Real Estate News & Commentary

How Real Estate Bubbles Form and Why They Pop

Expertise: Real Estate News & Commentary
18 Articles Written

The second half of 2019 has seen financial news inundated with opinions on bubbles and recessions and speculation on future outcomes. Too often, I find that critical components are left completely out of this discussion.

Want more articles like this?

Create an account today to get BiggerPocket's best blog articles delivered to your inbox

Sign up for free

The purpose of this article is to round out the discussion and cover some of these areas. This subject matter tends to be dry, but I’ll do my best to spice it up and keep it readable.

What Is Economic Growth?

First, let’s establish the difference between economic growth and bubbles.

Economic growth is traditionally defined as growth in gross domestic product (GDP). I would argue that there are better metrics to assess economic progress, but let’s focus on GDP, as it is the generally accepted metric.

GDP is composed of 4 segments: consumption, business investment, government spending, and net exports. Economists tally up all these numbers and calculate the growth, which tells us if the economy is expanding or contracting.

I'll cut to the chase for you: GDP growth comes down to how many people are working and how productive those workers are. Working people generate income, which is consumed or saved. The saved portion becomes investment (savings form deposits for loans or equity investments in companies).

Investment is the critical factor in economic growth as technology, machinery and equipment for workers is created, making them more productive and increasing their earnings. More earnings for the same amount of work means greater ability to consume or invest based on individual preferences, which continues to fuel the economy.

Putting It in Perspective

Let’s do a thought experiment to drive this idea home: Imagine you’re lost on an island with a small group of people.

You’ve got a spear to fish with and nothing else. You’re able to catch one fish per day with the spear. You eat one fish per day.

The same is true for the other people on the island. In this economy, the “GDP” never grows, because 100 percent of the output is consumed.

Silhouette of a fisherman at sunset. Fishing on mountain lake

Now, imagine you decide to go without eating for a day to build a fishing net. You “save” your fish until tomorrow and use today to build the net. This savings becomes an investment in capital equipment, allowing you to be more productive.

With your new equipment, you can catch three fish per day. Now you can eat one fish and have two left over.

Others on the island see that you have extra fish and decide to capitalize. One guy realizes he’s a better builder than fisherman and offers to build you a shelter in exchange for your extra fish. Another guy builds you tools for your excess fish the next day.

These guys also begin to invest in more productive processes for themselves, because their need for food is covered by your production. They develop tools and equipment to speed up the homebuilding and tool-making process. They can specialize and do what they do best.

Maybe someone on the island can start producing clothing, so everyone can cover up their junk. Come on, I know you were thinking it.

In this way, a market forms and economic growth occurs. The total amount of resources available to everyone grows due to the increased productivity of each worker, thanks to the capital investments that were made. Now everyone on the island has access to food, shelter, tools, and other goods that improve their quality of life.

Over time, additional saving and investment among the population creates greater productivity, allowing for evermore goods and services to be produced at lower costs. Resources in the economy get allocated efficiently based on who can use them most productively.

This example can be expanded and complicated to understand the way the modern economy grows over time and increases our standard of living.

What Is an Economic Bubble?

A bubble forms when the economy is distorted and too many resources get allocated to the wrong sectors. This typically happens through artificial interest rates, government policy, and investor psychology, in some combination.

In short, the economy’s natural mechanisms for correcting errors is bypassed, and malinvestment occurs on a large scale.

Central banks (the Federal Reserve, in our case) play the largest role in creating bubbles. By driving interest rates to artificially low levels and pumping non-interest-bearing “hot-potato” securities (dollars) into the market, they create a situation where investors speculate and take on ever-increasing risk in order to generate yield in a low-yield environment.

(More on this later.)

Most recently, this was expressed through the housing market, where artificially low interest rates and government policies encouraging home ownership and lending gave an erroneous signal that capital should be allocated to housing.

Investor psychology put the cherry on top, as everyone scrambled to get in on the boom and assumed housing prices could never go down.

Entrepreneurs allocated too much capital to land, building materials, and construction labor due to these false signals. The prices of these goods and services increased, and people dedicated an outsized portion of their income to obtaining them.

In this way, a bubble was created.

