The World Changed in September

Sale price statistics can be volatile, but it seems safe to say that the San Francisco real estate market changed in September. Take a look at the chart, below, which shows median home prices for San Francisco County.

The pink line shows the average level of home prices for the three-year period between July 1, 2005 and June 30, 2008. A fair interpretation of the chart is that, monthly fluctuations notwithstanding, prices were in a holding pattern over that three-year period. As late as August of 2008, prices were still within 2.5% of the three-year average. When Lehman Brothers filed for bankruptcy on September 15th, however, the world changed. Stock prices fell 7% during the remaining weeks of September, and have fallen another 25% since then.

I predicted at the time that the San Francisco real estate market would suffer as a result. (Okay, that wasn't much of a stretch.) In fact, San Francisco home prices fell 10% in September alone, and have fallen another 4% through the end of November. It's not clear that the stock market meltdown caused this drop. For starters, most of the sales that closed in September would have been initiated in August, before the meltdown really started. But it's starting to look as if something important happened to the San Francisco market in September.

More on Mortgage Rates

A few weeks ago, I wrote that mortage rates are likely to improve. That was based on 1) the Treasury's proposal to push mortgage rates down to 4.5%; and 2) the fact that the spread between 30-year mortgages and 10-year Treasury's was at 2.8 percentage points, which is nearly double its long-term average.

Paul Krugman weighed in today on the subject in his New York Times blog, arguing that since Fannie Mae and Freddie Mac (i.e., the dominant mortgage lenders in today's market) have effectively been nationalized, there is little reason for investors to shun their debt in favor of Treasury bonds. In other words, Fannie and Freddie should already be able to write new loans at a spread that's comparable to historical levels.

The historical average spread between 30-year mortgages and 10-year Treasury's is roughly 1.6 percentage points. Adding that to the current 2.15% yield on 10-year Treasury's, you get a 'normalized' mortgage rate of 3.75%. For comparison purposes, mortgages are currently being written at around 5.15%, which is already the lowest since the Fed started doing its rate survey in 1971.

Deflation: You Can't Have Your Cake and Eat It Too

"What's so bad about deflation? I'd love to pay less for the things I buy." I'll admit, that thought has occurred to me lately. I'm glad that gas costs half as much as it did a year ago. I'd be singing a different tune, however, if I were in the business of selling gas. The trouble with deflation is that almost everyone is in the business of selling something. For every buyer who benefits from lower prices, there is a seller who suffers. It’s clear, therefore, that a general reduction in prices is not an unqualified boon.

The concept of deflation is difficult because few of us have ever thought about it. So let's start with inflation.

If inflation is running at 2% when you buy your house, you'll probably pay about 6% interest on your mortgage. If inflation increases to 10%, your lender will increase the interest rate it charges on new mortgages to 14%. The extra 8% interest is intended to compensate the lender for the additional 8% erosion that it expects (annually) in the real value of its principal.

What happens if you get your loan when inflation is running at 2%, and then inflation increases to 10%? In that case, you get a windfall. Your salary will start increasing at a higher rate, in accordance with the higher rate of inflation. (You'll spend more money for haircuts, but the barber will have more money to spend in your store.) Your mortgage payments will remain fixed, however, so they’ll take up a lower percentage of your income than you had counted on.

Of course, your salary increases aren't 'real'. After all, they ultimately result from the Federal Reserve's decision to print more money. We know intuitively that putting more money into circulation won’t make us all richer, but it can make some of us richer. We just saw that an increase in the inflation rate will make it easier for you to service your loan, so you'll be a clear winner. On the other hand, your lender will lose out in the deal because your 6% interest payments won’t even compensate for the 10% annual erosion in the real value of your loan balance.

In short, a sudden increase in inflation results in a significant transfer of wealth, from your lender to you.

Now let's consider the opposite case, where the inflation rate falls from +2% to -10%. As before, there will be a transfer of wealth, but this time, it will be from you to your lender. Your salary will decline at a 10% annual rate, making it increasingly difficult to service your mortgage. Conversely, your lender will be receiving 6% interest on its principal, even while the real value of that principal is increasing at 10% per year.

