.

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