Is There a Real Estate Bubble?
BY DAMIR TOKIC, P HD
INTRODUCTION BRIEF LITERATURE ON “BUBBLES” AND “BURSTS”
IS THERE A REAL ESTATE BUBBLE? IF THERE IS, what will be the Generally, a bubble is a period of time when an asset’s
consequences on the economy as the bubble bursts? Who price reaches irrationally high levels. The bust is an
will be affected by it, and how? These questions reflect inevitable price correction. There have been many boom-
daily worries for a significant portion of market partici- to-bust episodes in different financial markets, throughout
pants and general population such as: homeowners, the history. This paper will focus on specific studies on
potential homebuyers, homebuilders, real estate investors, housing bubbles.
stock investors, bond investors, and policymakers.
Studies that compare housing bubbles with equity price
Unfortunately, less informed participants are not getting bubbles find that housing price busts were associated with
the straight answers, thereby risking losing a significant the more severe macroeconomic downturns than equity
portion of their home equity or incurring other types of price busts. Also, housing price booms are more likely to
financial losses. Is it questionable even if better informed be followed by busts. In particular, five factors account for
investors or experts really know the answers to these ques- greater severity of housing price busts:
1. Housing price busts have larger wealth effect on con-
We would like to refer the reader to the recent dot.com sumption than do equity price busts (Bayoumi and
bubble, when many experts and a few influential academ- Edison, 2003).
ics argued that a dot.com bubble did not exist. Needless to
2. Housing price busts were associated with stronger and
say, billions of dollars were lost as technology stocks
faster adverse effects on the banking system than equity
plummeted in March 2000. Is it likely that the same will
price busts (Eichengreen and Bordo, 2002).
happen again? Except this time, instead of tech stocks, real
estate values will drop?
This paper uses a think-tank approach to evaluate the
broad real estate market and its impact on economy. It is
an exercise that every individual can follow and logically About the Author
arrive at answers that could save someone’s existence. Damir Tokic, PhD, is an assistant professor of finance at the University of
First, the paper presents brief literature on “bubbles” and Houston - Downtown. His publications have appeared in journals such as:
the Journal of Investing, the Journal of Emerging Markets, Asia - Pacific
“bursts.” Then, it moves to specific questions regarding the
Business Review, Journal of Corporate Finance and Accounting and others
real estate markets. (firstname.lastname@example.org).
REAL ESTATE ISSUES 1 FAL L 2 0 0 5
Is There a Real Estate Bubble?
Exhibit 1—What does the construction process involve Exhibit 2—Effects of new home ownership on economy
and what are the effects on the economy?
1. Consumer Consumer borrows to buy new
1. Real estate Bank makes money on interest buys residen- furniture
developer Lawyers make money on fees tial property - Bank makes money on interest
borrows from Brokers make commissions - Production of furniture increas-
a bank to buy City makes money on permits es, jobs increase
land issuance - Furniture retailers make money
Land value increases Consumer decorates house
- Local governments make - Home décor retailers make
money on higher property money
taxes Consumer buys new technology
- Local government hires more (TVs, entertainment) for the home
city workers with increased If condo, consumer pay mainte-
budget nance fees. Management firm
2. Real estate Bank makes money on interest If house, consumer buys lawn
developer Developer buys raw materials equipment or hires maintenance
borrows - Price of commodities goes up personnel
money to - Miner companies increase Consumer pays real estate taxes.
begin con- production - City makes money, hires more
struction - Jobs are created in people
commodity-based industries - School districts have larger
and countries budgets hire more teachers
Developer buys or leases con- - Police, fire departments have
struction equipment larger budgets, hire more peo-
- Equipment producers increase ple
production - Ports and other city services
Developer hires construction have larger budgets and hire
workers more people
3. Real estate Buys new tiles
2. As home Consumer takes home equity loan
developer New air conditioners
prices increase: -Banks make money on interest
completes New alarms
-Consumer spending increases
construction New kitchens
with the extra cash
Property taxes increase
Demand for items that go into
- City, schools, police, fire depart-
final product increases, increas-
ment, port have larger budgets
ing production and jobs in those
and hire more (or spend in
Inspectors make money on final
Investors and speculators get
attracted to real estate returns
4. Residential Real estate agents make com-
- Buy properties for quick resale
property is missions
- Buy 2nd or 3rd homes or con-
sold Banks make money on interest
- Property prices increase even
Lawyers make money on fees.
