San Francisco Apartment Rents Falling Rapidly

Near-term fluctuations in apartment rents have little impact on long-term housing values. But they do offer a useful window into the health of the local economy. The view from that window doesn't look good right now. Take a look at the chart, below, which comes from SFRentStats.

The data comes from Craigslist, and covers the City of San Francisco.

Rents have fallen by about 20% since the spring of 2008. That doesn't mean that the sky is falling. Even after the decline, rents are no lower than they were two years ago, when the economy was generally thought to be on solid footing. As long as rents are falling, however, it will be difficult to argue that the San Francisco economy has turned the corner.

Price Declines Likely to Push Foreclosure Rates Higher

Why do homeowners default on their mortgages? Researchers generally focus on two main reasons: job losses and price declines. Job losses directly impact default activity, because they reduce borrowers' ability to service their mortgages. In contrast, the main impact of price declines is to reduce borrowers' incentives to service their mortgages. Which of these two reasons is more important?

Let's consider two scenarios. In scenario 1, the borrower loses his job but still has positive equity in his home. In this case, he may be unable to continue paying his mortgage, but he can preserve his equity (and his credit rating) simply by selling his home. Default is therefore unlikely.

In scenario 2, the borrower keeps his job but the market value of his home falls below the outstanding balance on his mortgage. In common parlance, the borrower is 'underwater' on his mortgage. If he falls far enough underwater, he may make a purely financial decision to walk away from his home, rather than continue paying his mortgage. Default therefore becomes increasingly likely as the value of the home falls, even though the borrower’s ability to service his mortgage remains unchanged.

The Great Recession has brought job losses as well as home price declines. To some extent, the two effects have fed on each other: Job losses have resulted in lower demand for housing, which has led to price declines; and price declines have resulted in lower housing construction, which has led to job losses. Nonetheless, the scenarios considered above suggest that an underwater borrower is a bigger default risk than a borrower who has simply lost his job. This is borne out by recent default activity in the Bay Area.

Consider the chart, below, which compares default rates for the first quarter of 2009 (vertical axis) to the percentage of mortgages that were underwater in November of 2008 (horizontal axis). Each dot represents one of the nine Bay Area counties.

The relationship between the two variables is clearly strong, and seems to indicate that being underwater is an excellent predictor of the likelihood that a borrower will default in the near term. (Note: Information on default activity was obtained from Dataquick. Information on underwater mortgages was obtained from Zillow, by way of the San Francisco Chronicle.)

Since I don’t have ongoing access to data about underwater mortgages, I thought it would be useful to create an alternative version of the chart above, using recent price declines as a proxy for the percentage of mortgages that are underwater.

The vertical axis shows the Q1 2009 default rate for each county, as before. The horizontal axis shows a measure of the recent price change for each county. (Using the average price for the three-year period from July, 2005 to June, 2008 as a base, I calculated the percentage change in price through the end of 2008. I reversed the axis to facilitate comparison with the first chart, above.)

The relationship isn’t as strong as before, but still seems compelling. In a future blog posting, I’ll develop a better proxy for the percentage of mortgages that are underwater. For now, I’ll point out that prices have continued to fall in every county except Marin (where they’ve risen by a meager 3% since the end of the year) and San Francisco (where they’ve remained flat). The wave of foreclosures in the Bay Area therefore seems likely to continue building for some time to come.

Foreclosure Rate Probably Won't Improve for Another Year

The Mortgage Bankers Association (MBA) released its latest National Delinquency Survey last Thursday. The seasonally adjusted delinquency rate for the first quarter of 2009 was 9.12%. That's the highest rate in the history of the MBA survey, going back to 1972.

The delinquency rate does not include loans that are in foreclosure. At the end of the first quarter, 3.85% of loans were in foreclosure. The combined first-quarter total of loans that were either delinquent or in foreclosure was 12.07%, which is also a record going back to 1972.

Here's an excerpt from the MBA press release:

"Looking forward, it does not appear the level of mortgage defaults will begin to fall until after the employment situation begins to improve. MBA’s forecast, a view now shared by the Federal Reserve and others, is that the unemployment rate will not hit its peak until mid-2010. Since changes in mortgage performance lag changes in the level of employment, it is unlikely we will see much of an improvement until after that."

Foreclosures have a major impact on the supply side of the housing market, as I've discussed in the past. My guess is that their impact will grow even larger in the next year.

Rising Home Sales Are Not a Harbinger of Housing Market Recovery

Commentators have been focusing on rising home sales as an indication of health in the Bay Area housing market. But those rising sales have been accompanied by sharply lower prices. Or to put it more accurately, rising sales have been caused by sharply lower prices. Take a look at the chart, below, which provides a schematic picture of what I'm talking about.

Market equilibrium occurs when supply equals demand. This is indicated in the chart by the intersection of the solid blue and purple lines. The supply of for-sale homes has risen significantly over the last year or so, due to heavy sales of bank-owned homes. This is indicated in the chart by the dashed blue line, which sits to the right of the original supply curve.

