Charles Kindleberger define a bubble as a sharp rise in price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers - generally speculators interested in profits from trading in the asset rather than its use or earning capacity. The rise is usually followed by a reversal of expectations and a sharp decline in price often resulting in a financial crisis.
Prices of houses go through cycles with highs and lows. Periods of boom when the prices are on an upward spiral constitute the highs and at the point such prices are not supported by the economic fundamentals, a house bubble is said to exist. The lows are characterized by a rapid decline in the prices and can result in many owners holding negative equity at which point the mortgage debt used to finance the house acquisition is more than the value of the house (Ouma, 2011).
The detection of bubbles in the housing market
The existence of price bubbles can be implied by the relationship between real estate prices and macroeconomic variables.
- If real estate prices are in line with variations of macroeconomic variables, or a price change can be explained by both fundamentals and reasonable shifts, the assumption of a price bubble can be rejected (Hui and Yue, 2006).
- Additionally, the order of integration of the series can indicate us the presence of bubbles. Thus, for example, if housing prices are explosive, presenting non-stationary behaviour or unit roots, or, in a fractional context, orders of integration equal to or higher than 1, and this order of integration is higher than the one produced by the economic fundamentals, we can also get some evidence of a bubble in the housing market.
- Methods of detecting a bubble
- One widely used method is cointegration. This model is used to test whether house prices or growth of house prices share common stochastic trends with economic forces, and if house prices do not deviate in the long run from fundamental economic variables there is no evidence for bubble.
- Fractionally integrated techniques are used first as a robust test for the unit roots but also in their own to analyze the existence of bubbles if the estimated fractional differencing parameter for the house price index is equal to or higher than 1.
Source: Kibunyi, Duncan & Ndiritu, Simon Wagura & Carcel, Hector & Gil-Alana, Luis. (2017). Real estate prices in Kenya: is there a bubble?. Journal of Housing and the Built Environment. 10.1007/s10901-017-9541-x.