Image courtesy of Flickr, Nick Webb
Throughout history, real estate bubbles have formed and burst in cycles that often fall within the same decade. Many see their investments rise in value, only see them fall again. Learn what occurs before, during and after a real estate bubble bursts.
It seems that a recession can come out of nowhere, then, after months or years of limping along, the economy recovers. After several years of recovery and growth, it all happens again. These occurrences of growth and contraction are known as an economic cycle.
At the beginning of growth cycle in the economy, investing in real estate becomes very popular. Property sellers see a chance to make money by increasing the sales price of their real estate properties. Buyers see real estate as a great opportunity and decide that the higher prices are justified because they can only go higher.
A real estate bubble is a period of time when the value and prices of purchasing properties increase rapidly due to an extraordinary demand from buyers who are willing to pay the higher prices. The longer the strong demand lasts, the higher the prices will go.
After multiple years of growth and rising prices, there comes a point at which buyers realize that the price of real estate is overvalued and are either unwilling to make an offer or do so at lower than asking prices. As this becomes the norm, the unraveling of the real estate bubble begins and prices start declining rapidly. Typically this is known as a "correction," in the short term, and known as a "recession" when it lasts more than several months. Rapid reversal of prices can lead to homes going "under water."
The issue with under water mortgages across the nation were one of the key elements that gave rise to foreclosures. This further reduced the decline in real estate prices and contributed to losses with the lenders for those mortgages, negatively impacting the overall economy. This is a simplified explanation at how the bursting of a bubble can cause a "ripple effect" throughout the economy.
Take notice of the chart below. As real estate prices started declining rapidly after 2006, the rate of foreclosures started increasing rapidly well into 2009, which is when the decline in real estate prices reached a bottom.
Let's take a look at a 14 year snapshot of median sales prices of single family homes within four major counties in California. Take notice of how the County of San Francisco has recovered beyond the height of the bubble in 2006, where as the other counties have not recovered quite as well.
San Francisco is experiencing a growth with companies in the technology sector (such as Facebook, Twitter, AirBnB, and Uber) expanding their businesses, which bring with them an influx of new, well-paying employment opportunities. As you view the graph below, pay particularly close attention to the following years:
In 1984, the fixed mortgage rate was a whopping 13.88%, while in 2014 the mortgage rate was 4.17% as outlined in the graph below. Thirty years ago, inflation was at an all-time high which caused interest rates to be high as well, but for the last decade or so, interest rates have been low enough that most people with a reasonable down payment can afford to purchase a home.
The most recent real estate bubble had its approximate beginning in the year 2000, at the peak of the " Dotcom Bubble." This was the year where interest rates started declining more rapidly and underwriting standards became less restrictive. Meanwhile, specialized mortgage financing programs, such as subprime loans, were heavily promoted by lenders to include more buyers and mortgage borrowers that would have otherwise been left out of the market had these programs not existed.
The rate of home ownership refers to the percentage of homes in the U.S. that are occupied by the owners themselves. This data is one of many tools used by professionals and investors alike to try and predict what way the real estate market will be heading in the future based on the historical data from the past.
The chart below will show you the rate of home ownership from 1965 to 2014. When the U.S. Census Bureau started keeping data on home ownership rates in 1965, approximately 63% of households in the U.S. were occupied by the owners. By the year 2004 (arguably the height of the pre-financial crisis housing bubble), home ownership had reached its peak at 69%. This figure has been in decline ever since. As of 2014, our current rate of home ownership stands at approximately 64.50%.
Many speculations swirl around as to why home ownership rates are declining again. There are some who speculate that underwriting standards with lenders are much more difficult and restrictive than the pre-crisis era. There are others who speculate that the influx of cash buyers (such as large institutional buyers and small investors) made it difficult for the average consumer with a 3.5% - 20% down payment to compete with on prices as they were limited in capital resources. Yet there are others still who speculate that the decline has less to do with income and qualifications of the buyers but more to do with lifestyle choices and living preferences.
Purchasing real estate is not a no win situation in spite of the danger of a real estate bubble bursting. Before making a purchase, it is important to investigate similar properties in the area to avoid overpaying. This is one of the reasons why having an experienced real estate agent is important.
It will also help to have a sizeable down payment when purchasing a home. A 20% down payment will help you avoid additional costs for mortgage insurance and ensure you have enough equity in the home to avoid being "under water" if and when a real estate bubble bursts.
In addition, keep track of interest rates and property values after you have purchased or refinanced your home. Rates can become low enough to be advisable to refinance your existing property, or purchase that second home or investment property you have been considering.
Historically, real estate bubbles can occur and burst within every decade, with the most recent one causing an economic recession. After a few years the market not only recovers, but the price dramatically increases, as we are currently experiencing. If you want to participate in this market and make an investment, ensure that you fully understand what you are getting involved with, and ensure that you can survive the ups and downs of the market without suffering personal financial setbacks.
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