Related: How to Invest in Property When You Fear a Housing Bubble

How & Why Bubbles Pop

The bursting of a bubble is a sign of the economy trying to heal. Once the errors in resource allocation are discovered, prices in the over-inflated areas come down and those mis-allocated resources get bought up by stronger businesses and put to better uses.

When a bubble pops, this is a necessary feature to correct the problem, which was the creation of the bubble in the first place.

The faster these resources can be reallocated to more productive uses, the faster the recession will end and recovery will begin.

taking-risks

Putting It in Perspective

It’s critical to understand the role interest rates play in the economy to grasp the bubble-making process. Interest rates are essentially Frodo’s “one ring” for the economy.

In an economy where market forces determine interest rates and prices, interest rates serve the vital role of coordinating production over time. Low interest rates serve as a signal to investors and businesses that savings are high and consumers are deferring current consumption.

There are saved resourced available as capital to entrepreneurs for expansion. This encourages longer-term investments by businesses that will payoff down the road.

Businesses will use the low cost of funds to invest in plants, machinery, equipment, and technology. This will create employment and a greater abundance of goods and services.

Conversely, a high interest rate environment would be a signal that consumption is preferred today and that less capital is readily available for investing. Businesses should carefully select projects.

Depositors, lenders, investors, and borrowers would all interact in millions of individual transactions to set the prices and terms for capital investment and interest rates. Over time, interest rates ebb and flow and the economy responds with periods of faster and slower growth.

Enter the Fed

The U.S. economy, in contrast, has interest rates controlled by the central bank. In an attempt to fine-tune the economy and avoid recessions (or reduce their impact), the Fed manipulates the interest rates in the economy.

That’s the theory at least. In practice, the Fed tends to create bubbles and exacerbate the business cycle. Looking back at most financial crises since the creation of the Fed, all were preceded by massive credit expansions enabled by the Fed.

When the Fed reduces interest rates below the market level, the idea is to stimulate borrowing and investment and to ignite the “animal spirits” of the economy. They do this by purchasing bonds on the open market and creating dollars at the push of a button.

Related: Bonds vs. Stocks vs. Real Estate: Which One Wins?

The problem is there is a reason why interest rates would otherwise be higher. By artificially lowering rates, a false signal is sent to businesses that it is the right time to borrow and invest.

Interest-sensitive sectors like housing, mining, energy, and construction get large capital inflows and begin competing for resources that are scarcer than realized.

Lowering interest rates and replacing interest-bearing bonds with interest-free dollars also creates a speculative frenzy among investors. Interest rates near zero make it so keeping money in traditional savings vehicles, like bank accounts or CDs, will mean losing money to inflation.

This has the effect of driving up the price of stocks, bonds, and real estate as investors awash in dollars continue to search for yield in a low interest rate environment.

Businesswoman hand placing or pulling wooden block on the tower. Business planning, Risk Management, Solution and strategy Concepts

Businesses make different decisions under this manipulated environment. Given the ease of issuing junk bonds at rates near 0 percent, the path of least resistance to increasing their stock price becomes borrowing money to fund stock buybacks or to pay special dividends.

This diverts money away from investing in new plants, property, and equipment that will bring hiring and productivity gains to the economy.

What’s the State of the Current Economy?

What usually goes undiscussed in economic circles is the role the Fed plays in the economy. A strong argument could be made that the Fed is a large contributor to where we see ourselves currently:

  • The stock market is valued similarly to 1929 and 2000.
  • Bonds have never been more expensive.
  • Cap rates are lower than they’ve ever been.
  • There is more debt in the economy than ever before. Student loans, corporate debt, and government debt are at astronomical levels.
  • Disparities in wealth and income are causing political unrest.

To be sure, multiple factors are at play, and one simple article can only scratch the surface. But the Federal Reserve needs to be at the center of the discussion.

When you’re doing your own evaluation of the economy in determining where and how to invest, make sure you factor in this key element. The Federal Reserve has embarked on a never-before-seen path of near 0 interest rates and massive money creation.

It’s anyone’s guess how this will all unwind, but if history is any guide, expect the economy to undergo some massive shifts if and when rates begin to normalize.

What’s your assessment of the Fed’s role in the economy? Are we currently in a bubble? Why or why not?

Share your thoughts below.

