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.