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What drives housing cycles

It's no secret that the U.S. housing market is cyclical and in the midst of yet another painful correction. The causes and characteristics of these cycles vary, at least in some respects, but the implications for homebuyers, home sellers and homeowners remain remarkably reliable as the cycles roll by.

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Housing cycles aren't all alike, yet over long periods of time a basic pattern can be discerned, says Mark Dotzour, chief economist of the Real Estate Center at Texas A&M University.

A cycle doesn't really have a start or a stop, but to pick a point at random, we might say that a housing cycle "starts" when economic activity heats up and interest rates rise. Higher interest rates make housing less affordable, so demand decreases and home prices fall. Then, as economic activity slows and interest rates decline, housing again becomes more affordable and, consequently, demand and prices go up. Then the cycle repeats. Housing tends to lead the economy and thus can be an indicator of future economic activity.

Subprime loans goosed demand for housing
The severity of the current housing cycle has been exacerbated, Dotzour explains, by two factors.

2 factors exacerbating the market's woes:

"In this cycle, we had a real abrupt change in demand (because) a certain segment of the homebuying public, mainly subprime and Alt-A buyers, were just completely shut out of the market overnight," Dotzour says. "Then what happens is that you get too much inventory and prices go soft."

Exuberant investment added to housing market frenzy
Speculation by investors and homebuyers' expectations of a major financial payoff also make housing more volatile than other economic sectors, says Nicolas P. Retsinas, director of the Joint Center for Housing Studies at Harvard University. This factor can be represented along a continuum between consumption, or the purchase of a home primarily for personal use, and investment, or the purchase of a home primarily to generate a capital gain or profit.

Phoenix and Las Vegas are good examples of speculative markets in the current cycle, Retsinas says. In 2006, more than 30 percent of the homes sold in those two cities were purchased by investors rather than homeowner-occupants. Both cities had experienced rapid price appreciation and accelerated new-home construction, which were followed by sharply higher foreclosure rates.

Next: How supply and demand work.
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