Phil McAlister is a Chicago-area native and real estate investor. With a career that has spanned investment banking, commercial lending, and real estate, he has extensive transaction experience fro...
Read more
    Adam Schneider Flipper/Rehabber from Raleigh, NC
    Replied 9 months ago
    Absolutely fantastic article.
    Wenda Kennedy JD from Nikiski, Alaska
    Replied 9 months ago
    I agree. I have been through many business cycles over my 40+ years in the real estate business. This article highlights both the business cycle and the debt cycle. It's pretty scary. I don't know when the bubble is going to burst, but one must be ready.
    Christopher Smith Investor from brentwood, california
    Replied 9 months ago
    What exactly is a "normalized interest rate"? In Japan, rates have been very low for 30 years, and the bank of Japan has had a formal (ZIRP) Zero interest rate policy for over 20 years. I think the notion that there is some immutable law that interest rates must inevitably rise is perhaps misplaced. I've been hearing since 2011 that rates will rise both iminently and with a vengeance. I guess even a broken clock is right two times a day.
    Phil McAlister Specialist from Chicago, IL
    Replied 9 months ago
    Japan is undoubtedly the outlier historically. Mostly due to cultural and demographic factors that are not in place elsewhere. There's no law that market based interest rates must rise or fall. But there is an immutable law that artificial economic constructs will correct themselves or manifest themselves as problems down the road. You cannot site a single case in history where manipulation of the money supply and interest rates did not have a negative reckoning.
    Christopher Smith Investor from brentwood, california
    Replied 9 months ago
    Reminds me of General's always fighting the last war.
    Ivan Barratt Developer from Indianapolis, IN
    Replied 9 months ago
    Negative for some! Profoundly successful for others!
    Kevin McGuire Rental Property Investor from Seattle, WA
    Replied 9 months ago
    Wow, really great macro economics lesson here, very clearly constructed. Thanks Phil!
    John Murray from Portland, Oregon
    Replied 9 months ago
    Here is one piece of the puzzle that is missing the 3 large mortgage machines and investments banks. Enter Freddie , Fannie and Ginnie and investment banks. In the first decade of of the 20th century the 3 big mortgage machines bought so many mortgages from mortgage brokers that were really stinkers as did the investment banks. The" securitized" stinkers were not only sold to the big 3 but bundled and sold on the open market. To add to the problem the same organizations that sold them also shorted them. So all the mortgages that strippers and the like were completely worthless. Enter the US Treasury, and crony socialism that cannot fail. The Fed infused funds into some of the commercial and investment banks but not all. Some had to be sacrificed to the Money God. Enter the solution Dodd Frank. Mark to Market Accounting was relieved of duty and banks were required by regulators to actually reflect the truth on their balance sheets. The difference between 1929 and today's economic situation is very simple. The gold standard is gone and the Fed can print and devalue currency at will. The Fed will devalue currency when needed which will be infused to stop the economic bleeding. The next big infusion is up for debate but one thing is for sure it will happen.
    Ivan Barratt Developer from Indianapolis, IN
    Replied 9 months ago
    Next big (little b) infusion is happening now. See repo markets. Next Big (Capital B) infusion is surely around the corner. Interest rates will be lower a year from now than they are today. Curious though, the dollar is still strengthening? How long can that last? No one knows but gold likely a good hedge. My strategy: own large, well located, income producing multifamily levered with fixed rate debt maturities varying in length by 12 - 35 years locks. Pair that with effective execution on the management side and it's nearly impossible to destroy.
    Nick Gann Real Estate Agent from Murfreesboro, TN
    Replied 9 months ago
    Dig it. Peter Schiff goes quite in depth and has some similar perspectives. Buying back debt to refinance more debt will be the downfall of this nation. It'll work till it doesn't. Hyper inflation will kill the dollar. We need to default on the debt, raise rates so stupid spending of money decreases, and build an economy based on production of goods... which we are from.
    Mark Stedman Investor from Nashua, NH
    Replied 9 months ago
    Yep. There’s a lot of things going on simultaneously. 20 years from now we will reminisce about 2016-2020 as being “the good ole days”
    Michael Krotchie Realtor from Tucson, AZ
    Replied 9 months ago
    Great article Phil.. in addition I would suggest further reading on why Installment Loans of today are fast becoming Subprime Loans of yesteryear - https://www.bloomberg.com/news/articles/2019-10-29/america-s-middle-class-is-getting-hooked-on-debt-with-100-rates "Subprime installment loans are now being bundled into securities for sale to bond investors, providing issuers an even lower cost of capital and expanded investor base."
