Unlike the stock market, where most people understand and accept the risk that stock prices might fall, most people who buy a house don't ever think that the value of their home might decrease.

Traditionally, the housing market has not been as subject to pricing bubbles as other asset markets have been because the large transaction costs of purchasing a home and the carrying costs of owning and maintaining a home discourage speculative behavior. However, housing markets do go through periods of "irrational exuberance". In this article, we'll discuss what causes housing price bubbles, the triggers that cause housing bubbles to burst and why home buyers should look to long-term averages when making critical housing decisions. (To read more about deciding to purchase a home, see Investing In Real Estate.)

Mean Reversion

Too often, homeowners make the damaging error of assuming recent price performance will continue into the future without first considering the long-term rates of price appreciation and the potential for mean reversion. The laws of physics state that when any object (which has a density greater than air) is propelled upward, it will return to earth because of the forces of gravity act upon it. The laws of finance say that markets that go through periods of rapid price appreciation or depreciation will, in time, revert to a price point that puts them in line with where their long-term average rates of appreciation indicate they should be. This is known as mean reversion.

Prices in the housing market follow this law of mean reversion too - after periods of rapid price appreciation (or depreciation), they revert to where their long-term average rates of appreciation indicate they should be. Home price mean reversion can be rapid or gradual. Home prices might fall (or rise) quickly to a point that puts them back in line with the long-term average, or they might stay constant until the long-term average catches up with them.

The theoretical value shown above has been derived by calculating the average quarterly percentage increase in the Housing Price Index from the first quarter of 1985 through the fourth quarter of 1998 (the approximate point at which home prices began to rise rapidly above the long-term trend). The calculated average quarterly percentage increase was then applied to the starting value shown in the graph and each subsequent value to derive the theoretical Housing Price Index value.

The Causes of a Housing Market Bubble

The price of housing, like the price of any good or service in a free market, is driven by supply and demand. When demand increases and/or supply decreases, prices go up. In the absence of a natural disaster that might decrease the supply of housing, prices rise because demand trends outpace current supply trends. Just as important is that the supply of housing is slow to react to increases in demand because it takes a long time to build a house, and in highly developed areas there simply isn't any more land to build on. So, if there is a sudden or prolonged increase in demand, prices are sure to rise. (To learn more about supply and demand, see Economics Basics and Stock Basics: What Causes Stock Prices To Change.)

Once you've established that an above-average rise in housing prices is primarily driven by an increase in demand, you might ask what the causes of that increase in demand are. There are several:

1. An upturn in general economic activity and prosperity that puts more disposable income in consumers' pockets and encourages home ownership.

2. An increase in the population or the demographic segment of the population entering the housing market.

3. A low general level of interest rates, particularly short-term interest rates, that makes homes more affordable.

4. Innovative mortgage products with low initial monthly payments that make homes more affordable. (To learn more about mortgages, see our Mortgage Basics tutorial.)

5. Easy access to credit (a lowering of underwriting standards) that brings more buyers to market.

6. High-yielding structured mortgage bonds, as demanded by investors, that make more mortgage credit available to borrowers.

7. A potential mispricing of risk by mortgage lenders and mortgage bond investors that expands the availability of credit to borrowers.

8. The short-term relationship between a mortgage broker and a borrower under which borrowers are sometime encouraged to take excessive risks.

9. A lack of financial literacy and excessive risk-taking by mortgage borrowers.

10. Speculative and risky behavior by home buyers and property investors fueled by unrealistic and unsustainable home price appreciation estimates.

All of these variables can combine to cause a housing market bubble. They tend to feed off of each other. A detailed discussion of each is out of the scope of this article. We simply point out that in general, like all bubbles, an uptick in activity and prices precedes excessive risk-taking and speculative behavior by all market participants: buyers, borrowers, lenders, builders and investors.

The Forces that Cause the Bubble to Burst

The bubble bursts when excessive risk-taking becomes pervasive throughout the housing system. This happens while the supply of housing is still increasing. In other words, demand decreases while supply increases, resulting in a fall in prices.

This pervasiveness of risk throughout the system is triggered by losses suffered by homeowners, mortgage lenders, mortgage investors and property investors. Those losses could be triggered by a number of things, including:

1. An increase in interest rates that puts homeownership out of reach for some buyers and, in some instances, makes the home a person currently owns unaffordable, leading to default and foreclosure, which eventually adds to supply.

2. A downturn in general economic activity that leads to less disposable income, job loss and/or fewer available jobs, which decreases the demand for housing.

3. Demand is exhausted, bringing supply and demand into equilibrium and slowing the rapid pace of home price appreciation that some homeowners, particularly speculators, count on to make their purchases affordable or profitable. When rapid price appreciation stagnates, those who count on it to afford their homes long term might lose their homes, bringing more supply to the market.

The bottom line is that when loses mount, credit standards are tightened, easy mortgage borrowing is no longer available, demand decreases, supply increases, speculators leave the market and prices fall.

Making Price Appreciation Estimates When Buying a Home

Too many home buyers use recent price performance as a benchmark for what they expect over the next several years. Based on their unrealistic estimates, they take excessive risks. This excessive risk-taking is usually associated with the choice of a mortgage and the size or cost of the home the consumer purchases. There are several mortgage products that are heavily marketed to consumers and that are designed to be relatively short-term loans. Borrowers choose these mortgages based on the expectation that they will refinance out of that mortgage within a certain number of years, and will be able to do so because of the equity they will have in their homes at that point. (For related reading, see Mortgages: How Much Can You Afford?)

Recent home price performance is generally not a good prediction of future home price performance. Home buyers should look to long-term rates of home price appreciation and consider the financial principle of mean reversion when making important financing decisions. Speculators should do the same.

While taking risks is not inherently bad and, in fact, taking risks is sometimes necessary and advisable, the key to making a good "risk-based" decision is to understand and measure the risks by making financially sound estimates. This is especially applicable to the largest and most important financial decision most people make - the purchase and financing of a home.

Bottom Line

A simple and important principle of finance is mean reversion. While housing markets are not as subject to bubbles as some markets, housing bubbles do exist. Long-term averages provide a good indication of where housing prices will eventually end up during periods of rapid appreciation followed by stagnant or falling prices. The same is true for periods of below average price appreciation.