Explaining Real Estate Price Bubbles

Bubbles form in investment real estate, leading to the questions: Where is the top? When will prices no longer rise? An answer to both of these questions is: when the money runs out. In real estate investment there are two sources of funds: the buyer's investment (down payment) and the lender's capital (the loan amount). The lender operates as a sort of governor, investing less as prices rise, thereby refusing to finance the speculative part of the bubble (that part unsupported by commensurate increases in net rent). With the lender's withdrawal, given fixed prices, buyer down payments must rise, placing downward pressure on investor yields. Fewer buyers become willing to accept those lower yields and the market at those prices falls.

The lender may also constrain activity by increasing the debt coverage ratio (DCR), which is the property net income divided by debt payments. The excess debt coverage ratio (XDCR = DCR-1 = BTCF), therefore, is the amount by which property net income exceeds debt payments. So-called "break-even cash flow" is that condition where loan payments equal net income, or before-tax cash flow (BTCF) is zero.

The graphic begins with the typical maximum loan-to-value ratio (LTV) of 80% and minimum XDCR of 0. Transactions take place at the intersection of the two planes. The line at that intersection may be viewed as a measure of the breadth of the market. Holding one control in its original extreme position and changing the other shows how the market shrinks to the point where practically no funds remain. It is at this point the bubble ceases to expand.