    Eric Carr Real Estate Broker from Los Angeles, CA
    Replied 9 months ago
    FANTASTIC article
    Michael P. Lindekugel Real Estate Broker from Seattle, WA
    Replied 9 months ago
    Kinda sorta. What you are describing is more recession than bubble. Recessions are normal business cycles with contractions is economic activity that can be triggered or caused by lots of reasons many of which you mentioned. An economic bubble is a recession caused by a particular asset class or segment of the economy based on highly implausible or speculative pricing that runs out of steam. Assets are typically trading as drastic prices beyond their intrinsic value. As wolfstreet calls it consensual hallucination - It’s when everyone is pulling in the same direction, energetically hyping everything, willfully swallowing any propaganda or outright falsehood, and not just nibbling on it, but swallowing it hook, line, and sinker, and strenuously avoiding exposure to any fundamental reality. For only one reason: to make more money. recessions are business cycles to clear out the bad stuff such as inflated asset pricing or bubbles, bad investments, bad investors, bad companies, etc. in 50 years there have been seven recessions. In the first six housing slowdown was a symptom of the recession. During the last recession, The Great Recession, housing and lending caused the recession. About inflation there may not be much monetary inflation, but there certainly is asset inflation. There is asset inflation in just about every asset class - stocks, bonds, residential real estate, commercial real estate. the world economy has the biggest ever credit market bubble of inflated asset prices including bonds and loans with $17T have negative yields. Central bank negative yields have been screwing up economies all over the world for years. Massive commercial real estate bubble fueled much by Chinese investors. When the Chinese sell off it won’t be pretty. IPO bubble with billions of invested in companies losing billions of dollars and zero change of making a profit ever. Central banks in other countries operate and control differently than the US Federal Reserve. To clarify the US federal reserve has ZERO control over consumer interest rates and including mortgage rates. The Federal Reserve controls the Federal Funds Rate, also known as the Overnight Rate, and the Discount Rate. The Prime Rate is not set by the Fed and it is not a single rate. Banks offer prime to their best customers. To that end there is no artificial interest rates at the Fed level. It is intentional. The intention of the federal reserve’s manipulation of the fed funds rate and discount rate is to incentivize banks to lower consumer interest rates. it is not uncommon for mortgage rates and other consumer interest rates to move in the opposite direction. Consumer interest rates are driven by supply, demand, inflation predictions which can be seen the Treasury market. There can be artificial interest at the consumer level when there is irrational investment. That is very rare. Interest rates were already historically low when the fed needlessly decreased interest rates several times this year. It did not spur borrowing with consumers or corporations. Corporations were not asking for lower rates for expansion or investment. That was already happening with massive borrowing. Before the Fed lowered interest rates it identified concerns of ballooned corporate borrowing putting corporations at risk defaulting on debt service in a recession and risking failure as a going concern. The Fed also identified some concerns in balloons in some segments of consumer debt prior to lowering interest rates. The Fed rate drops were unnecessary and had no impact as intended. With rates so low should there be an recession then the fed loses lowering interest rates as a tool in the toolbox to possibly fuel borrowing and spending to pull the country out of a recession. during the last depression the Fed used Quantitative Easing or QE to pull the US out of a recession. The US treasury still holds assets from QE from the Great Recession. Wall Street broker-dealers and banks have caused the current bond and treasury market problems purposefully hoping the Fed would engage in a new round of QE, so they can reap in massive massive profits. the US is entering new territory. sort of. The US is in what is called advanced-economy monetary policy meaning that ultra-low or negative interest rates and QE in effect in the advanced economies could be doing more harm than good. considering these policies have been in place for many years and the Fed needlessly cut rates three times this year when there was/is no economic need to do so there is the very real fear the Fed and other central banks would be helpless in countering the next economic crisis. The Fed does not “pumping non-interest-bearing “hot-potato” securities”. Treasuries are bonds and the price and yield is determined by supply and demand in the market from investors’ expectations about short term inflation and long term