A Bubble is a Matter of Perception or a Matter of Reality

A Bubble is a matter of perception writes one writer regarding real estate. She claims that real estate is not in a bubble because prices on real estate cannot go down 50% over night.

She writes, “A bubble is a market in which the value of the key asset is inflated based on speculation and psychology. Because of this, true bubble markets can burst overnight when something happens to shatter the perception of value.”

The first part of her sentence describes the residential real estate market. The price of residential real estate became initially inflated because of two reasons. First, the barriers to entry were removed. The mortgage industry made it to where just about anyone could get a mortgage whether they truly qualified or not. Interest rates were falling to historic lows. This increased buying activity.

Second, as a result of the first reason, investors started jumping on the increase in activity and spurred the speculation by flipping houses and properties.

Increased buying increases the prices of the real estate. Thus it was created through cheap money (low interest rates) and easy to get mortgages with choices of payment.

True bubbles can burst overnight. However, it took 25 months for the stock market to deflate from its bubble. That didn’t happen overnight and that was a bubble.

She calls it a corrective cycle. Thus indicating that this is just going to go through normal times and then real estate will start going back up. There is a big difference between this time period and other cycles.

In the past, we weren’t dealing with the irresponsible lending and borrowing that has taken place. Over 2 trillion dollars worth of adjustable rate mortgages will be coming due over the next two years. Just the small amounts of ARM’s that have come due recently, have dramatically increased the foreclosure rate. As this happens, real estate prices should continue to be under pressure. In addition, rising interest rates have also dampened real estate buying.

Buyers typically don’t buy while prices are falling. They wait for a better deal. They also buy much less in rising interest rate environments. Finally, people that walk away from mortgages because of rising interest rates and the inability to pay force pressure on markets. Thus, real estate could fall a lot lower before it starts recovering making it look like a bubble rather than the perception of one.