The problem gets worse. Because the value of your home is likely to be falling (just like everything else), your lender will be getting anxious about its collateral. If you default on your loan (an increasingly likely outcome considering the circumstances), the proceeds from a foreclosure sale may not be enough to pay off the principal. That will make your lender increasingly reluctant to extend new credit against your home. In short, while your creditworthiness is deteriorating and your likelihood of default is increasing, some banker will be losing his job because his employer isn't doing enough mortgage business.

And so on. There's more to the story, but by now it should be clear that deflation means more than discounts at Wal-Mart.

Don't Count on Foreign Buyers to Rescue San Francisco Real Estate

When the housing crash started grabbing headlines last year, real estate insiders were hopefully espousing the theory that foreign buyers would prop up demand for San Francisco housing. The idea was that the declining dollar made US real estate cheaper for foreign buyers, who naturally preferred world class cities like San Francisco and New York. Unfortunately, the theory makes little sense. The reason for any sudden drop in the dollar is that foreigners are trying to reduce their holdings of US assets. Why, then, should they suddenly increase their demand for San Francisco real estate?

The dollar has indeed declined over the last several years, but the decline has been gradual and modest. A careful look at the facts suggests that the resulting impact on foreign demand for San Francisco real estate has been marginal at best.

Currencies rarely move in lockstep with one another: while one currency is appreciating relative to the dollar, another one might be depreciating. In such cases, how can we say whether the dollar is getting cheaper or dearer? Economists address this problem by using trade-weighted exchange rates. The idea is to create an index whose value is adjusted from period to period by applying a weighted-average of the percentage changes in a representative group of exchange rates. The weights are chosen to reflect the amount of trade that each country does with the United States.

Take a look at the chart, below, which shows the inflation-adjusted value of the dollar, measured against a trade-weighted basket of foreign currencies.

Remember that this 'exchange rate' is actually an index: a 10% increase in the level of the index indicates that the dollar has appreciated by 10%, but the level of the index itself is meaningless. (I obtained this series from the Federal Reserve. I re-scaled it so that the average of the index over the last 20 years is 100.)

The index reached its peak value of 117.7 in February of 2002. It reached its recent low of 88.6 in March of 2008. The peak-to-trough change was approximately -25%, which is indeed a sizable decline. Keep in mind, however, that most of this decline happened gradually, over a six-year period. In other words, it's not as if San Francisco real estate suddenly went on sale. The index did fall at an accelerated rate beginning in late 2007, but the cheap-dollar/foreign-buyer theory had taken root long before then. And when the sudden fall did occur, foreign buying slowed, just as I suggested above. (The National Association of Realtors reported that fewer Realtors were working with foreign buyers in August of 2008 -- when the dollar was near its low -- than in August of 2007.)

The latest index value is 98.6. That represents a discount of 16 percentage points relative to the 2002 peak. Again, that's a sizable discount, but it's not exactly a half-off sale. I'm not saying that foreign demand for San Francisco real estate has not increased, but a discount of that size seems unlikely to have had anything more than a marginal impact. And once you reject that simplistic explanation, the notion that foreign demand will prop up San Francisco real estate starts looking like wishful thinking.

Mortgage Rates Seem Likely to Improve

Here's an encouraging piece of news for the real estate market: The Treasury Department is working on a plan to push mortgage rates down to 4.5%. The details are being worked out, but the essence of the plan is that the Treasury will act as a bank: They'll borrow money from private investors (by selling Treasury bonds) and lend the proceeds to homeowners. As long as the loans get repaid, the Treasury will actually earn a profit, determined by the spread between its lending rate (4.5% in this case) and its borrowing rate.

The Treasury's borrowing costs have been coming down lately, as investors all over the world dump risky assets and pour money into Treasury bonds. Since December of last year, the yield on 10-year Treasury bonds has fallen from 4.1% to 2.7% (as of December 5th). That's the lowest rate in the last 50 years, by a good margin.

Meanwhile, 30-year mortgage rates have remained stable. When the subprime loan crisis started making headlines in 2007, mortgage rates were in the low 6%-range. They've fallen since then, but are still within 0.75 percentage point of their pre-crisis levels. In contrast, 10-year Treasury yields have fallen by almost three times that amount.

