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Real Estate bubbles

In a seller's market buyers often ask "Where does this stop?" Many observe buyer frenzy and ask "When will the bubble burst?" Perhaps a fair question in turbulent times, but "burst" many not be the right term. Real estate bubbles, unlike stock market bubbles, tend to either stop inflating or slowly deflate rather than burst. The reason for this can be traced to the interaction between buyer and seller activity and the regulating activity of lenders.

Lenders employ two primary risk management tools when underwriting loans, loan to value ratio (LTV) and debt coverage ratio (DCR). Buyers make investment decisions based on a number of factors, three of which are the amount of leverage (LTV), the capitalization rate (CR) and the cash-on-cash (C/C) return. Common to measures used by both parties is the interest rate on the loan. There are interesting relationships between these measures that help us understand how real estate bubbles expand and contract.

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