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.