With Treasury yields falling and mortgage rates remaining stable, the interest rate spread between the two classes of securities has increased to levels that haven't been seen in the last twenty years. (This is one of the primary indicators of distress in the credit markets.) From 1987 to 2006, the average spread between 30-year mortgages and 10-year Treasurys was 1.6 percentage points. Today, the spread is 2.8 percentage points. It hasn't been that high since the early 1980's, when inflation was running rampant.

Anyway, back to the Treasury's plan. Assuming that Treasury yields remain below 3% (a good bet when inflation is running at close to 0%), a mortgage rate of 4.5% represents a spread of at least 1.5 percentage points. That's consistent with historical averages. So even if the Treasury plan is abandoned, there are good reasons to expect that private lenders will push mortgage rates down to the same levels.

Banks will have to be recapitalized in order for that to happen, but I don't think we'll have to wait for home prices to stabilize. (During the housing market downturn of the early 1990's, the mortgage spread actually fell below 1.5 percentage points.) Even if the Treasury plan is abandoned, there's a good chance that we'll see 30-year mortgage rates below 5% within the next year.

A Temperature Gauge for the San Francisco Real Estate Market

How is the San Francisco real estate market doing? Unfortunately, that can be a difficult question to answer. Take a look at the chart, below, which shows historical sale prices for two-bedroom condos.

I'd summarize this chart by saying that prices plateaued in the summer of 2005, and haven't shown any obvious trend since then. So much for the last three years, you say, but what about the last three months? Consider the chart, below, which shows the annual rate of change for two-bedroom condo prices.

Unfortunately, I find this chart even more difficult to summarize than the first one. If you asked me how the market is doing and this was all I had to go on, I'd probably wind up reading data points straight from the chart. That doesn't seem helpful, particularly if you're not interested in two-bedroom condos. There must be a better way to characterize the state of the market.

You may remember that when the housing frenzy was at its peak, overbidding and multiple-offers were common. Take a look at the chart, below, which shows the percentage of two-bedroom condos that were sold above the asking price.

I've also included the change in average sale price (taken from the second chart, above). The two series track each other fairly closely, which suggests that either one can be used as a proxy for the other. The advantage of focusing on bidding activity instead of price changes is that it provides a cleaner snapshot of the market.

If I say that prices have fallen 5% in the last three months, you'll probably want to know how much they changed in the three months before that. Or maybe you'll want to know the level from which they started, and whether I believe that that level was appropriate. Pretty soon, we'll be far afield from the original question, which was, "How is the market doing?"

Okay, here goes: During the last few months, only about 20% of the housing units sold in San Francisco have gone for more than the asking price. In contrast, when the dotcom and housing bubbles were at their peaks, 80% of sales were for more than the asking price. Except for a few months following September 11, 2001, the recent rate of over-bidding activity is at its lowest level in the last ten years.

In other words, the San Francisco housing market has cooled dramatically.

Fewer People Are Planning to Buy Homes

This article in today's New York Times is full of bad news for housing. Among other things:

• S&P/Case-Shiller released its home price indices for September. The 20-market national index is down by 17% from last September's level, and is down by 22% from its peak (which occurred in July, 2006). The California markets fared even worse. From September of 2007 to September of 2008, San Francisco, Los Angeles, and San Diego fell by 30%, 28%, and 26%, respectively. Each of the three markets is now about one third lower than it was at its peak. Considering recent activity in the housing and financial markets, the October and November index values will likely come in even lower than September's.

• According to the latest Conference Board consumer survey, just 1.9% of households are planning to buy a home in the next six months. There are roughly 117 million households in the US, so if we annualize the Conference Board's estimate, that works out to about 4.4 million home purchases in the next year. To put that in perspective, the National Association of Realtors reported yesterday that the seasonally adjusted annual rate of home sales was approximately 5.0 million for the month of October. (That's for existing homes only; the rate would be somewhat higher if we included new homes as well.) In other words, if the Conference Board survey is to be believed, the rate of home sales is likely to fall substantially from its already depressed level.

