Bay Area Housing Permits Near 30-Year Low

Permits for construction of new Bay Area housing units hit a 30-year low in 2009. Activity has rebounded since then, but 2010 is still on track to be the second-worst year for Bay Area housing construction since at least 1980.

I annualized the July year-to-date figures to get an estimate (roughly 7,000 units) for calendar 2010. That's less than half of the 30-year average of around 19,000 units. Although I didn't show it in the chart, the pattern of permit activity is nearly identical in each of the three main metropolitan areas of the Bay Area, i.e., Oakland, San Francisco, and San Jose.

Hotel Room Rates at Lowest Levels in Twenty Years

Here's a quick snapshot of the business climate in San Francisco. The average daily rate for San Francsico hotel rooms is at its lowest level (in inflation-adjusted terms) in twenty years.

Note: I've used the Consumer Price Index to convert historical room rates to 2010 dollars.

Occupancy rates have actually been running well above average. In that kind of environment, room rates usually rise quickly. My guess is that the mix of hotel guests has changed during the recession, with price-sensitive tourists replacing high-paying business travelers. If so, then San Francisco's business climate is soft indeed.

Foreclosure Activity Has Limited Impact on Home Prices

Homeowners who are underwater on their mortgages often make ‘strategic’ decisions to walk away from their homes. Take a look at the chart, below, which is an updated version of one that I first presented in June 2009.

The vertical axis shows the annualized default rate for the three month period ending in August, for each of the nine Bay Area counties. The horizontal axis shows the percentage change in price through May, measured relative to the three-year period from July 2005 to June 2008 (i.e., the bubble years).

Note: I reversed the horizontal axis to make the chart easier to read. Ideally, it would show the percentage of homes that are underwater. I don’t have detailed data on underwater homes, however, so I used the change in price relative to the bubble years as a proxy for the percentage of homes that are underwater. You can read more about this proxy for underwater homes here and here.

The relationship between the two variables is clearly strong, and supports the idea that underwater homeowners are making cold-blooded decisions to default, simply because they believe it’s in their interest to do so.

On the other side of the coin, there seems to be a widespread belief that heavy foreclosure activity depresses sale prices. If that’s true, then falling prices can lead to a self-reinforcing “doom loop” where underwater homeowners walk away from their homes, which then hit the market as foreclosures and depress prices even further.

Perhaps that story holds true in other markets, but there isn’t much support for it here in the Bay Area. Take a look at the chart, below, which compares recent price changes to REO sale activity for the nine Bay Area counties.

The vertical axis shows the change in median price over the last twelve months. The horizontal axis shows the number of bank-owned homes (REO’s) that have been sold during the same period.

REO’s accounted for more than 30% of all sales in five of the nine Bay Area counties. All but one of these counties outperformed San Francisco, where REO’s accounted for only 15% of sales. I wouldn’t call this an ironclad case but I don’t think Bay Area homeowners need to worry about foreclosures depressing property values.

Inventory Model Suggests California Housing Market Has Stabilized

Historically, the inventory of unsold homes has been a good predictor of near-term price movements. I first wrote about the correlation between these two series in October of 2008. At the beginning of that year, the unsold inventory of single family homes in California had been equivalent to 14.3 months of supply. That was well above the historical median of 6.3 months, suggesting that 2008 would be a weak year.

In fact, 2008 turned out to be an abysmal year, largely because of the developing financial crisis. Home prices already had fallen 27% by August (the most recent month available at the time of my posting) and went on to record a 41% decline for the year.

I’ve updated my October 2008 chart through July of 2010. The chart compares the beginning-of-year inventory of single family homes in California to the change in median real price during that same year. As you can see, with the notable exception of 2008 and to a lesser extent, 2007, the beginning-of-year inventory has been a very good predictor of subsequent price movements.

The California housing market seems to have returned to equilibrium over the last year or so, at least as far as the balance between supply and demand. 2010 began with an unsold inventory equivalent to only 4.1 months of supply. That's somewhat lower than the historical median, suggesting that 2010 will actually see modest price increases. In fact, the median price of a single family home in California had increased by around 5% through the end of July (the most recent month available). Even with the recent drop in sales activity (following the expiration of the first-time buyer tax credit) the unsold inventory of homes in July was still only 5.8 months. That's in line with the historical median, suggesting that the near-term outlook for California home prices is reasonably good.

Note: I plan to do a similar analysis for San Francisco, but it will take some time. The unsold-inventory data that I had been using for San Francisco appears to be unreliable.

San Francisco Rents Are Firming Up

Rents in the City appear to be firming up. Take a look at the chart, below, which shows a history of the median asking rent per room in San Francisco.

The chart comes from SFRentStats. Unfortunately, I don't have a free source of actual (contract) rents, but asking rents should provide a reliable proxy.

The Bay Area job market stabilized in the spring of 2009. It's no surprise, therefore, that the rental market is also showing signs of stability. And because prospective home buyers generally make cost comparisons between renting and owning, stability in the rental market tends to foster stability in the purchase market. That's one of the reasons why I don't think home prices will fall appreciably unless the job market takes another dive.

Bay Area Home Prices Are Within 15% of Long-Run Equilibrium

My favorite way to assess 'fair value' for home prices is to compare them to rents. On that basis, Bay Area home prices appear to be about 15% higher than they 'should be'. Take a look at the chart, below, which shows Bay Area home prices, rents, and median household incomes for the period since 1975.

Note: You can find descriptions of the data series here.

After briefly reaching a level consistent with long-run equilibrium, Bay Area home prices began climbing again in the spring of 2009. Prices have increased by about 18% since then, and are now somewhere between 10% and 15% above equilibrium.

In my last post, I said that prices probably won't fall appreciably as long as the unemployment rate holds steady. How is that consistent with prices being 15% above equilibrium?

There are two ways for the relationship between prices and rents to adjust: prices can fall or rents can rise. Historically, rent increases have been the dominant adjustment mechanism. For instance, between 1990 and 1996, the price-to-rent ratio fell by 21 percentage points but price declines were responsible for only 8 percentage points of that adjustment; rent increases accounted for the rest. I expect a similar pattern of adjustments this time around.

Will Home Prices Fall Again?

The question I'm hearing most often at the moment is, "Do you think home prices will fall again?" My answer is, not unless the job market takes another dive. Take a look at the chart below, which shows the Case Shiller home price index and the unemployment rate for the Bay Area.

The current recession is unusual because it was brought on by falling home prices. Financial institutions and households both were highly leveraged at the peak of the housing market. As a result, their balance sheets suffered serious damage when home prices fell. Economic demand naturally fell, leading to the current recession. (As you can see from the chart, home prices began falling rapidly before unemployment started climbing. That's consistent with the idea that falling home prices caused the recession.)

That's not the normal pattern. Normally, job losses lead to falling home prices, as in the last recession. When the job market stabilizes, home prices tend to stabilize as well. That's what happened in the last recession and it appears to be happening again. The job market stabilized around June of 2009 and since then, Bay Area home prices have increased by roughly 15%.

I wouldn't bet on continued price increases, but as long as the unemployment rate holds steady, my guess is that home prices won't fall appreciably from here.

Note: I didn't have time to make this case as strongly as I'd like. I'll have more to say about it soon.