What Is a Housing Bubble and Why Does It Occur?

Oct 02, 2023 By Triston Martin

Demand, speculative activity, and irrational expenditure can contribute to a housing bubble or real estate bubble. A rise in need in the face of a restricted supply, which takes a while to refill and expand, is a common starting point for housing bubbles.

Because of the influx of speculative capital, the market's demand continues to rise. A dramatic decline in prices—and the bubble's bust—occurs when supply grows and demand drops or stagnates.

An Overview of the Housing Bubble

However, a real estate bubble can endure for many years. Various factors can lead to increased home prices that are out of bounds. Still, the most common are:

  • Demand manipulation.
  • Speculation.
  • Unusually high investment levels.
  • Excess liquidity.
  • A deregulated real estate financing market.
  • Extreme forms of mortgage-based derivative products.

As a result, the supply/demand ratio rises. International Monetary Fund (IMF) estimates that the duration of a housing bubble is twice as long as that of equity bubbles.

What Is the Reason for a Real Estate Bubble?

Due to the high transaction and carrying costs associated with owning a home, housing markets have traditionally been less susceptible to bubbles than other financial sectors. When the supply of credit increases rapidly, the combination of cheap interest rates and relaxing credit screening rules can attract borrowers into the market and stimulate demand for credit. The housing bubble might implode if interest rates increase and lending requirements tighten.

U.S. Housing Bubble of 2000

During the mid-2000s, the U.S. housing market bubble was primarily caused by another drop related to the technology industry. It was closely linked to the 2007-2008 financial crises, and some even believe it was the root cause.

During the late 1990s dot-com boom, several new technology businesses saw their stock values skyrocket in a short period. Investors were willing to pay large sums for companies in the early stages of development and hadn't yet made a profit.

The Housing Bubble vs. the Tech Bubble

During the housing bubble, speculative trading by hedge funds and other financial organizations generated a boom in subprime lending. Home equity disappeared, and the jobless rate soared to 10.6 percent during the Great Recession. Consumers reduced their spending as more people lost their jobs, resulting in further contraction of the economy.

For the economy to start expanding again, many government stimulus measures were implemented, notably the Economic Stimulus Act of 2008 and the American Reinvestment and Recovery Act of 2009.

What Individual Investors Should Know

As a rule, real estate and the stock market have a minimal association. There is no direct correlation between the stock and housing markets, and the opposite is true. Understanding how a housing bubble might affect your short- and long-term portfolio is critical.

If the reasons for a housing bubble aren't directly linked to the stock market and the aftermath isn't accompanied by a more significant recession, the impact on day traders might be small." You may want to examine defensive stocks if you're worried about a bubble before a recession since they may assist you in controlling risk.

How Does a Real Estate Bubble Burst?

It comes to an end when demand declines or stagnates due to rising mortgage rates or inflation eating away at savings, while supply returns to being in line with demand (when construction catches up). There is a risk that the bubble will burst, leading to lower prices.

Due to fast-growing prices and supply problems, mortgage rates have increased over the last month as a result. According to Freddie Mac, for the first time since May 2019, the 30-year fixed-rate mortgage hit 4% on March 17.

The Federal Reserve expects to raise rates six more times this year, which means it's likely to soar. For the week ending March 31, the 30-year fixed-rate mortgage averaged 4.67 percent. 30-year rates were 3.1% in the year prior.

Affordability Issues May Cause a Bubble

Robert Dietz, SVP and chief economist of the National Association of Homebuilders, told Insider that "housing affordability sank to a decade-low in the third quarter of 2020". Housing affordability is likely to be further strained by rising interest rates in 2022.

The recent increase in mortgage rates is anticipated to put extra pressure on affordability, even as home builders increase the housing supply. Buyers may have to adjust to increased monthly mortgage payments if U.S. home prices continue to rise at their current pace.

What Impact Does the Housing Bubble Have on the Overall Economy?

The U.S. economy relies heavily on the real estate and housing markets. Individually, the Congressional Research Service estimates that the individual occupant owns around 65 percent of all occupied dwelling units. In the United States, homes are frequently a significant source of household wealth, and the construction of homes supports a wide range of jobs.

Residential investment may be affected by the housing price, which in turn affects the economy. New building spending might be encouraged when housing values rise, resulting in a more robust economic expansion. The weakening of economic growth is expected to be exacerbated if property values fall.

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