Bay Area Home Prices Still Falling

Bay Area home prices are down 40% in the last twelve months. That's according to last Thursday's press release from Dataquick. San Francisco was the best performing market, with a twelve-month price change of minus 12%. San Mateo County was second best, at minus 22%.

Perhaps a more interesting statistic is that 45% of all (existing) homes sold in the Bay Area during October had been foreclosed on within the last twelve months. That's an astounding number. In San Francisco, previously foreclosed homes accounted for a surprising 11% of total sales.

Bay Area Home Prices: Where's the Bottom?

One of the purposes of this blog is to shed some light on the notion of "fair value" for Bay Area housing. Today's entry focuses on the relationship between home prices and household incomes.

I'll adopt the naive assumption that over the long haul, home prices and household incomes should move in tandem with one another. It's easy to come up with reasons why that assumption might fail, but it seems like a good starting point; in any event, it has worked pretty well in the past.

Consider the chart below, which shows home prices and household incomes for the three-county region that includes Marin, San Francisco, and San Mateo Counties.

The pink diamonds represent an index of median household income. The solid blue line is the OFHEO home price index. (OFHEO stands for Office of Federal Housing Enterprise Oversight.) It's not a perfect index (among other things, it includes only single family homes), but it correlates closely with other common home price indices, and it's a particularly convenient index for purposes of this analysis. Both series are indexed to a value of 1.0 in 1999.

As you can see, the two series tracked each other closely over the 25-year period ending in 2000. After that, prices climbed much quicker than incomes. By 2006, the ratio of home prices to household incomes exceeded its pre-1999 level by about 80%. The ratio has fallen dramatically since then, but is still about 45% higher than its long-term average.

Notice that I haven't talked about what the price-to-income ratio should actually be. Instead, I've pointed out that the ratio has been stable in the past, and that it's now far above its long-term average, even after the recent price declines. As I said, it's easy to come up with arguments as to why the "fair" level for the ratio should have risen. But I don't know if those arguments can stand up to 25 years of history.

Note: The household income figures were obtained from the Census Bureau. You can find the OFHEO home price index here.

Underwater Homes in the Bay Area

Here's some useful market intelligence from Zillow (by way of the San Francisco Chronicle):

http://www.sfgate.com/webdb/homepricesdrop/

Choose a zipcode and the database will tell you what percentage of homes are currently underwater (i.e., are worth less than the amount owed on the mortgage). It will also tell you what percentage of sales have resulted in losses within the last year.

According to Zillow, 7% of San Francisco homes are currently underwater, while 15% of sales within the last year were for less than the sellers had originally paid. Those numbers don't seem alarming. For the greater Bay Area, however, Zillow estimates that 21% of homes are underwater, and that 47% of sales were for less than the sellers had originally paid.

That seems like a recipe for a continuation of the downward spiral of Bay Area home prices. (You can get a summary of the other Bay Area counties by viewing this online map.)

An Interesting Map from the New York Times

I'm not a fan of blogs that reprint other people's material, but this map from the New York Times is worth spreading around. It shows the percentage of homes in each state that are worth less than the amount owed on their mortgages. According to the map, 27% of the homes in California are 'underwater'.

Supply Constraints Won't Save San Francisco

"San Francisco prices will never go down because you can't build here." That was a popular theory when the housing market was hot. Even now, many people seem to believe that supply constraints will protect San Francisco from the nationwide housing bust. Never mind that San Francisco prices have already fallen almost 20% from their peak. The theory never made sense in the first place because it was based on muddled economics. Prices are determined by the interplay of supply and demand, not supply alone. You don't have to go far from San Francisco to see what I mean.

Between 2000 and 2007, the San Francisco housing stock increased by 11,300 units, or roughly 3.3%. During the same seven-year period, the housing stocks in Alameda, Marin, and San Mateo Counties increased by 4.5%, 3.2%, and 2.4% respectively. Those are small numbers, all of them in the same ballpark as San Francisco. If supply constraints alone were sufficient to prop up housing prices, we'd expect these other counties to have held up as well as San Francisco.