Appraisers and inspectors make
- Banks make even more money
on these loans
Real estate developer makes
- Real estate agents, lawyers
profit on sale
make money as well
3. As interest Consumer refinances and lowers
rates decrease the payments
3. Housing price busts were more likely to have been pre-
Consumers spending increases
ceded by a boom so that there were larger imbalances to
be unwound (Bordo and Jeanne, 2002).
4. Housing price busts were more likely associated with 5. Housing price busts were associated with tighter mone-
generalized asset price bear market than equity price busts tary policy than equity price busts (Schwartz, 1995).
(Ito and Iwaisako, 1995).
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Is There a Real Estate Bubble?
Exhibit 3—Real estate pricing factors Exhibit 4—Reasons behind motivated sellers
Real estate Population growth 1. Foreclosure Lost a job, unable to make payments
demand fac- - Baby boom cycles Divorce
tors - Immigration Medical expenses
Ability to buy Other unforeseen expenses
- Good credit Unable to pay property taxes
- Full time job Home value falls below the total loan
- Ability to borrow amount, stop making payments
- Savings for down-payment Has to move
Housing assistance programs
- HUD, Freddie Mac, Fannie Mai 3. Defective Previously unknown environmental
- Assistance with down-payment property hazard emerges.
- Guaranteed loans for sub-prime Neighbor problems
Low interest rates 4. Life Marriage
- Interest payments lower changes Children
- Consumer builds equity faster Larger or smaller family
Trend of fashion Retirement
- Desire to upgrade
- Everybody is buying 5. Speculators Unable to sell a property bought for
Speculation investment purposes.
- Rising real estate prices. 6. Inventory Developers’ supply exceeds the
- Low interest rates liquidation demand, must liquidate the
- Zero down, interest only mort- inventory
7. Fear that Declining home prices may trigger
home equity even more selling to protect the
Real estate Land constraints will be lost home equity
supply factors -Regional issues due to declin- Especially for owners with 2nd or 3rd
Tear down old housing to build new ing prices mortgage
- Prime locations
- Sub-prime locations revitalization 8. Interest Borrowers with variable rate mort-
Townhouses, high-rises, condos, rates increase gages pay higher interest
houses closer to each other Possible default as payments increase
Interest rates – ability to borrow
THINK-TANK EXERCISE homeowners pay property taxes, which benefits city budg-
Our exercise starts with an environment where a real ets.
estate developer decides to build a housing project. What
In our perfect environment a real estate developer builds
does the construction process involve and what are the
homes and sells them to public for profits. The reality test
effects of construction on the economy (Exhibit 1)? It
of this environment will be a function of consumer
seems like the major effect of booming construction on
demand and the ability to satisfy that demand. Excessive
economy is job creation, not only in construction, but also
imbalance between the demand for housing and the corre-
in services that support construction, and manufacturing
sponding supply will greatly affect housing prices. If the
that supplies the housing industry.
demand exceeds the supply, home prices will increase. If
Once the project is completed and sold out, what are the the supply exceeds the demand, home prices will decrease.
effects of new home ownership on the economy (Exhibit Our next exercise discusses the factors that affect the
2)? New home ownership requires further consumption, demand for housing and the factors that affect the supply
including home décor, furniture, and technology. of housing (Exhibit 3). The major demand factor is the
Consumption of other goods also increases as consumer ability of consumers to buy a house. Full time employ-
wealth increases due to rising home values. In addition, ment is a necessary precondition to: save money for the
down payment, afford the monthly payment, and to quali-
REAL ESTATE ISSUES 3 FAL L 2 0 0 5
Is There a Real Estate Bubble?
Exhibit 5—Reasons for slowing demand for housing Finally, our exercise ends with the question, if there is a
housing bubble, what will be the effects on the economy
1. Population Baby boom cycle once the bubble bursts (Exhibit 2). As literature suggests,
growth slows Anti-immigrant laws the consequences of housing bust can be severe for the
down economy. First, the jobs are lost in construction and in
economy wide. Seconds, the wealth is lost as home prices
2. Weak labor Outsourcing of jobs to India, China
market and other plummet. Both of these are translated into slower con-
Slow wage/salary growth rate sumption. Finally, financial sector suffers as lending activi-
Popularity of part time—temporary ty disappears, and existing loans face defaults.
