Two years ago, your coworker bought a house in your same neighborhood at a steal price. This year, you decided to jump into the house-hunting game... and discovered that a similar house would cost 20 percent more.
Yikes! With property values rising so quickly in many parts of the nation, are we on the cusp of another housing bubble?
In one word: no. In fact, we are far, far away from bubble territory. Below Trulia shares a few housing bubble basics showing why we're a long shot from the next housing bubble.
What's a Bubble?
Let's start this explanation with the basics: What's a housing bubble?
A "bubble" is an unsustainable rise in prices, often fueled by speculation and lending. It's characterized by easy credit, irrational exuberance, and a rapid rise in prices.
Bubbles can affect housing, commodities like gold or copper, or the overall stock market as a whole.
What Caused the Last Bubble?
Several factors contributed to the last housing bubble, including:
#1: Loose Lending Standards
During the last bubble, financial institutions lent money to anyone with a pulse. (That's only a half-joke). The criteria, or standard, that borrowers needed to meet in order to qualify for a loan was a very low bar.
For example: Many institutions didn't require borrowers to prove their income. The borrower would self-report their income (write down a number), and the lender did nothing to independently verify whether or not this number was accurate.
What happened? People borrowed more than they should — often on adjustable-rate mortgages, which had low introductory teaser payments, followed by higher payments several years down the road. Eventually, they couldn't make their payments, which led to foreclosure. Ultimately, when this happens to a large population of homeowners, it depresses housing prices.
Many people assumed that houses will always rise in value. As a result, a rush of builders and developers rushed to create new construction, glutting the market with inventory.
How did the developers pay for this construction? With loans, of course.
Banks issued loans to builders, who created massive inventory, and also issued loans to individual buyers, who gobbled up that inventory.
As a result, builders began over-leveraging. Developers would borrow massive amounts of money to build homes "on spec," with the assumption that demand would never cease.
And for awhile, they were right. Buyers, who assumed house prices would rise forever, and who easily qualified for mortgages, eagerly bought houses. This fueled builder's enthusiasm. And the self-reinforcing cycle continued — all built on a foundation of easy credit, and an assumption that prices would keep on rising.
#3: CDO Sales
Here's a third reason that a bubble formed:
The banks needed money, in order to issue loans. Where would that money come from?
From securities. Functionally, the banks borrowed money (by selling "collateralized debt obligations," or CDO's) and used that money to issue loans to builders and buyers. The banks earned profits on the "spread" between the rate at which they could borrow and the rate at which they could lend.
And that's fine — as long as the banks are borrowing at an interest rate that's aligned with the actual risk involved.
Here's where trouble entered the picture:
Banks took the riskiest loans (subprime loans) and packaged these as ultra-safe securities. In other words, they sold risky assets under the guise of safe assets.
And they did this a LOT. In the three-year timespan from 2003 to 2006, CDO sales rose tenfold, from a $30 billion industry to a $225 billion industry.
When housing prices dropped, many investors (including many major institutional investors, such as the government of Iceland) lost their investments in these securities. This triggered capital markets to plummet.
Why It's Different Today
The three conditions outlined above are drastically different today:
#1: Strict Lending Standards
Today's borrowers must meet higher standards. They need strong credit scores, low debt-to-income ratios, and (generally) need to provide at least two years' of proven income history. Financial institutions will look at their paystubs and tax records in order to verify their income.
The result? Today's borrowers are more likely to be able to actually afford their loan repayments — meaning fewer of them will be subject to short sales and foreclosures.
#2: Less Speculation
Banks have much stricter lending criteria for both builders and buyers. Investors can no longer create a real estate development company on leverage alone; they often need a hefty downpayment (25 to 30 percent or more) to borrow the funds to build a new condominium complex or apartment building. The "loan-to-value" ratio, as it's called, is stricter than ever.
#3: No CDO Bubble
As you might imagine, institutional investors are leery of complex financial instruments like CDO's. The rapid rise of CDO's from 2003 to 2006 isn't repeating itself today.
So Why Are Housing Prices Skyrocketing?
Many people look at one characteristic of the 2014 housing market — the rapid rise in home prices — and wonder if we're in another bubble.
We're not. The main drivers of a bubble (easy credit, loose lending standards, and overblown enthusiasm and speculation) aren't present in today's market.
In many major markets across the U.S., year-over-year housing prices look like they've made enormous gains. According to Trulia's Bubble Watch Report, year-over-year growth in asking home prices (as of February 2014) is up 12.6 percent in Atlanta, 10.4 percent in Indianapolis, and 15.8 percent in Dallas. In other words: cities across the nation are seeing impressive gains.
But those gains are a drop in the bucket compared to how much further they need to recover just to reach "normal" levels.
The peak housing prices, by the way, aren't considered "normal." During the bubble, houses were overvalued by anywhere from 8 percent in Houston to 86 percent in Miami. When the bubble popped, houses plummeted into "undervalued" territory.
And while those values are recovering, many cities across the U.S. still feature undervalued houses.
Houses in Atlanta, for example, are still undervalued by about 15 percent — in spite of the 12 percent year-over-year price surge. Indianapolis homes are undervalued by 13 percent, while Dallas homes appear to be at "normal" levels — neither under- nor over-valued.
Some cities (especially in California) are seeing house prices that appear to be slightly overvalued. But today's overvaluation pales in comparison to the wild speculation that fueled the bubble from 2002 – 2007.
So if you want to buy a home, don't sweat that we're in a bubble. Today's market is different than the one we experienced a decade ago.
This article Why Another Housing Bubble Isn't Happening...Yet originally appeared on Trulia.com.
This is no bubble. This is for real.
The Economist compares this disruptive invention to the steam engine and the printing press. Business Insider says it's "the next trillion dollar industry." And everyone from BMW, to Nike, to the U.S. Air Force is already using it every day. Watch The Motley Fool's shocking video presentation today to discover the garage gadget that's putting an end to the Made In China era... and learn the investing strategy we've used to double our money on these 3 stocks. Click here to watch now!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.