Here's what actually happened. According to the California Association of Realtors, as of September of 2008, the San Francisco market had fallen by 19% from its peak. Relative to their own peaks, Alameda, Marin, and San Mateo Counties had fallen by 37%, 29%, and 25%, respectively. In other words, despite similar rates of new supply, these markets all performed worse than San Francisco, Alameda much more so.

There's no mystery about what happened to the Alameda County market - it was swamped by a wave of foreclosures. (Foreclosure sales accounted for almost a third of Alameda County resale activity during August.) But that happened even though the supply of new housing in Alameda County was almost as limited as in San Francisco.

I'm not saying that San Francisco is due for a fall. But the notion that supply constraints will protect it from the housing bust is wishful thinking.

Note: The housing stock data were obtained from the Census Bureau.

Consumer Confidence Takes a Hit

Turmoil on Wall Street doesn't usually filter down to Main Street, but few people living have seen the kind of financial market upheaval that we've experienced in the last couple of months. It seems to be having an impact on Main Street. The Conference Board reported yesterday that consumer confidence fell to an all-time low of 38.0 in October. The one-month decline in the index (-23.4 points) was the third largest on record. You can read the press release here.

Funny Forecasts and Vested Interests

In my posting on October 23rd ("The Future(s) of San Francisco Real Estate"), I said I'm skeptical of real estate experts because they often have built-in incentives to present the market in a favorable light. Here's a good example, which I'd forgotten about until today.

In February of 2005, David Lereah, chief economist of the National Association of Realtors, published this little gem of a book: "Are You Missing the Real Estate Boom?: The Boom Will Not Bust and Why Property Values Will Continue to Climb Through the End of the Decade - And How to Profit From Them".

For the record, new home sales peaked less than six months later, in the summer of 2005. The Case-Shiller 20-market composite price index peaked the following summer, in July of 2006. I've made my share of bad predictions but Lereah's was spectacularly bad and spectacularly self-serving.

It's not that I don't trust any experts. I read and respect the work of serious academics. All others, I take with a grain of salt.

Housing Inventory Drives Price Movements

In the long run, housing prices are driven by fundamental variables such as income and population growth on the demand side, and land availability and construction costs on the supply side. These variables generally move in predictable long-term trends. The recent housing bubble suggests, however, that long-term trend variables are not the only factors that drive housing prices. If you're thinking about buying or selling a home within the next year or so, it would be nice to have a near-term price forecasting tool.

Take a look at the chart below, which compares the beginning-of-year inventory of single family homes in California to the change in median real price during that same year.

Inventory is stated as the number of months required to sell the current stock of for-sale housing, assuming that selling activity remains at current levels. I plotted it using an inverted scale in order to highlight the correlation with price changes.

The apparent strong relationship between the two series will be easier to understand if you consider what the inventory variable is really measuring. Months-of-inventory is a ratio, whose numerator is the number of houses currently for sale; in other words, the numerator is a measure of housing supply. The denominator is the current monthly rate of sales; in other words, it's a measure of housing demand. The combined ratio provides a snapshot of the balance between supply and demand. We shouldn't be surprised, therefore, to see a strong relationship between this ratio and subsequent near-term price movements.

Real estate practitioners often assert that the housing market is equally balanced between buyers and sellers when there is six months worth of inventory. The chart bears this out. In years when the beginning-of-year inventory was less than six months, the average increase in median real price was 11.6%. In years when the beginning-of-year inventory was greater than six months, the average increase was -1.7%.

This isn't a recipe for quick riches. For starters, housing bubbles are rare occurrences; it may be awhile before we see another year of 20% price increases. Remember also that buying or selling a home involves large transaction costs. When you account for those, a buy/sell strategy based on months-of-inventory is unlikely to yield substantial profits. Nonetheless, if you're planning to buy or sell a home within the next year, it seems wise to keep this basic supply/demand snapshot in mind.

The inventory of single-family homes in California was roughly 12 months at the beginning of 2008. The most recent figure was 6.7 months, as of August (although that’s not a seasonally adjusted figure). In light of what's happened in financial markets since then, my guess is that inventory has increased significantly. That suggests that home prices will be soft in the coming months. (Before you panic, remember that the average real price decline in high-inventory years was only 1.7%.)