3. Low DISCUSSION—IS THERE A REAL ESTATE BUBBLE?
No money for down-payment
savings rate Unable to qualify to loan due to lack Our exercise would be worthless unless we are able to
of savings answer whether there is a bubble or not. The starting
4. Increase in The combination of high spending, point of our discussion and the major assumption is: for a
personal low savings and sluggish job market housing bubble to exist there has to be a significant
bankruptcies could increase personal bankruptcies amount of speculation.
Bad credit—unable to qualify for
mortgage Speculation, in our opinion, can take two forms. First, a
5. Troubles at High default rates in sub-prime mort- real estate developer could overestimate the demand for
housing gage market could discourage fur- housing and build an excessive inventory of speculative
assistance ther housing assistance homes. Second, a homebuyer can speculate by buying
properties for investment purposes with the hope to resell
6. Declining Keep away speculators
them later for profits. These two speculators are very dif-
ferent as homebuilders control supply while speculator
7. Higher More expensive to borrow money buyers control the demand.
interest rates Higher interest payments—slower
equity building The major warning sign for a real estate market is when
Higher monthly payments—harder to
majority of buyers are speculators purchasing second or
qualify for the loan
Keep away speculators third homes for investment purposes. Why? It signals that
consumer demand for primary residence is weak due to
any reason discussed earlier. If the consumer demand is
fy for the mortgage. Supply factors are mostly regional, as
weak, who is going to buy properties from speculators?
the availability of land to build differs across regions.
Who is going to buy excess inventory from homebuilders?
However, as long as the demand is strong, homebuilders
can find a way to develop a property on limited land, such There has to be a trigger or a tipping point that bursts the
as build townhouses or revitalize old neighborhoods. bubble. Most likely, that trigger will come either from a
home builder liquidating the inventory below the market
Now that we understand the housing market pricing fac-
value, or speculators selling their investment properties
tors, we can begin to introduce the discussion whether
bellow the purchasing price. But what would cause such a
there is a real estate bubble or not. Our major assumption
sell off? Speculators may be willing to hold on to their
is that for bubble to arise there has to be a high probability
investments until the cost of holding on to a property
for a sharp decrease in the price. Otherwise, we would not
increases. Specifically, the prospects of higher interest rates
be talking about the bubble. Next, we propose that two
will increase the cost of holding on to investment property
conditions would essentially cause the bubble to burst: 1)
and trigger a motivated sell. Declining home values and
there have to be motivated sellers (Exhibit 4) and 2) there
increasing interest rates will keep away new speculators
has to be slowing demand for housing (Exhibit 5). The
and further decrease the demand for housing. Excess
lethal combination of abundant motivated sellers, with
inventory of new homes and the large number of motivat-
buyers nowhere to be found, is the prescription for hous-
ed speculative sales, are likely to cause further decrease of
ing bust. Real estate speculation is definitely a worrisome
activity that can create very motivated sellers, especially if
the labor markers are weak and interest rates are rising.
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Is There a Real Estate Bubble?
Exhibit 6—Effect of slow real estate market on economy
1. Less Less bank borrowing
construction Less transactions for lawyers and brokers
Loss of construction jobs
Slowing demand for commodities
Slowing demand for construction equipment
Slowing demand for tile, kitchen, bath, windows, and other housing products
2. Slower Less bank borrowing
home sales Less transactions for lawyers and brokers
Lower aggregate commissions for brokers
Less business for inspectors, appraisers
Less business for management companies and maintenance personnel.
Slower furniture sales.