inflation. Also, investors may move capital out of the equity markets into the debt markets for security based on inflation expectations. As demand drives the price up above par the yield decreases. As demand decreases the price decreases. When the price decreases below par the yield increases to attract investors with a higher effective interest rate. As you mentioned this trading could be speculative or simply inflation based investing for more security. US Treasuries are considered zero risk. Investors are not acquiring treasuries for ever increasing risk as you mentioned. Again, there are no artificial interest rates. Interest rates are mostly risk based priced. Low interest rates may encourage homeownership. government policies are intended to manipulate behavior such as tax treatment for mortgage interest. The current housing market high prices are from lack of supply which started in the 2000s and ever increasing cost of construction.
    Phil McAlister Specialist from Chicago, IL
    Replied 9 months ago
    I was struggling to follow to path of this a little bit, but I'll just say that yes, there absolutely are artificial interest rates and yes, the Fed absolutely does create dollars that become hot potatoes in financial markets.
    Michael P. Lindekugel Real Estate Broker from Seattle, WA
    Replied 9 months ago
    where are the artificial interest rates? Treasury prints money not the Fed. where are the hot potatoes?
    Phil McAlister Specialist from Chicago, IL
    Replied 9 months ago
    The fed creates base money (currency and bank reserves) by depositing the funds electronically into the accounts of the people selling them the bonds. This is undisputed fact. The relationship between base money (relative to the size of nominal GDP) and 3 month T - bills is one of the strongest in all of economics. Therefore, the Fed, by way of replacing bonds with base money, alters short term interest rates. They can also directly alter longer term rates by directly buying those bonds and driving down their yields. By definition, an interest rate determined by a group of people in Washington that is different that what it would otherwise be if determined by buyers and sellers on an open market, is ARTIFICIAL. The newly created base money always has to be held by someone, but no one wants them. Hot potatoes.
    Michael P. Lindekugel Real Estate Broker from Seattle, WA
    Replied 9 months ago
    The fed does not create money. The Treasury prints money and sells it at manufacturing cost to the Fed. The Fed is the lender of last resort to commercial banks. The member Reserve Banks provide short term deposit liquidity to banks. The Central Bank in the Federal Reserve banking system acts the checking account for the US Government, Treasury, IRS, etc. through the Central Bank the Fed sells treasury bills, and bonds. Reserve balances, federal funds, Federal Reserve Deposits are the deposits private banks are required to keep at the local Federal Reserve Bank. the fed does not loan money to people. The “group of people in WA”…..that would be the FOMC. The Federal Reserve or FOMC controls the Federal Funds Rate, also known as the Overnight Rate, and the Discount Rate. That is intentional not artificial. That is not consumer interest rates. Consumer interest rates don’t necessarily move in the same direction as the FOMC decisions. When the Fed gobbles up government bonds and other assets on a mass scale to inject money into the economy raising the price of the bond or asset and lowering yields beyond market equilibrium yield that is Quantitative Easing or QE. QE is when expansionary monetary policy does not have the desired impact on short term market interest rates. Whether the Fed engages in expansionary money policy or QE it is intentional not artificial. Part of the charter of the Fed is to intentionally influence interest rate for a desired behavior to steer the economy. If you are going to say that is artificial, then anything the Fed does to influence anything creates an artificial environment.
    Phil McAlister Specialist from Chicago, IL
    Replied 9 months ago
    Yikes.
    Michael P. Lindekugel Real Estate Broker from Seattle, WA
    Replied 9 months ago
    i understand what you mean when you say "artificial". i dont label it artificial because that is part of the Fed's charter to steer the economy. yikes is exactly how i feel. the government still owns billions of treasuries that it bought after 2008 at inflated prices as part of the QE to recover from the Great Recession. cheeto tax cuts have added to the US debt. that means few options in the Fed's tool box to create inflation to avoid a recession. we have lots of recession mixed signals. Speculative power house brokerages such as the ones bailed out during the Great Recession make noise about a recession. That causes smaller speculative investors to buy treasuries. At the same time the powerhouses are buying treasuries. All that demand pushes treasury prices up which means the yields collapse. To manipulate treasury prices further into the stratosphere you drag the central banks into the fray and beat them with a stick (Who are his cheeto's friends? Power house brokerages). That is US $22.5T treasuries. The powerhouses need to sell off the treasuries to profit prior to maturity. Wait until maturity and all you get is face value. The premium or profits are wiped out. Boom recession hits. Central bank starts banks buying treasuries at inflated prices as part of the new round of QE and the power houses take profits and run. Market manipulation.