By the way, you may be curious about the relationship between months-of-inventory and long term price changes. Months-of-inventory is sensitive to short-term factors such as interest rate fluctuations, recessions, and stock market turmoil. That’s why it correlates with near term price changes. For precisely the same reason, however, it is unlikely to predict long term returns.

The Future(s) of San Francisco Real Estate

What does the future hold for San Francisco real estate prices? I'm skeptical of 'expert' opinions, especially since real estate experts often have built-in incentives to present the housing market in a favorable light. (Real estate agents and mortgage brokers make a lot more money when the housing market is strong.) There's at least one group of opinion makers, however, who are financially incentivized to make accurate predictions about home prices. I'm talking about the people who gamble in the housing futures market.

The chart above shows the recent history of home prices for San Francisco and the greater Bay Area. The San Francisco data series (solid blue line) comes from Data Quick, and runs through August, 2008. The Bay Area data series (dashed purple line) comes from S&P/Case-Shiller, and runs through July, 2008. The purple diamonds come from the CME futures market, and represent futures market predictions for Bay Area home prices; that series runs through May, 2009.

Futures markets enable investors to sign contracts today for financial transactions that they intend to execute in the future. A typical futures contract locks in the price and terms of a transaction, but specifies that the money and goods are to be exchanged at a future date. You might enter into a futures contract if you were a farmer who wanted to lock in the sale price for some crops that you had just planted. If market prices fall between the time that you sign your contract and the time that you deliver your crops, you will have 'won' your futures bet. (Your contractually agreed sale price will be higher than the market prices that prevail at harvest time.) On the other hand, if market prices rise, you will have 'lost' your futures bet. (If you hadn't signed the contract, you could have sold your crops at a higher price.)

The housing futures market works much the same way. People who transact in this market are essentially making bets on the direction of housing prices. That doesn't make them experts. (The recent turmoil in the banking system should persuade you that even experts can be badly wrong about asset prices.) However, futures market players do have strong financial incentives to make accurate predictions about the direction of housing prices. Furthermore, these predictions take the form of publicly displayed and continuously updated futures prices, rather than fluffy language couched in caveats.

The latest futures prices imply that Bay Area housing prices will fall by another 10% between now and May, 2009. That would take housing prices back to the same level as at the beginning of 2002. (For what it's worth, that's largely consistent with other 'expert' opinions.)

By the way, the chart shows that San Francisco home prices have held up well by comparison with the rest of the Bay Area. All kinds of reasons could be offered to justify this state of affairs; I won't get into that right now. But before you dismiss what's going on in the rest of the Bay Area and say it-can't-happen-here, ask yourself if that doesn't sound like wishful thinking.

Note: The S&P/Case-Shiller indices can be found by clicking here, and the CME futures prices can be found by clicking here.

The Hidden Cost of Renting

I often hear people (especially real estate agents) say, "As a homeowner, you get the benefit of price appreciation." Technically, that statement is true but it needs some interpretation. For starters, how do you benefit from price appreciation if you never sell your house? If you live to 100 and die in the house that you bought 50 years ago, does that mean that you lost the homeownership gamble?

Not by a longshot. As a homeowner, the bulk of your housing cost (namely, interest on your loan) is fixed for life. As a renter, on the other hand, you can expect steady rent increases for the rest of your days. (Yes, I know San Francisco has rent control, but what if you decide to move?)

The chart below compares median rent to median household income for the Bay Area. There is obviously a strong correlation between the two data series. That's to be expected in a densely populated region like the Bay Area. As incomes rise, people naturally demand more housing. Zoning restrictions limit the supply of new construction, however, so higher demand leads directly to higher rents.

Over the 38-year period represented in the chart, rents and incomes both increased by more than 600%. In contrast, if you had been a homeowner for that same 38-year period, your only cost increases would have been associated with marginal items such as insurance and property tax. Those are not insignificant items, but they'll start to look that way after 20 or 30 years of 5% rent increases.

