The Real Estate Bubble Phenomenon
A. The Formation of a Real Estate Bubble
Formation of a real estate bubble traditionally results in a rapid rise in real estate prices and mortgage credit. In an economic recovery, improved job outlook and increased buying power promote real estate investment by households and businesses. Demand increases, supply is fairly tight in the short term (it takes time to build new housing and rental accommodation), and prices and rents go up. Eventually, builders and investors increase supply.
As climbing prices attract new buyers seeking appreciation, cyclical acceleration promotes speculation. A prolonged and self-sustaining acceleration in prices signals market over-evaluation, i.e., a real estate bubble. Because of the rise in both price and demand, the volume of outstanding loans increases and mortgage credit accelerates. Lenders contribute indirectly to market price increases when they support demand by arranging financing for potential buyers.
B. Identifying a Real Estate Bubble
Although everyone can see the cyclical growth of housing markets and recognize the existence of a real estate boom, not everyone agrees on whether or not we are experiencing a real estate bubble. How can one tell if the rise in prices is based on solid and sustainable economic or demographic factors rather than irrational optimism among market players? A number of criteria have been defined for detecting the existence of a real estate bubble:
1. steep increases in the real price (housing prices adjusted for inflation) of new and existing houses;
2. price increases affecting all segments of the real estate market;
3. price increase not restricted to a few urban centres;
4. widening gap between price growth and household ability to pay;
5. in rental markets, prices that rise more quickly than forecast return to landlords.
The relationship between housing prices and mortgage payments on the one hand and household income on the other is a good indicator of whether or not a real estate bubble is forming. It is almost impossible, however, to measure the actual presence of a bubble; the fact that it existed is confirmed only when it has burst.
C. The Bursting of a Real Estate Bubble
Interest rates play a key role in the formation and bursting of a real estate bubble. Initially, falling or relatively long-term low interest rates stimulate price increases and an influx of buyers and capital. At a given moment in the price expansion phase, some people hesitate to enter the market due to the high prices, some property owners see returns shrink, others wish to sell to realize equity or because they are unable to keep up with mortgage payments following a downturn in their personal financial situation.
A rise in interest rates signals that the market has peaked. From that time on, the cost of owning a dwelling increases, demand decreases, and price increases decelerate. If rate hikes continue, prices drop fairly quickly and the bubble eventually bursts. Thousands of households suddenly find themselves with a debt level greater than the market value of their property.
D. The Repercussions of a Bursting Bubble: Deterioration of the Banking System, Household Debt and Credit Rationing
The immediate effect of a correction in housing prices or the bursting of a bubble is depletion of the wealth effect and an attendant negative impact on household consumption.
This mechanism is only partly offset by a downward adjustment of rents and the attendant positive impact on income. These features mark the cyclical slowdown of the economy.
A downturn in the real estate market can have the same sort of destabilizing effects on the banking system as that witnessed in relation to the meltdown of the information technology and telecommunications industries. Investors drawn by expected capital gains can find themselves unable to pay off their debts, especially short-term loans made when interest rates were on the rise. During a sharp downturn in economic activity, some households that took out mortgage loans may, if their financial situation deteriorates, be unable to honour the debt.
Finally, the access of economic agents to credit (including non-mortgage credit) is more restricted. Financial institutions make many loans secured by collateral, more often than not real property assets. When prices fall, everything else being equal, the borrower's capacity is reduced.
The bursting of a real estate bubble can also produce a crisis in the banking system: consider Alberta in the early 1980s, the Savings and Loan crisis in the United States and, even more spectacular, the Japanese crisis in the early 1990s. For financial institutions, the rising volume of non-performing loans reduces profitability. In the most extreme cases, the bankruptcy of some financial institutions can have an impact on the entire financial system, even on industry. Once that happens, government intervention seems inevitable, with the attendant net increase in public debt.
Another version of Housing Bubble Defination: What is a Bubble?