When a Real Estate Bubble Bursts

A Real Estate bubble is no different from any other economic bubble. Because of that you can research economic bubbles of any type and get a general idea of how the process works and what happens when a bubble “bursts”.

An economic bubble is created when demand is outstripping supply to that point that prices become unsustainable. A market price is determined where supply meets demand. As demand grows, if supply does not grow with it, prices go up. Think of it this way:

If I have 100 pies for sale, and there are 100 buyers, I can sell all of my pies for whatever price the market bears, let’s say $10 a pie. What happens if I have 100 pies and there are 200 buyers? I can raise my price because, since there are more buyers than pies, someone will pay more than $10 for a pie to ensure that they get one.

The housing issues we have experienced were due to an increased demand in housing. This was exacerbated by low interest rates and easy credit qualifying guidelines. As demand rose and supply couldn’t keep up, prices rose. The more prices rose, the more speculative the market became. People who were not Real Estate investors began gambling by buying properties in hot areas hoping to “flip” them a few months later for a profit. The speculative environment fueled prices even higher. The end of the bubble occurs when prices have exceeded sustainable levels. In this case, slowing appreciation began to catch up to the easy credit loans. When homeowners were unable to draw money out of their homes to live because values were not high enough, these loans began to default. As the loans defaulted a cycle was created. The cycle started with slowing appreciation, which lead to loan default. Loan default led to a lessened appetite for these mortgages as the investors had started to see losses from their investments. As appetite subsided, and banks and investment bankers were unable to package the loans being written, guidelines on new loans tightened. As the losses increased guidelines tightened further.

Tightening guidelines led to previously credit worthy borrowers no longer being able to qualify for financing. This again had an affect on values as less buyers meant that sellers who could, would lower their price to attract the remaining buyers. Repeat this entire process several times over and you can see how a Real Estate bubble bursts.

Lets go back to the pie example. When I had 100 pies and 200 buyers I could sell my pies for a premium. What happens when I have 100 pies and 50 buyers? I have to lower the price, probably lower than the initial $10 price, to try to entice people to buy my pies. That is the aftermath of a bubble. To stabilize a burst bubble, supply and demand have to meet again. Once there are enough buyers for all of the homes for sale, prices will stabilize. Once prices stabilize the market will regain some sense of normalcy and eventually move back towards appreciation. Although it is highly unlikely that the market will return to what we have seen over the past few years.