The rise in pricing of California real estate has caught many observers off guard and has caused many to wonder aloud if the high numbers are sustainable or just another speculative bubble waiting to burst. If you have been following the numbers this week, you know that it’s been reported that sales are up 15% year over year and prices are up 19% during the same period. Sounds pretty unbelievable right? There are several explanations so let me try to address them.
First, sales are up for a variety of reasons and it is not investors as many pundits have suggested. Investors were the driving force of sales activity when no one else was buying. Distressed properties made up more than 35% of all sales and deals could be had. Cash buyers scooped up homes at the foreclosure auction at the courthouse steps; they bought door to door from people who were underwater and the bought short sales. Most sophisticated investors do not buy homes at market value, there’s just not enough profit given the risk (risk-reward). If they are “flippers” they have to buy at .80 cents on the dollar or better, to have enough margin to account for rehabbing and selling costs. What about rentals? In California the average rate of return for a property purchased and held as a rental, is about 5%. Not bad when compared to the rates of return from your local bank, but not exactly a number that is going to drive every mom and pop with a few hundred thousand in disposable cash, into real estate. Sure there are folks buying for the 5% return, but don’t believe for a minute that these investors are driving the market up 19%.
Second, to analyze the numbers, one first must understand what the 19% rise in value represents. This is a median number. A median number is the line at which half the homes sold sell for more and half for less; that is the median. This is different from the average which combines the total gross dollar sales numbers and divides by the number of sales. The thing about a median number is that it can be moved with the simple increase in sales of one price range or another. In other words, if more low end homes are selling which was the case with all the distressed properties, the sheer volume of lower end homes “pulls” the median down. Conversely, if suddenly there are fewer distressed properties selling and in addition a greater number of higher priced properties selling, the median gets “pushed” upwards. This has been the case over the past several months and explains why the year over year number is so large at 19%.
Third, that’s not the whole story, for in fact homes are also appreciating and they are doing so at an incredible clip. Why? Demand is exceeding the supply of available homes and that fundamental market force is driving up the price. How much? Try 2% over the past month. The affect on the median of fewer distressed properties explains the year over year price change as I’ve explained, but a 2% month over month is pure market dynamics at work. Some are suspecting it’s speculation; it may be a frenzy, but it is not people “speculating” that prices are going to rise so they will buy now for a quick profit later.
Forth, why is demand exceeding supply to the point that we are appreciating at 2% a month? This is a more complicated answer because there are several forces at work. First, interest rates are at an all time low. In conjunction with a nearly 30% decline in value since the bubble’s peak, home affordability has never been greater. Second, there has been a dearth of home building over the past 5 years in areas and cities that have seen a rise in population rather than a decline; fewer homes manufactured to met a rising demand. Third, many people either owe more on their home than it’s worth, thus making selling not an option or they simply don’t have enough equity (yet) to sell and have a down payment on a replacement property. This is partly due to the decline in equity positions paralleling the drop in overall value but also is a reflection on the tight lending standards we have today which largely require 20% down. Remember, since the mid 1990’s, many folks bought with 5 or 10% down and even if they had put aside an equivalent down payment through personal savings or by paying down their existing mortgage, in most cases today, they need 20% to purchase because the rules the lenders are using have changed. This in turn makes those folks stay put, not list their home for sale and further constrain supply. Forth, because there are fewer homes for sale, finding a replacement property, even if you have the required down payment, is exceedingly difficult. Thus, would be sellers, looking at available inventory conclude, now may not be the best time to sell since they really don’t want to be homeless because there’s nothing for them to buy. So they too, don’t put their home for sale, constraining supply even further.
In looking at the numbers here along the Los Angeles/Ventura County line, our inventory is below levels of 2003-4 for this time of year, when like today, homes were appreciating at a 1-2% a month clip. So are we in a bubble? No. Consider the stock market in spring 2009, the DOW hit 6500. Today it’s over 13,000. Have businesses improved their bottom line by 100%? Is the economy 100% stronger? Of course not, but the market over reacted during the sell off and has bounced back to find its equilibrium. Housing is no different and will do the same. The 30% drop in California property values, particularly in the population centers, was an overreaction and now the market is doing what any market does, finding it’s point of balance. Are we there yet? No, and likely not even close. When will we know we are close? When people can sell their home and freely buy a replacement property with relative ease. Until then, expect continued month over month appreciation, because the pendulum always swings too far one way – and we swung pretty far to the negative, and right now things are swinging back.