Definition of a Housing Bubble
Recent reports about the hot real estate market in Canada have generated a lot of discussion about whether or not we are seeing the beginnings of another housing bubble.
To answer that question, it helps to understand what a bubble actually is, how one gets started, and its possible impact.
Definition of a Housing Bubble
For housing bubbles, the Investor’s Dictionary offers this definition:
“A real estate bubble or property bubble…is a type of economic bubble that occurs periodically in local or global real estate markets. It is characterized by rapid increases in the valuations of real property such as housing until they reach unsustainable levels relative to incomes and other economic indicators, followed by decreases that can result in many owners holding negative equity (a mortgage debt higher than the value of the property). Unlike a stock market crash following a bubble, a real-estate “crash” is a slow process, because sellers just decide not to sell.”
Are There Any Warning Signs?
Most people only recognize housing bubbles in hindsight, after the crash has occurred. To help people weather potential storms better, economists have started using certain indicators to try and identify bubbles in specific geographic areas. They begin by comparing current prices to the prices seen during previous boom cycles. This comparison gives them an idea of whether current housing prices are inflated.
Economists then look at other indicators that fall into two broad categories: valuation (cost of homes vs. what most people can afford) and debt (how much debt homeowners are carrying).
On the valuation side, economists evaluate the price to income ratio and deposit to income ratio to determine the percentage of income people need to pay for a house and its down payment. On the debt side, they examine the debt to income ratio or the total cost of home ownership relative to a family’s income.
There are other factors involved in economists’ assessments, but these main indicators can give them a pretty good idea of whether or not a bubble is forming.
Impact of the Housing Bubble
As we have seen recently, when house prices go up and the cost of borrowing goes down (to sometimes artificially low levels), a perfect storm is created. People have faith that house prices will remain high and they may bite off more than they can chew.
When prices drop, the impact on people who are over-leveraged can be severe. They may find themselves with mortgages worth more than the value of their homes. Some may be forced into foreclosure, as we have seen recently in the United States and, to some degree, Canada.
Are we in a bubble now? It is too soon to tell, although most economists are suggesting the market is a little overheated and that some cooling off is necessary. Recent increases in mortgage rates have acted as a shot of cold water, and may be all that we need to avoid a boom and bust cycle.
Regardless of current trends in the housing market, the best defense against the bubble is wise investing. If you enlist the help of a mortgage professional and plan carefully you should be able to manage the ebbs and flows of the housing market.