How to Spot a Real Estate Bubble

Jeremy Bowman | The Motley Fool

You don’t need a great memory to recall the last real estate bubble. Just 10 years ago, an implosion in the United States housing market and several others around the globe catapulted the world into the worst financial crisis since the Great Depression. The S&P 500 lost half of its value, the unemployment rate doubled, several investment banks were forced to dissolve or merge in order to survive, and millions of Americans were foreclosed on and lost their homes. Millions of others simply abandoned them as the homes were underwater or worth less than what they owed on their mortgages.

It’s no wonder, then, that homebuyers and others, especially in areas with limited housing supply like Silicon Valley, San Francisco, and Los Angeles, may be nervous about the next real estate bubble as home prices are rising and buying a home is generally the biggest investment that Americans make in their lifetimes.

Though there’s no definitive way to spot a real estate bubble and experts don’t even agree on whether one can be identified or prevented, there are a number of indicators that homebuyers and shoppers can follow in order to determine the likelihood of a bubble. Those indicators include:

  • Interest rates since low rates tend to fuel bubbles.

  • Home price indexes, a measurement of housing prices for single-family homes in a given location. These offer the easiest way to follow the rise and fall of home prices.

  • Price-to-rent ratio, which is the ratio of the price of home to the annual rent that it would generate and a measure of affordability of renting versus buying. Lower ratios indicate that buying is cheaper, while higher ratios would signify that renting is the better deal. Price-to-rent ratios tend to rise during a bubble as speculative interest in homebuying lifts home prices.

  • Determine to what extent rising prices are being driven by speculators rather than residents as housing bubbles tend to be driven by speculators, or investors who are buying homes to turn a quick profit, rather than live in them.

We’ll go into those techniques later, but let’s first define the key term here and go over some basics that every homebuyer and investor should understand.

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