How are real estate bubbles created?

If you have any interest in property you will no doubt have come across the term “real estate bubble” on numerous occasions. But what is a real estate bubble? How do they occur? Is the end always inevitable?

What creates a bubble?

If there is one term to describe the reasons for real estate bubbles it has to be “over exuberance” with investors falling over themselves to get a piece of the action. There have been many such occasions over the years with the property press at the moment suggesting Los Angeles is a real estate bubble about to pop. We’ve also seen the likes of Dubai which went from something miles off the property investment radar to a must have investment and then all the way back down.

There is no doubt that the media play a major role in creating bubbles, talking up property values to the point where they bear no resemblance to the cold hard facts. There are situations where prices can get slightly ahead of reality but there have been many instances where crazy valuations come into play and some experts and followers try to justify them.

Will investors never learn?

There are many different types of investor, short, medium and longer term, looking for very different exposure through different assets. What tends to happen with the creation of a real estate bubble is the emergence of long-term investors who believe there is value in a particular market. Once prices start to rise, and the stories emerge in the media, this can attract some of the more short-term investors who work on relatively small margins. These are the ones which tend to create the “froth” in a property market and where time is of the essence to get in and, perhaps more importantly, to get out.

While many people will criticise short-term investors the truth is that short-term investors very often add significantly to the general liquidity of markets. Liquidity is a major element of any mature property market because it allows investors to buy freely and perhaps more importantly to sell freely. So, while short-term investors can add the froth to perhaps an already over buoyant market they do have a role to play in the wider picture.

Fear and greed

On numerous occasions we have discussed the emotions of fear and greed which are behind many investment decisions for those who go with “gut feeling”. There is the fear of missing out which forces people to pay over the odds for property and there is the greed which ensures that many investors will hold on until the bitter end – which can often lead to losses. Chasing the last pound can be dangerous for your wealth and it is very important that you “leave some for the next person”. Does this sound like a strange phrase?

It simply means that to sell before the market turns is perhaps the optimum moment (there are still buyers keen to invest) because once the market turns, and short-term investors flee, prices can very quickly deflate. This can leave many with a very difficult decision, sell up or hope that the market recovers?

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