How Real Estate Bubbles Form and Why They Pop

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.

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.

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.

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.

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.

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.

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.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.