On Bay Area Residential Real Estate

I've spent the past months closely studying the residential real estate market in the Bay Area. Like many people, I've been flirting with putting (what's left) of my money into income properties given the relative unattractiveness of the equity and bond markets. I believe that it is not only a terrible time to purchase anything in the Area but, if I owned property now, I would sell it and reap any profits I could. Overall, I believe several factors/signs will cause supply to increase, while demand will be decreasing, thus causing a significant decline in prices. Eventually, the decrease in prices will reach a tipping point where a panic sell will ensue, causing a crash similar to what we saw in the stock market.

The signs as I see them:

Decreasing demand:

-- People are moving out and losing their jobs. Layoffs are still happening at an alarming rate in the Bay Area. Unemployment is now at 7.7% in San Jose proper. The loss of jobs has resulted in a 30% increase in foreclosures (http://www.sfgate.com/cgi-bin/article.cgi?file=/c/a/2002/10/31/MN52875.DTL). Challenger, Gray & Christmas, a Chicago-based outplacement firm, states that dot-com layoffs were 51,564 nationwide by the end of April, up 37 percent from the previous record set in January. U-Haul statistics show that 12.7 percent more people moved out of San Francisco than moved in from March to mid-April, while 43 percent more moved out of Mountain View and Palo Alto in Silicon Valley.

-- The high cost of doing business in the Bay Area also means that more companies are incented to move work to cheaper locales. This trend is increasing significantly.

-- Misaligned buyer motives. Most people I speak with see now as a terrific time to buy real estate because capital is so cheap. Mortgage rates dipped below 6% for the first time in decades. Unfortunately, people are buying because the cost of capital is low and because the stock market stinks, NOT because they believe that prices are advantageous. This is a mania phoenomenon similar to what happened to the stock market in the 90s. Interest rates must eventually rise.

-- Quality of Life/Terrorism. Sadly, I believe that many folks will be moving from the area in search of higher quality of life and (perhaps subconsiously) to escape the potential threat of a terrorist attack in the area. Clearly, San Francisco has to be on the Top 10 Hit List of many potential terrorists. Big city life now has an added danger and many people will be motivated by that.

-- Decreasing rental rates. Cheaper rent means people are going to be less incented to buy. This Craigslist graph demonstrates how rental supply is increasing. In fact, rents in SOMA San Francisco have dropped by 75% in some properties.


Increasing Supply:

-- Landlords are motivated to cash out. The misalignment of Rental Rates has reached pretty epic proportions in the area. To illustrate, I looked at dozens of properties for sale in San Francisco. In general the asking price would generate a mortgage 2-3 times the monthly rental income for the property. In a healthy market (such as Stockton, CA), rental properties sell for prices that result in mortage payments 75%-100% of the monthly rental income for the average listed property. Bay Area Landlords are not stupid people. They are becoming incented to sell as rental rates go down.

-- Buildling starts have not gone done significantly. New housing starts decreased by 28% in 2002 relative to 2001 (as of early 2002). New homes are continuing to be built. Just drive down SOMA in San Francisco.


Some other worrisome signs to look at:

-- The book factor. Real Estate Howto Books are flourishing at bookstores now and many are in the Top 100 at Amazon.com. Border's has gone from a single shelf of books to an entire bookcase, which is 5 times larger in less than a year. A similar trend happened when stock market investing took off.
-- The median home price here is over 4 times the national average (over 400k versus about 100k). This is very similar to looking at the P/E (price to earnings ratio) of a stock. In the late 90's, P/E multiples were greatly out of whack and a crash ensued. In the case of the "earnings" of a residence, it's either the rental income or the "utility" an owner-occupant receives. In both cases, the ratio is incredibly out of alignment, further encouraging people to sell.

So, the market is going to tank, but how much? No one can predict the future, but my gut says that the Domino Effect seems to be the ultimate destiny for the area because people have so much of their net worth tied up in these homes. String a few $200k losses together and you start talking real money! As an interesting anecdote, one friend of mine has already taken a paper loss on his home in the Bay Area of over $100k, around 15% of his home value. He's able to handle that loss, but it's only a matter of time until people start to see these losses increasing and then release they need to get out as quickly as possible. Then, the crash ensues. As we've seen in the stock market, prices can't go up forever at breakneck pace. It's to be seen if the decrease will be soft or hard, but it's coming and my bet is on a crash.