Unlike the stock market where people understand and accept the risk that prices may fall from time to time—sometimes severely—many people who buy a house do not really think that the value of their home will ever decrease by all that much.

Indeed, historically, the housing market has not been affected by price bubbles when compared with other asset classes. That could be due in part to the large transaction costs associated with purchasing a home, not to mention the carrying costs of owning and maintaining a home—all of which discourage speculative behavior. However, housing markets do sometimes go through periods of irrational exuberance and see prices rise rapidly before falling back in line.

In this article, we'll discuss the causes of housing price bubbles, the triggers that make housing bubbles burst, and why home buyers should look to long-term averages when making critical housing decisions.

Key Takeaways

  • Housing bubbles are temporary periods of months or years characterized by high demand, low supply, and inflated prices above fundamentals.
  • These bubbles are caused by a variety of factors including rising economic prosperity, low interest rates, wider mortgage product offerings, and easy to access credit.
  • Forces that make a housing bubble pop include a downturn in the economy, a rise in interest rates, as well as a drop in demand.

What Is a Housing Bubble?

Before getting into the causes of housing bubbles and what makes them go pop, it is important to understand a housing bubble in and of itself. These generally begin with a jump in housing demand, despite a limited amount of inventory available.

Demand further increases when speculators enter the market, making the bubble bigger as they snap up investment properties and fixer-upper flips. With limited supply and so much new demand, prices naturally rise.

Housing bubbles have a direct impact on the real estate industry, but also homeowners and their personal finances. The impact a bubble can have on the economy (e.g., on interest rates, lending standards, and securitization practices) can force people to find ways to keep up with their mortgage payments when times suddenly turn and get tough. Some may even have to dig deeper into their pockets, using savings and retirement funds just to keep their homes. Others will go bankrupt and foreclose.

Any bubble is normally just a temporary event. Although bubbles in the equity markets can happen more frequently, housing bubbles can persist for much longer, according to the International Monetary Fund (IMF), and can last several years.

Causes of Housing Market Bubbles

The price of housing, like the price of any good or service in a free market, is driven by the law of supply and demand. When demand increases or supply decreases, prices go up. In the absence of some natural disaster, which can decrease the immediate supply of homes, prices rise when demand tends to outpace supply trends. The supply of housing can also be slow to react to increases in demand because it takes a long time to build or fix up 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.

Once it is established that an above-average rise in housing prices is initially driven by a demand shock, we must ask what the causes of that increase in demand are. There are several possibilities:

  • A rise in general economic activity and increased prosperity that puts more disposable income in consumers' pockets and encourages homeownership
  • An increase in the population or the demographic segment of the population entering the housing market
  • A low, general level of interest rates, particularly short-term interest rates, that makes homes more affordable
  • Innovative or new mortgage products with low initial monthly payments that make homes more affordable to new demographic segments
  • Easy access to credit—often with lower underwriting standards—that also brings more buyers to the market
  • High-yielding structured mortgage bonds (MBS), as demanded by Wall Street investors that make more mortgage credit available to borrowers
  • A potential mispricing of risk by mortgage lenders and mortgage bond investors that expands the availability of credit to borrowers
  • The short-term relationship between a mortgage broker and a borrower under which borrowers are sometimes encouraged to take excessive risks
  • A lack of financial literacy and excessive risk-taking by mortgage borrowers.
  • Speculative and risky behavior by home buyers and property investors fueled by unrealistic and unsustainable home price appreciation estimates.
  • An increase in home flipping.

Each of these variables can combine with one another to cause a housing market bubble to take off. Indeed, these factors 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.

Forces that Burst the Bubble

The bubble finally bursts when excessive risk-taking becomes pervasive throughout the housing system and prices no longer reflect anything close to fundamentals. This will happen while the supply of housing is still increasing in response to the prior demand spike. In other words, demand decreases while supply still increases, resulting in a sharp fall in prices as nobody is left to pay for even more homes and even higher prices.

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

  • 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. This often leads to default and foreclosure, which eventually adds to the current supply available in the market.
  • A downturn in general economic activity that leads to less disposable income, job loss or fewer available jobs, which decreases the demand for housing. A recession is particularly dangerous.
  • 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 may lose their homes, bringing more supply to the market.

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

The 2007–08 Housing Market Crash

In the mid-2000s, the U.S. economy experienced a widespread housing bubble that had a direct impact on bringing on the Great Recession. Following the dotcom bubble, values in real estate began to creep up, fueling a rise in homeownership among speculative buyers, investors, and other consumers. Low interest rates, relaxed lending standards—including extremely low down payment requirements—allowed people who would otherwise never have been able to purchase a home to become homeowners. This drove home prices up even more.

But many speculative investors stopped buying because the risk was getting too high, leading other buyers to get out of the market. Indeed, it turned out that when the economy took a turn for the worse, a whole lot of subprime borrowers found themselves unable to pay their monthly mortgages. This, in turn, caused prices to drop. Mortgage-backed securities were sold off in massive quantities, while mortgage defaults and foreclosures rose to unprecedented levels.

Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

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 eventually returns to earth because the forces of gravity act upon it. The laws of finance similarly state 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 reversion to the mean.

Prices in the housing market follow this tendency for mean reversion, too. After periods of rapid price appreciation, or in some cases, depreciation, they revert to where their long-term average rates of appreciation indicate they should be. Home price mean reversion can be either rapid or gradual. Home prices may move quickly to a point that puts them back in line with the long-term average, or they may 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.

Price Appreciation Estimates

Too many home buyers use only recent price performance as benchmarks 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 designed to be relatively short-term loans. Borrowers choose these mortgages based on the expectation they will be able to refinance out of that mortgage within a certain number of years, and they will be able to do so because of the equity they will have in their homes at that point.

Recent home price performance is not, however, generally a good prediction of future home price performance. Homebuyers 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.

The 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.