Real Estate Bubble

A real estate bubble happens when speculation and easy credit push property prices far above the level rents and incomes justify, followed by a fall. In cap rate terms, a bubble shows up as cap rates falling far below interest rates and historical norms.

When buyers accept very low cap rates, they are counting on price growth rather than income. If the example property's NOI of $28,892 sold at a 4% cap rate, the price would be about $722,000. A later return to 5.78% on the same NOI would cut the value back to $500,000.

Watching cap rates is one way to judge whether a market is pricing in too much growth. Low cap rates are not proof of a bubble, since they can reflect low interest rates, but a wide gap between cap rates and borrowing costs is a warning sign.