There are many reasons to believe that housing is in a bubble in many countries, and that in the US, residential real-estate in certain markets peaked in late 2005, and is now on the brink of a multi-year decline. This is a vast subject, but to summarize the main reasons to think this is a bubble are :

1) Interest Rates were at 46-year lows in 2002-04, which reduces mortgage payments for a given house, but inflates home values. This causes the ratio of home prices to salaries and home prices to rent to rise far above the trendline. At the same time, when interest rates rise (as they have since early 2005), home prices fall a couple years later as payments for a given home price rise and buyers are forced to adjust downwards.

2) Speculation is rampant, because the low interest rates from 2002-04 caused price increases of 15% a year to occur, and lead people to believe this is the normal trajectory of the trendline. This has tempted people to buy additional homes for investment, and happily accept the fact that rent income is much less than the mortgage payment, under the expectation that equity gains will offset the negative monthly cash flow.

Now, the bubble of the last 3-4 years was due to low interest rates at the front of the yield curve, which is something that the Federal Reserve controls, and which has given rise to new types of adjustable-rate mortgages that are advantageous only when short-term rates are very low. The rise of the Fed Funds Rate back to moderate levels guarantees a correction of the recent bubble, and is easily predictable.

However, there is another unrepeatable phenomenon residing beneath the first bubble, at the other end of the yield curve - the decline in long-term rates over the last 25 years.

The yield of the 10-year bond, which somewhat corelates to 30-year mortgage rates, peaked in the early 1980s and bottomed out in 2003. This long downward drift in mortgage rates generated upward movement on housing, and permitted housing to rise at a rate greater than nominal per capita GDP over this period. Even if someone purchased a house in the early 1990s, their mortgage rate was 10%, vs. just 6% in 2001 (before the recent bubble). This is the reason why the old rule of thumb of prospective homeowners being wise not the purchase a house priced more than 2.5 times their annual income was applicable in the 1970s and 1980s, but somehow gave way to home prices of 5-7 times income being considered normal. The hypothetical example below may help illustrate this phenomenon.

Now, the 10-year note yields (and mortgage rates) have begun to rise. While the rise has merely been by 1% so far, and even if rates never get that much higher than they are is now, it is impossible for the drop in yield from 1981 to 2001 to be repeated. When the 10-year yield is 5% and mortage rates are 6.5%, there is no room for them to drop another 3%. Theoretical 3% mortgage rates would result in homes being priced at 10 times average salaries nationwide, and even then have no further room for appreciation from that point. The floor has been hit, and there is nowhere else to go for further rate declines.

Thus, while the bubble created by low short-term rates from 2002-04 may dissipate in the next two years, after that, the next 20 years will additionally no longer have a tailwind of declining long-term rates behind housing, and the trendline of housing prices will be forced to converge towards mere increases in inflation and per-capita real GDP, or about 5% a year in the US. This is after the short-term bubble corrects.

While I do believe that economic growth rates are exponential and accelerating, housing, being a product without a knowledge-based component, is less likely to participate in this accelerating curve. Increasingly greater returns will be seen in the stock market, and stocks, particularly those of knowledge-based businesses, will continue to draw capital away from real-estate, over the next 20 years.