Bay Area Real Estate Analysis

Recently I came across a real estate analysis that was published in June 2004 by the Economic Development Alliance for Business in cooperation with the UCLA Anderson Forecast. I am assuming that they feel the same way, only stronger, as of June 2005. Exerpts below.

The Bay Area differed somewhat from the rest of the nation—the run up in prices occurred in the late nineties as a result of the tech rush in the area. Prices flattened out in 2001 as tech started to experience its first cold spell. Nevertheless pent up demand remained an important supporter of the market, as did falling mortgage rates. My opinion has begun to change, however, over the past eighteen months as rents have continued to decline sharply in the region and mortgage rates have bottomed out. As discussed in the past, these are two of the major drivers in housing prices. Yet price appreciation has actually accelerated and is currently at its fastest pace ever. As prices have grown they have caught up to and clearly surpassed any level of sustainability. What’s most surprising about this is that it has occurred during such a deep regional economic recession. Prices in the Bay Area are now in real terms 75% above where they were 7 years ago. Overall appreciation in the eighties was just 65% in real terms.

Despite the claims of many pundits, it is certainly not ‘business as usual’ in the real estate markets. One common claim is that the slow pace of homebuilding and low resale inventory levels can justify the current price level. Remember that low inventory levels are an effect of an overheated market, not the cause of one. People are snapping up properties trying to cash in on their built up home equity and lock in on low rates while they can. And while the supply of houses for sale may be somewhat tight right now, building has been accelerating both across the state and across the nation. And in any case there is a contradiction of sorts in the market. Remember that tight supply is a short-term issue that drives rents up—and of course rents have been falling. Housing prices, being based on rents both today and in the future, are necessarily long-term. The only way to reconcile these two divergent trends is to suppose that growth of rents in the future are going to be enormous—in fact they would need to double in real terms over the next decade—a pace never seen before. It is clear that the market has indeed entered a ‘bubble’ mode—where people are making purchase decisions not on the basis of the fundamentals, but based on the fear of being left out of the market any longer.

So is it time to sell and move the family into an apartment until this blows over? The discussion above should not be interpreted as a prediction that a massive price decline is in the works for housing. It is worth noting that nominal real estate prices have never declined for the US overall—at least over the past 40 years. Instead past bubbles have ended with nominal prices stagnating until the forces of income growth and inflation have allowed the fundamentals to ‘catch up’ with prices. The same can be said for regional prices. The following graph shows a cross-sectional look at home prices and employment growth across regions. Here we see that declines in nominal prices are associated primarily with declines in local employment. In short, without a major regional downturn there is little historical evidence that would support a major price decline for the US.

The best advice for potential buyers to follow at this point is not to buy for short run gain, but to concentrate on buying for the long haul. Avoid spending more than can be afforded, leaving space in your budget for potential economic problems in the future, and do not use adjustable rate mortgages unless your income can handle the potential for a major rise in rates.