A real estate bubble occurs when property prices rise rapidly within a short space of time. Inflation and wages often fail to keep pace with the rising property prices, which means that the price increases eventually become unsustainable. The direct negative effects of a real estate bubble include increased foreclosures, and the indirect effects can include higher rates of unemployment.
Prices of houses, like all marketable commodities, are in part driven by supply and demand. When there are more buyers than homes for sale, competition among buyers leads to an increase in property prices. Many buyers knowingly pay excessive prices for property in the belief that the longer they wait to buy, the more prices will rise. The desire of buyers to participate in the real estate market before houses become prohibitively expensive is a major driving force behind the typical real estate bubble.
Fiscal policies aimed at stimulating business spending can have the effect of creating or exacerbating a real estate bubble. Central banks often cut interest rates so that borrowing becomes less expensive for businesses, and this cost saving makes it easier for businesses to expand and hire new employees. As businesses expand, more people can afford to buy houses, and this causes an increase in the demand for housing. Construction firms cannot always build enough new houses quickly enough to meet this demand. Consequently, a real estate bubble occurs.
When houses become prohibitively expensive, large numbers of people are unable to afford homes, and as a result, the supply of homes outweighs the demand. Existing property owners are forced to sell their homes for below-market prices because they are otherwise unable to attract buyers. As increasing numbers of homeowners sell their homes for lower and lower prices, the real estate bubble comes to an end. People who bought homes prior to the end of the bubble have mortgage balances that exceed their property’s value. Such people cannot sell their homes unless they have sufficient savings to cover the excess debt.
People who cannot afford to pay down their mortgages prior to selling their homes often end up going into foreclosure. High numbers of foreclosures cause real estate prices to fall even further. Investors lose money because of the falling prices of securities that are tied to mortgages and real estate. Consequently, investors have less money to spend, which means that corporate profits drop and firms begin to cut costs by laying off employees. Housing prices eventually fall so low that buyers are drawn back into the market looking for deals, and as more people begin to buy real estate again, a new real estate bubble starts to form.
