A Real Estate bubble occurs as housing prices rise because of increased speculation, actual legitimate demand, and irrational exuberance all working in concert. These bubbles generally begin because of a legitimate rise in demand for housing and Real Estate at the same time as the housing supply is quite limited.
Because of this limit in supplies, it needs quite a significant amount of time in order for the available housing stock to be replenished and grow. In such a climate, speculators appear on the market and begin to really encourage demand. Finally, demand will stagnate and even decrease as the supply is finally increasing to catch up to the prior demand. This results in a catastrophic bursting of the bubble in the form of disorderly, rapid, and sharply decreasing prices that finally become a self-fulfilling prophecy.
In the past, housing markets did not suffer as often from such bubble phenomenon as did other kinds of financial markets like stocks and bonds. This was because the carrying costs and purchasing prices of homes are significant barriers to investment entry for smaller and medium sized investors. Thanks in large part to historically low interest rates and an unfathomable loosening of credit standards, borrowers were able to enter the market in record demand and drive massive orders for houses. Conversely, raising interest rates and tightening up on standards for credit reduces demand effectively, which leads to the Real Estate bubble bursting quickly.
These Real Estate bubbles are also referred to commonly as housing bubbles or property market bubbles. These economic bubbles can inflate either in worldwide real estate markets or only on small local markets. They generally come after the buildup of a land boom. Land booms prove to be the quick growth in market price of houses and land to the point when they attain levels which are ultimately unsustainable and then lead to a sharp decline in said bubble.
The financial crisis and Great Recession of 2007-2009 evolved out of the Real Estate bubble bursting that had inflated from the early 2000s in all major countries of the world. It took years for this bubble to rise as investors abandoned the global stock markets in record numbers following the bursting of the dotcom bubble and resulting 2000 stock market crash. They poured their capital instead into real estate and house properties during the following six years. The craze which surrounded homeownership rose to frightening levels while interest rates were crashing and responsible lending underwriting all but disappeared.
Analysts have estimated as many as 56% of all house purchases in those six years came from individuals who could not have afforded to buy a house under traditional lending requirements. These people became known as the infamous and economy-wrecking subprime borrowers. The overwhelming majority of such loans were issued as adjustable rate mortgages, or ARMs, that carried an upfront lower interest rate with a punishing schedule set to adjust the prevailing interest rate massively upward after from three to five years passed.
The government was much to blame for the irresponsible encouragement of universal homeownership which they pressed banks to allow in those years. Banks responded to the directives by slashing their interest rates and tough requirements. This encouraged a home purchasing bonanza that had not been witnessed in American history heretofore. Prices increased by as much as from 50 percent to 100 percent in various parts of the nation. The bubble sucked in financial speculators who started flipping houses in order to earn even tens of thousands of dollars of profits with only two weeks of holding such properties. Analysts have further estimated after the fact that fully 30 percent of the housing prices were based on purely speculative endeavors from the zenith of the Real Estate bubble in 2005 to 2007.
As the interest rates began to gradually rise while stocks finally rebounded, adjustable rate mortgages started resetting at massively higher interest rates in a show that the economy was beginning to slow down by 2007. Home prices already sat at impossible to justify and sustain levels and the risk premium had finally risen to be too high for the speculators who suddenly ceased buying houses without warning.
Home prices started to plummet after home buyers realized that the prices could in fact drop. This led to an enormous sell off in the associated and now-infamous mortgage backed securities, or MBS market. The home prices finally dropped by over 40 percent in parts of the country that had been the most overheated, like Florida, Nevada, Arizona, Colorado, and California. This led to incredible default rates on mortgages that caused as many as tens of millions of homes to be foreclosed upon by the banks in the following several years.