As long as demand is stable, you can always sell more of your product if you reduce the price. Falling prices do in fact seem to have stimulated demand for homes in the Bay Area, suggesting that demand may be stabilizing. That's better than falling demand, but it's hardly a sign of recovery. A true recovery in the housing market will be marked by rising demand.

How will we know when that happens? In the schematic picture above, rising demand would be indicated by moving the demand curve to the right.

The new equilibrium is marked, not only by higher sales, but by higher prices as well. The picture won't be quite as simple if supply is still rising (then the blue line would move to the right as well), but you get the idea by now. As long as prices are still falling, it will be difficult to argue that the housing market is recovering.

Continuing Deterioration in Residential Construction Bodes Poorly for the Economy

The Commerce Department just released its April report on new residential construction. Housing starts fell to a 50-year record low of 458,000 units. That's 13% lower than the figure for March, and 54% lower than the figure for April of last year. The number of permits for new construction also fell to a record low of 494,000. That's 3% lower than the figure for March, and 50% lower than the figure for April of last year.

The recent declines in housing starts and permits are wholly the result of reduced activity in the multi-family (apartment) sector. Many writers have made much of the fact that single-family activity is actually picking up (however slowly). That seems like wishful thinking. Demand for housing won't recover as long as the economy is losing jobs at a rapid pace. And residential construction activity has actually been a very good leading indicator of overall economic activity. Continuing rapid deterioration in this sector suggests that the broader economy is still deteriorating, and that an upturn in housing demand is still some ways off.

Report Shows Continuing Weakness in City Economy

The San Francisco Controller's office just released the March edition of its Monthly Economic Barometer. It's a great place to find quick-and-dirty statistics about the City's economy. The latest batch of numbers are discouraging:

• The March unemployment rate was 9.0%. That's the highest rate since 1984. A year ago, the unemployment rate was 4.3%.
• The median home price fell 3.6% from February, and 19.3% from last year. (The current median price is $617,000. The record of $835,000 was achieved in May, 2007.)
• Apartment rents fell 1.6% from February, and 8.1% from last year.
• Commercial rents fell 13% from February, and 22% from last year.
• Hotel occupancies fell 5% from February, and 14% from last year.

Those are the highlights. The rest of the report is equally disheartening. You have to be dyed-in-the-wool optimist to find any good news in it.

If you want to read the next Monthly Economic Barometer when it comes out, you can find it here.

Deterioration of the High End Housing Market

The Chronicle ran a front page story about the Bay Area housing market in Sunday’s paper. The gist of the story was that the high end of the market is showing signs of distress, and is beginning to deteriorate.

The article was partially correct: there has indeed been a notable change in the high end of the market, but it’s premature to attribute that change to distress. And it’s inaccurate to claim that the high end of the market has only recently begun to deteriorate.

Let’s start with what’s happened recently. Take a look at the chart, below, which shows historical listing activity for single family homes in District 7 (which is a good proxy for the high end of the San Francisco market).

The blue bars indicate the number of new single family home listings in each year. (The figure for 2009 was obtained by annualizing year-to-date listings through the end of April and applying a minor correction for seasonality.) The purple line indicates the median asking price for those new listings. Together, these series provide a historical overview of the supply side of the market.

After several years of restrained activity, listings in District 7 bounced back strongly in the first four months of 2009. Meanwhile, asking prices continued their recent downward trend. The latter observation suggests that the sharp increase in listing activity is being driven at least partially by recent economic turmoil, rather than any renewed sense of opportunity. Keep in mind, however, that the number of listings is high only in comparison with the last few years. When compared to pre-2005 levels, listing activity is merely average. So it seems premature to conclude that owners of high-end homes are suffering from financial distress.

So much for the supply side of the market. What about demand? Contrary to what the Chronicle article suggested, demand for high end homes has been deteriorating for at least two years. Take a look at the chart, below, which shows historical sales volumes for single family homes in District 7.

Sales volumes in District 7 have fallen in every year since 2004. As long as prices were rising, declining sales could be attributed to higher asking prices (i.e., tighter supply). When prices began to decline in 2007, however, it became clear that demand was declining as well. (See this earlier posting for a cartoon picture that lays out the reasoning.) The rate of deterioration appears to have accelerated in 2009, but it’s incorrect to suggest that demand is only now beginning to suffer.

The inventory of high end for-sale homes in the Bay Area has climbed significantly in the last year, and now exceeds a year’s worth of supply. The Chronicle seems to have attributed the higher inventory entirely to the sharp increase in listing activity. If the rest of the Bay Area is like San Francisco, however, the increase in listing activity has merely returned listings to a level that would have been considered normal a few years ago. It therefore seems premature to conclude that high end sellers are ‘distressed’. And by ignoring the steady fall in demand over the last two years, the article reaches an overly dramatic conclusion, namely, that distress has suddenly overtaken the high end of the market. The reality is less exciting than that.