Now to be honest, rents probably won't increase at a 5% annual rate in the future. The Federal Reserve is unlikely to repeat the mistakes of the 1970's, so inflation is likely to be lower than it was in the past. Let's assume it will be 2.5%. If that were the end of the story, we would conclude that rents are likely to increase by 2.5% per year. However, median incomes in the Bay Area have generally grown faster than inflation, by about 1% per year. (That makes sense. Improvements in technology lead to higher productivity, which leads to higher income even after accounting for price inflation.) All told then, rents are likely to increase by 3%-4% per year. Over a 20-year period, that translates to a cumulative increase of somewhere between 80% and 120%. Over 30 years, the cumulative increase will be between 140% and 320%.

That's the hidden cost of renting. It's also the true benefit of owning, at least in a financial sense. While owners get to lock in the bulk of their housing costs when they close escrow, renters can look forward to a lifetime of rent increases. When projected out over 20 or 30 years, the impact of those rent increases will be measured in multiples, not percentages.

Stock Market Fallout

On October 13th, I said that stock market turmoil would force many prospective home buyers out of the market. It turns out, on the same day I wrote that, the online discount broker Redfin announced that they were laying off 20% of their staff. Here's what they said:

Today Redfin laid off roughly 20% of our employees.

Unlike other startups, our industry’s recession started a year ago, when home prices first plunged.

Since then, we’ve fought like starving animals, and with some success: while industry-wide transaction volumes dropped 33%, we grew revenues by nearly 50%. Traffic grew more than 300%.

Even a month ago, we were raising 2009 revenue projections. All our markets, now including Chicago, contributed profits.

But the past few weeks have seen a major reversal. As the stock market wiped out prospective down-payments, tours and offers dropped 30%. Transactions that were done came undone. October will still be pretty good, then we’re headed for a big dip.

http://blog.redfin.com/blog/2008/10/a_very_tough_day.html

Let's hope the stock market stabilizes soon.

Rents and Real Estate Prices

In the long run, home prices should move in tandem with rents. Or so the theory goes. As anyone who is reading this blog probably knows, Bay Area home prices grew much faster than rents for most of the last decade. That's the main reason why some people claimed that we were experiencing a bubble: Owning a home became so much more expensive than renting that nobody would buy a home unless he expected prices to continue rising rapidly.

Indeed, now that home prices are headed down (at least in most parts of the Bay Area), the buying panic has subsided and many buyers have moved to the sidelines. And as long as prices continue heading down, buyers have a strong incentive to remain on the sidelines. (The logic of bubbles works in reverse when prices are falling.) At some point, however, prices will stabilize and buyers will face a difficult question, namely, how do you determine the fair value of a home?

I won't address that question directly today. (I'll get back to it soon enough.) Instead, I'll take an indirect approach that requires some heroic assumptions, but has the virtue of being quick and dirty. Consider the chart below, which shows the Case-Shiller home price index for the San Francisco metro area, adjusted to remove the impact of inflation.

Even after the recent plunge in the housing market, inflation-adjusted (i.e., "real") home prices are still far higher than they were ten years ago. By itself, however, that observation doesn't say much about the "fairness" or "correctness" of current housing prices. The main reason is that rents are higher now than they were ten years ago. How much higher? I don't have a good historical rent series at my fingertips, but academic studies have found that real Bay Area rents have increased by around 1.5% per year over the last several decades. (There are good reasons to expect that result, but that's a story for another day.)

The chart includes an artificial "rent" index, set to equal the initial (1987) value of the Case-Shiller home price index. The rent index is artificial because it does not purport to track actual rents, but is instead constructed so that it grows by exactly 1.5% per year. Since real rents have grown at roughly the same rate, the artificial index should track historical rents fairly closely, although of course it won't reflect fluctuations around the historical trend.

Over the 21-year period from 1987 to now, Bay Area home prices have increased faster than rents, even after accounting for the recent downturn in the housing market. That’s indicated in the chart by the deviation of the home price index from the rent index. The home price index has increased by 68% (in inflation-adjusted terms) since 1987, while the rent index has increased by only 36%. If you assume that homes were fairly valued in 1987 -- a truly heroic assumption -- then the chart suggests that they are still overvalued by about 23%, even after the dramatic price declines that occurred in most parts of the Bay Area.

Is San Francisco vulvernable after all?

