Is Another Real Estate Bubble About to Burst?

Eric Madsen

Home prices surged thanks to low inventory and pandemic-related factors. But the market is showing early signs of cooling. Certain factors could turn a hot market into a cold one.

As a consultant on high-stakes litigation involving mortgage-backed securities, Eric Madsen had a front-row seat to the fallout after the last US real estate bubble burst. Today, with housing prices recently jumping at their fastest rate in decades, Madsen sees similarities—and important differences.

Q: What is behind the surging home prices in the US? How was this happening in an economy that hasn’t fully recovered from the pandemic?

EM: With increasing inventory, the market is now showing some early signs of cooling, but the pandemic was a main driver behind high demand. Millennials previously had been slow to enter the housing market. But many who might have continued delaying a home purchase changed course when faced with remote work, often with their kids taking classes in the same room. They could now work from anywhere, making markets like Boise, Idaho, and Billings, Montana, with larger homes and lower prices, both attractive and feasible. Plus, rock-bottom mortgage rates, a booming stock market and stimulus money combined to create an opportune moment to buy at a time when the pandemic drove people to look for more space. Mortgages for vacation homes nearly doubled.

But the inventory just hasn’t been there. Baby boomers already were slower than past generations to downsize, and the pandemic gave them more reasons for delay. With the overhanging threat of infection, densely populated condo buildings or retirement communities didn’t fit the bill. Plus, selling real estate involves close interaction with lots of people, something everyone—and especially older generations—avoided. And other factors were at play: lumber prices skyrocketed, and cement and labor shortages may have affected new construction.

Q: What do you expect will happen in the coming year?

EM: I expect inventory to continue increasing. Most of it will come from two sources: new construction and baby boomers looking to downsize. As the pandemic subsides, some will feel they no longer need as much space and will look to sell. But baby boomers will be the biggest source—it’s been called the silver tsunami. So far, it hasn’t hit, which means it will be more sudden when it does come. 

Coming out of the pandemic, baby boomers will have new motivation to sell. First, they’re now either further into or closer to retirement. Many decided to retire early. Second, the hot housing market has handed retiring baby boomers a gift: a substantial increase in home equity just as they look to lock in some financial security. Baby boomers witnessed the bubble burst 13 years ago, so they know how quickly things can reverse. If they sense prices have peaked or are starting to slip, we could see a sudden rush to sell and face too much inventory and falling prices.

Q: A recent study released by the National Association of Realtors calls for extreme measures to increase housing supply, including zoning changes, converting some commercial properties for residential use and even federal intervention. What’s your response?

EM: In states and regions where housing prices have been consistently high over long stretches of time—California, for example—action along those lines could make sense. But not on a nationwide basis.

New-home construction plummeted during the last market crash and has been slow to recover. But now it’s now back around its long-term average. The last crash was blamed partly on overbuilding, so we have to be careful. A massive increase in new construction could sink this market, especially now that we’re seeing early signs of cooling.

Cries of a widespread housing shortage are misleading. Two basic factors drive long-term housing prices: people and housing units. This ratio—people to housing—has been trending down over the past 20 years. The pandemic has pushed it down even further. During COVID, birth rates plunged and are now below replacement levels, and life expectancy also took a hit. Meanwhile, total housing units have increased. This suggests skyrocketing housing prices are more of a short-term problem—a frenzy to own real estate, driven by low interest rates, extra cash, FOMO (fear of missing out) and a sudden yearning for more space.

If the problem was a lack of housing units, we’d expect to see rents surge along with prices. In some markets, they have. But rents in major cities took a nosedive—especially in San Francisco and New York—even while home prices jumped. As the disconnect between surging home prices and soft rents increases, selling and renting become more attractive. This gives new life to rents and reins in prices.

Q: Will we see a repeat of what happened at the end of the last decade—both from a bubble perspective and the flood of litigation afterward? 

The last bust was severe largely because of the collapse in the market for mortgage-backed securities rather than typical supply-and-demand issues. This time, based on where things are now, we might see more of a correction as buyers refuse high prices, retiring baby boomers look to sell and demand for larger spaces shrinks with a waning pandemic. The recent surge in the Delta COVID variant could extend the demand for larger spaces and delay a housing reversal. However, even with an extended pandemic, if interest rates rise in response to what appears to be rising inflation, or if overbuilding occurs, the market could correct quickly. But real estate corrections usually unfold slowly over several years. 

Whether litigation follows depends on the underlying factors. Markets can correct or even crash without wrongdoing—it’s just the nature of booms and busts, and we see it happen in the stock market. Massive litigation that followed the last housing cycle was focused on problems with subprime and Alt-A lending and pervasive mortgages with teaser rates that ballooned after a few years. Subprime lending and exotic mortgages aren’t nearly as common as they were in the years leading up to the last crash.

Q: Is there any reason to think things could get closer to a 2008-style bust?

The key factor to watch is what the mortgage-lending industry does now that the housing market appears to be cooling. It seems banks have been much more cautious since the last crash, but nonbank lenders have become big players, and they’re turning increasingly to subprime and low-doc loans, which they’re now calling nonqualified or non-QM loans.

That on its own should not cause alarm. Lenders have had their hands full with credit-worthy borrowers who have been making large down payments. However, when that pool dries up, lenders could become increasingly dependent on subprime borrowers to fill the gap. If that becomes widespread and those subprime loans are represented as higher quality than they are, that could make the inevitable correction worse—and lead to similar streams of litigation.