Slower home décor sales
Slower new technology sales
All together, leading to loss of jobs in banks, law firms, brokerages, management companies, retail
stores, furniture and construction equipment producing firms
3. Declining Lower property taxes
land and - Lower budget for cities, schools, police, fire departments, ports…
home values - Loss of jobs and less public spending
- Speculators unable to sell investment properties for profit, and unable to sell for loss—no money
to close the deal
- Loss of jobs associated with slower real estate markets
- Higher interest rates for variable mortgage rate borrowers increase payments
Loss of home equity, especially serious if home value falls bellow the loan value
- Consumer wealth would decrease, affecting the consumer confidence—the wealth effect
4. Stock Financial sector
market down- Construction- and housing-based sectors
turn Commodity-based firms and emerging markets
Further erosion of consumer wealth
5. Big picture Loss of jobs, declining property taxes, declining consumer wealth and corporate profits would make
– the budget it harder to lower the U.S. budget deficit
Slowdown in housing market, as we proposed, would at els. One only has to take a drive through any U.S. city and
first cause slowing economy, which would translate into its suburbs to notice an abundant supply of newly built
loss of jobs. Homeowners who lose these jobs are likely to condos and single-family homes. One can also notice so
miss their mortgage payments and file for bankruptcy. At many “for sale” signs and “open houses” on existing
this point serious consequences would start for the econo- homes. Isn’t this the prescription for a housing bust, as
my as numerous foreclosures further decrease home val- described earlier? In our opinion it is.
ues and banks feel the increased number of non-perform-
There seems to be no data to indicate who are the
investors buying second or third homes. However, some
In summary, whether there is a real estate bubble or not analysts suggest that baby boomers have been buying
depends on amount of speculation in these markets. homes for their retirement, which has been the primary
National Association of REALTORS shows that 23% of demand factor for second homes. Eventually, retired baby-
home purchases in 2004 were by investors. That means boomers will have to sell their primary residences before
that almost 1 out of 4 homes bought in 2004 were pur- moving to their new homes. This will only increase the
chased only to be resold at the higher price sometime in selling pressures and contribute to the housing bust.
the future. At the same time, building permits and hous-
Some other analysts see a high level of short-term home
ing starts continue to grow in 2005 to historically high lev-
“flipping,” where speculators invest in a second, third, or
REAL ESTATE ISSUES 5 FAL L 2 0 0 5
Is There a Real Estate Bubble?
fourth home with the hope to resell them for profits with- investors cause the excess demand, while the speculator
in the short period of time. Sometimes, speculators buy homebuilders cause the excess supply. The demand-supply
homes/condos while in construction and resell them imbalance has to cause the price correction. The only
before the construction is completed. question is for how long speculators will be willing to hold
on to their investments, before selling below the purchas-
Another theory is that, after the stock market crash in
ing price. We conclude, as long as interest rates are low.
2000, baby boomers took money out of the stock market
Therefore, market participants should closely follow the
and invested in real estate, hoping that real estate is less
interest rates as the potential trigger for housing bubble
risky and more likely to appreciate than the stock market.
In addition, a property can be rented out to supplement
their incomes in retirement. REFERENCES
Whether baby boomers have been buying second homes Bayoumi, Tamin, and Hali Edison, 2003, “Is Wealth Increasingly Driving
Consumption?” IMF Working Paper (Washington: International Monetary Fund).
to live in them once they retire, or to rent them out to
supplement their incomes, or whether other investors have Bordo, Michael, and Olivier Jeanne, 2002, “Boom-Busts in Asset Prices, Economic
Instability and Monetary Policy,” NBER Working Paper No. 8966 (Cambridge, Mass.:
been “flipping” homes for short term gain, a historically
National Bureau of Economic Research).
high statistic that shows that 23% of homes purchased in
Eichengreen, Barry, and Michael Bordo, 2002, “Crises Now and Then: What Lessons
2004 were second home investments is alarming because
from the Last Era of Financial Globalization?” NBER Working Paper No. 8716
it indicates unsustainable demand that will inevitably (Cambridge, Mass.: National Bureau of Economic Research).
result in bust.
Ito, Takatoshi, and Tokua Iwaisako, 1995, “Explaining Asset Bubbles in Japan,”
NBER Working Paper No. 5358 (Cambridge, Mass.: National Bureau of Economic
SUMMARY Schwartz, Anna, 1995, “Why Financial Stability Depends on Price Stability,”
This paper discusses whether this is a housing bubble or Economic Affairs, Vol. 15, pp. 21-25.
not, and what will be the consequences if such a bubble
exists. Using a simple exercise of what happens if, we con-
clude that there is a housing bubble because speculator
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