I'm not saying that the sky is falling, but San Francisco real estate may be vulnerable after all. Prices and sales volumes have both been falling for the last several months. Take a look at Chart #1, below, showing median sale prices for condos in San Francisco.

Chart #1: Median condo sale price, by month

Condo prices have been trending lower for the last four months, and are now almost 15% lower than they were in May. The median price for September (the latest available) is the lowest result in almost two years.

By itself, that doesn't mean much -- monthly prices are volatile, after all. However, sales volumes have been trending lower as well, while inventory has been trending up. Take a look at Chart #2, below, showing sales volumes and inventory levels for condos in San Francisco.

Chart #2: For-sale inventory and recent sales, compared

(San Francisco condos, by month)

The inventory of for-sale listings at the end of September was at its highest level of the last two years. Meanwhile, except for the two (seasonally low) January entries, total sales for September were at their lowest level of the last two years. The scale of the chart may obscure the degree of deterioration in sales volumes, so here are some numbers:

- September 2006 total sales: 182
- September 2007 total sales: 149
- September 2008 total sales: 119

So the recent level of sales activity is 20% below its level of a year ago, and 35% below its level of two years ago.

Real estate practitioners often combine inventory and sales volumes into a single statistic, by taking the ratio of for-sale inventory to the most recent monthly sales volume. The result is an inventory figure measured in months, i.e., the number of months required to clear the current inventory, assuming that recent sales activity remains constant. Chart #3 shows the number of months of inventory for San Francisco condos.

Chart #3: Months of inventory for San Francisco Condos

Inventory has been trending up recently and is now above six months -- a level that is commonly held to be consistent with a buyer's market. That's a recent phenomenon, which hasn't been seen in the last decade. (You'll have to take my word for that -- I don't have the data at my fingertips.)

To summarize:

- Prices have been trending down for four months, and are now at their lowest level in almost two years.

- Inventory (measured in months of sales) is at its highest level in a decade.

Again, I'm not trying to sound any alarms. But we may be seeing indications that San Francisco is not immune to the nationwide housing downturn. I'll have more to say about this in my next blog entry.

Welcome to my new blog!

Welcome to my new blog! I'm a San Francisco real estate agent and investor. This blog will focus on Bay Area real estate, but will also take detours into finance and economics, which are my other strong suits.

Let's get started.

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If you live in San Francisco, you may be surprised to learn that most Bay Area housing markets have fallen significantly from their peaks. According the CAR, as of August of 2008, median home prices in six of the nine Bay Area counties have fallen by over 30% from their peak values. In contrast, the San Francisco market has held up pretty well. Median prices here have changed hardly at all in the last year, and are still within 10% of their peak, which occurred in May of 2007. That may be about to change, however, as a result of the recent stock market turmoil.

The stock market has fallen dramatically in recent weeks, and is currently around 35% below its 52-week high. Even including today's 11% gain, it is still 20% below its level of just 30 days ago. What will this do to the San Francisco housing market?

Let's consider a hypothetical buyer who’s looking for a $700,000 condo. With solid credit and fully documented income, he should be able to purchase his condo with only $70,000 (i.e., 10%) down. I say 'only' $70,000, but that's a substantial amount of money. Most people with that kind of money will have a least some of it invested in the stock market. Let's say it's 50%. That's $35,000. Or rather, it was $35,000. In the last month, that $35,000 balance will have declined to around $28,000, meaning that our buyer now has only $63,000 to put down. Unless he has additional cash to cover his $7,000 loss, his maximum purchase price will now be $630,000, not $700,000.

If you've ever had your heart set on a $700,000 condo, and have then been told that you'll have to settle for a $630,000 unit instead, you'll realize that this transition will not go smoothly. Any serious buyer can readily distinguish a $700,000 condo from one that's worth only $630,000. Many of these people are likely to bow out of the market, at least temporarily, rather than settle for a unit that they wouldn’t even have considered a month ago. That will lead to a painful period of slowing sales and declining prices.

This cartoon picture does not apply to every buyer. For starters, some will have much more than $70,000 to put down on their $700,000 purchases. And of course, this is all subject to change as stock prices fluctuate. But if today's dramatic stock market bounce is a one-off event, then look for continued slowing in the San Francisco market.