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.