    Dave G. Investor from Phoenix, Arizona
    Replied 9 months ago
    My undergrad degree was Econ, and this article nails it. Love the island example. So many investors would improve their performance by gaining and applying basic macroeconomic understanding explained here. Nice work.
    Dave Rav from Summerville, SC
    Replied 9 months ago
    Absolutely fantastic, well written article! Way to sum it up. Great explanation.
    Aaron Wright Investor from Collinsville, Illinois
    Replied 9 months ago
    Glad to see this explanation that closely parallels the Austrian theory of the business cycle. So many people need to know about this perspective, as it is the only one that accurately describes what is really happening.
    John Murray from Portland, Oregon
    Replied 9 months ago
    It is always interesting to get others views on how the financial relationship between the Fed and the Treasury. It is true that the Treasury actually mints and prints currency. The actual percent of minted and printed currency is just north of about 5% of the total money in circulation. I'm no economist just a multimillionaire that understands how money works. The Fed controls the value of the currency through manipulation of the cost of money that is used to leverage investments. The Treasury collects money and releases money to the Fed. The Fed dictates to Treasury the value of currency. The Fed controls the economy, the Treasury is the collection of profits from the Fed. This is mainly in the form of taxes and fees. The Treasury is a branch of the Chief Executive, the Fed is a private government corporation. The Fed will and has control of the value of the currency since the early part of the 20th century. Did I miss something?
    Phil McAlister Specialist from Chicago, IL
    Replied 9 months ago
    There is a difference between printing physical currency, which is largely irrelevant to interest rates and the money supply in today's economy, and the creation of new base money, which is bank reserves and digital currency in the banks. The Treasury does print the actual physical paper but that doesn't impact the money supply or interest rates, the only purpose is to provide enough physical currency to allow cash transactions in the economy. Congress determines the deficit, Treasury issues the bonds, and the Fed determines the money supply by altering the mix of bonds and base money. When the Fed buys a bond they create new bank reserves and credit the seller's account with them. They are essentially swapping out one government liability (bond) with another (currency). Take a dollar out of your wallet and look at the top. It says Federal Reserve Note. Only fiscal deficits can determine the total aggregate amount of government debt outstanding, and only the Fed can determine how much of that will be held by the public as bonds vs. base money. It is the swapping of interest bearing securities for zero interest base money that drives down interest rates and creates a speculative bubble. The fed does not dictate the value of the currency. The fed does not control the economy. The fed does not generate profits in the form of taxes and fees, though they do receive interest income from the treasury when the hold bonds, which they give right back to the treasury. This is how they monetize the debt.
    John Murray from Portland, Oregon
    Replied 9 months ago
    OK I got it now. The Fed does not set the price of what it cost to borrow money to commercial and investment banks. The commercial and investment banks leverage the borrowed funds to lend to others and make a profit. The portion of the profits are returned to the Treasury in the form of taxes and fees. In 2007-2008 when the investment and some commercial banks needed more funds to stay solvent, the Fed released funds and devalued the currency to the point that the Canadian dollar and other world currencies increased in value and the US dollar lost value under guidance from the Treasury. So it is the Treasury that dictates the price of money to the Fed to leverage investments. The Fed does not set the prime rate, the Treasury does. The Fed does not control the economy, the Treasury does under the direction of the Chief Executive. I got it now.
    Colin March Rental Property Investor from Portland, ME
    Replied 8 months ago
    Low interest rates caused the last housing bubble and crash? Is equity/skin in the game less important than interest rates? How many nationwide housing bubbles and crashes have there been in the US? How does multi-family housing usually perform during recessions? Does velocity of appreciation play a part in bubbles or timeline doesn't matter?
    Phil McAlister Specialist from Chicago, IL
    Replied 6 months ago
    Yes, maybe, one, great, and yes. :)