Everyone says the real estate market is reliable, robust and here to stay. In some ways, that is true. But every rule has an exception. In the case of the housing market- the exception is a housing bubble.
A housing bubble is a form of serious financial crisis that can break an economy. In this example, we will try to understand what is a housing bubble, what are the warning signs of one, and how it can be prevented.
Bubbles in the US economy
The dot com bubble of 1990s
In the late 1990s, people were discovering the revolutionary impact of the internet on entrepreneurship. There were many tech start ups mushrooming all over the country, with the promise of high returns and unlimited potential.
In just a period of 5 years between 1995 and 2000, the Nasdaq index, which was dominated by tech companies, rose from under 1000 to more than 5000. People got curious about this new market, and they wanted in.
There were many venture capital investors ready to fund startups, because they expected the IT sector to boom in the future. A lot of money was spent in branding and advertising these tech products. Some startups went over budget with the marketing expenses.
Internet companies dominated stock indexes, IPOs, and news articles. In reality, there was a lot of technological advancement, and there were big players like Cisco and Oracle who were driving this growth. But there were also many other small startups with less solid fundamentals that were driving the rise in stock prices.
Entrepreneurs were overconfident, and investors encouraged them. After peaking in March, 2000, the Nasdaq index crashed by 2001. Within a matter of months, company CEOS went from riches to rags, funding dried up, and the stock values dropped rapidly.
The 2008 Housing Crisis
Everyone remembers the financial crisis that happened in 2008– that is a perfect example of what a housing bubble looks like. The 2007-08 credit crisis happened because people were allowed to borrow loans without adequate credit score and savings to pay them back.
As more and more people flocked toward the American dream of ownership, the government’s policies also started supporting this trend. Many people lost their money in bonds and related investments.
Eventually- the inevitable happened. People defaulted on their home loans, and properties were foreclosed. Investors as well as major brokerage firms suffered heavy losses. Although we are past that phase now, it is important to keep checking for similar patterns in the future, so that we know where to put our money.
What is a housing bubble?
Imagine that the housing market is like a balloon or a bubble. It is growing bigger in size because demand is rising, more people want to buy houses, and the real estate prices are soaring. So the bubble looks big, and you feel like the market is really strong and full of opportunity.
But the catch is, that the bubble can grow only so big before it finally bursts. This is because the capacity of the real estate market, just like the bubble, is limited. The market sustains because of economic balance, but sometimes people ignore this crucial aspect.
Instead, they believe that the bubble will keep getting bigger, and they keep blowing it up by buying houses at even higher prices. People invest more money in real estate. Eventually, supply exceeds demand. The prices drop, and the housing bubble bursts.
In simple words, it is a type of severe imbalance between demand and supply that happens because of speculation, herd mentality and impulsive spending. The optimism ends when the market conditions are no longer sustainable, and people suffer heavy financial losses.
How does a housing bubble form?
Typically, a real estate bubble starts when there is a sudden surge in demand for housing. Demand could rise for several reasons. Perhaps people have more disposable income, a new generation of investors has just entered the market, there are some newer, more attractive mortgages that entice people into buying homes even if they don’t have enough savings for that.
Soon, mortgage borrowers take excessive risks, lenders are eager to get more business, and with government sanctions for easier access to credit, the economy descends into chaos. The result is more economic activity, rising prices, and dangerous speculative behaviour by lenders, borrowers, and investors.
When does the bubble burst?
The risk of the bubble bursting is high when the real estate prices no longer reflect the actual value of property, and they are blown out of proportion by superficial demand. Construction projects continue to expand, and they expect demand to grow even more in the future.
Slowly, sales decline and prices reach a plateau. At the same time, many prospective homebuyers feel that home ownership is out of reach. The prices are so high that they actually discourage people from buying.
This happens because as the economy collapses, companies cut costs and layoffs happen. People who lose jobs are no longer able to afford houses, and if they are already paying off a home loan, they are at high risk of defaulting. Many people have to empty out their retirement savings to keep a roof over their head.
Soon enough though, speculators leave the market and prices start falling. It becomes more and more difficult for people to access loans, and demand is exhausted.
How to navigate a housing bubble
If you find yourself thinking of selling your house because it’s in an area where real estate prices are soaring- think twice. It is a common trend, during this period, to sell the house and buy a better property. But it’s not always a wise decision. That’s exactly how people contribute to the bubble.
In such times, it’s best to stay put, and adopt a more conservative investment strategy. Focus on maintaining and conserving all the assets that you have, and ensure a steady income until the bubble-like situation subsides. Basically, think twice before making investments, research everything on your own, and take less risks, even if it means less returns.
If you are curious about housing bubbles and similar market trends, we hope this article was an interesting read. These incidents remind us to be mindful of the limits of the market, and not accept any speculation at face value.
