Real Estate Market: waiting for the big one

Several months ago, I wrote a post titled Housing Boom or Housing Bubble, where I spoke about the overinflated real estate market here in the United States. Many people have argued that since houses have "intrinsic value" in that they provide a place to live, the market cannot crash - to me, this argument lacks merit. I think this market is ripe for a crash.

Personally, I think the housing market here is a bubble reminiscent of the Nasdaq stock market in the late 1990s. In the 1990s, people made lofty references to the "new economy" where stocks went up and never came down, and all this came to an end in the crash of 2001. People over the past few years have made similar references to housing as a market that goes up and never comes down - and I expect these people are in for a major surprise.

Let's consider the mechanics of how a housing market crash might occur.

Stage 1: Gradual Decline

Like any free market, housing prices are governed by a balance between supply and demand. If an imbalance is created between supply and demand, the price adjusts until the demand and supply are equal: if demand outweighs supply, the price goes up, but if supply outweighs demand, the price goes down.

As I mentioned in my prior post, a key factor in the formation of the current housing bubble has been historically low interest rates. However, these interest rates have been creeping up over the past few months, and the demand has been gradually slowing, leading to a leveling-off in housing prices as has been reported in the news media this week. If interest rates contiue to go up, the housing prices will fully level off, and start into a steady but gradual decline as the demand declines in response to interest rates.

Stage 2: The decline accelerates

Once people start to realize the housing market is in a downward spiral, their behaviors in the housing market will start to change. Prospective buyers will realize that if they wait a while longer before buying, they can save money, and prospective sellers will realize that they will earn more money if they sell quickly than if they wait. Thus, in response to this behavior, housing demand shrinks, and housing supply increases, and the rate of decline of housing prices increases further.

Stage 3: Price free-fall

As the price decline accelerates, people start to get emotional. Homeowners who have been accustomed to their wealth increasing every year as their home values go up see the equity in their homes evaporate, and may even find their mortgages under water (owing more to the bank than what their homes are worth). Some of these folks start to panic, and panic selling envelops the market.

Meanwhile, prospective buyers quickly realize that the housing market is in the midst of a crash and demand completely dries up.

This toxic combination of increased supply and near-zero demand results in a price free-fall that continues until the prices fall below the point investors consider a bargain.

Stage 4: Leveling-off

After the market has fallen far enough, some buyers will view the prices as a bargain, and will start to jump into the market, causing the prices to level off. It is quite likely the market may over-correct - dropping below the point it eventually settles down to, then bouncing up a bit as investors start their bargain hunting. After a few more up and down cycles, the housing market settles down to a stable level - far below the level it was at when the bubble was at its peak.

Will this scenario happen? Nobody can be certain. But, with the news developments over the past few weeks, this scenario is seeming more and more likely, and is one major reason I am personally staying out of this market - riding out the upcoming storm in the safety of my rented apartment.