Wednesday, June 19, 2013

Another housing bubble in the Bay Area

I moved to the Bay Area in 1994.
Source: Zillow.com

I bought my first house in 1996.

I sold that house in 2000 for more than twice what I paid for it, and moved up to Truckee, CA.

I moved back to the Bay Area in 2006 during the last housing bubble and felt that the market was overvalued, so I decided to rent.    I found a high end rental house and have been renting for the last 7 years.  I have saved roughly $600K in housing costs during that time vs owning the same house.

Record growth this year
The market this year is red hot.    Year over year home prices are up about 31%.    Across the street from me a developer built a 4,000 sqft house on a 8,000 sqft lot and sold it for $4 million.    The most expensive home on the street previously had been only $2.5 million.   The owner of the house I have been leasing noticed and has wisely decided to cash in on the current market, so now I need to find a new place to live.   I have been making the tour of houses in Menlo Park for the last two months and I'm exasperated.  Very average houses are going for well above asking price and land values are crazy.    Complete tear downs are selling for close to $2 million.  How does this make sense?    I created a spread sheet to try and analyze the market and see if it makes any sense.

According to Zillow the average house in Menlo Park is currently $1.46 million dollars, that is up from $1.04 million in May of 2011.   Keep in mind that these are averages and include condos and distressed properties and houses literally right next to highway 101.    The real truth is that you can't buy a "normal" house for less than $1.9 million and that "normal" house will be about 1,600 sqft.   The average cost per square foot is at or above $1000 sq/ft.   Any house that you might consider "fancy" is 3 million or more.

The recommended guidelines for housing costs are about 28% of after tax income.   In California, people are used to spending more income on housing so doubling the figure is about 55%.   I built a spread sheet that calculates the full cost of owning a home and will calculate the income required for 28%, 55% and 75% of income going towards housing.   The spreadsheet takes into account the mortgage interest tax deduction and the property tax deductions.

If I run the numbers for $1.46 million and $1.9 million here are incomes necessary to have 28%, 55% and 75% of income going to housing

Necessary income for $1.4 Million house
28.00%55.00%75.00%
$688,198.86$322,812.16 $221,766.95

Necessary income for $1.9 Million house
28.00%55.00%75.00%
$885,066.96$421,091.92 $292,782.77

Now lets look at the average income in Menlo Park.    Average income can be misleading since it also includes people who are not home owners.   The published average household income for Menlo Park is about $110,000.    If I dig a little deeper and take just the most affluent area of Menlo Park we can find that the household income for West Menlo is about $220,000.  (The data source is city-data.com)

So we can see that at $1.4 million the average household would be spending 75% of income on housing.   The real reality of $1.9 million would find that average household would have to spend 94.5% of their income on housing.

I think that it is pretty clear from the data that the average person cannot afford the average house right now.    But what does that mean?

What is causing the spike in prices
If the average person living in an area could not afford to re-buy the house that they are living in, what does that mean?   
  • The neighborhood could have a recent influx of new buyers that are more wealthy than the existing base.  (This is usually called gentrification)
  • Supply is constrained and this is temporarily pushing up prices.
  • Interest rates are about to rise and people are buying before they go up.
  • The Facebook effect?
  • The tulip craze is back.
Is it really Gentrification?
Gentrification is a possibility, but is it really happening?  How many people really make $885K a year?     Let's me more reasonable, lets allow for 55% of income for affordability, so the real question is how many people really make over $420K.    According to the IRS in 2010, 800,000 people in the US make $500K or more.   How many of them live in California?   I can't find a direct source for this, but we can estimate it.    According to the IRS in 2009 about 20% of Millionaires live in California.   If I generously estimate that 75% of them live in the Bay Area and not LA then we have about 15% of all the Millionaires living in the Bay Area.    That's 120,000 people (very approximately) in the Bay Area with household income above $500,000 per year.     So I guess this is  a possibility.  

Similar Neighborhoods in the penninsula:  (number of households)
  • Menlo Park: (12,000)
  • Palo Alto:   (25,000)
  • Atherton:   (2,500)
  • Los Altos:  (10,000)
  • Hillsborough: (3,600)
  • Los Gatos:  (12,000)
  • Woodside:   (2,000)
  • Total: (67,100)  peninsula only
Constrained Supply
This does seem to be a serious problem.   There just are not enough houses for all the people moving here.    Additionally, Prop 13 encourages people to stay in their homes and never move, so there is very little turn over in the market.   High prices combined with taxes hurt turnover as well.    If you are living in a house that is suddenly worth 2 million dollars it is very hard to sell because taxes will take half the proceeds.   Then you need someplace else to live and everything costs more than a million dollars.

Basic economics says that prices will go up if there is more demand than supply.    But how high and why now?    Supply has been a problem for the last 20 years.   Why is the market up 30% in one year?

Interest rates on the rise
I think the recent spike may be related to interest rates.   As interest rates climb the monthly cost of a home goes up substantially.    I did all my affordability calculations at 4% interest.   Here is a table of annual cost for a 1.9 million dollar house at different interest rates: 

4%5%6%7%
$146,000$160,000$173,000 $188,000

That equates to more than a thousand dollars a month in difference for each percentage point.    At 7% you would spend $42,000 more per year on the same house than at 4%.    If interest rates return to normal levels of 7% over the next few years, it should cool the market considerably.


Facebook?
There is more than 75 Billion dollars worth of new value in the Menlo Park area.   The vast majority of that is owned by a small number of people, but there are at least a few hundred new Millionaires in the last year.

Tulip craze?
Are we in another temporary bubble?    I really don't know, but I hope so.    Nobody benefits from sky high real estate prices, except the real estate industry itself.    Surrounding neighborhoods are also experiencing record setting prices.    The Zillow Palo Alto index is over $1.7 Million and even towns like Sunnyvale and Mountain View, which are traditionally far less expensive, are approaching $1 million.     Local companies will not be able to attract talent to the area if people can't find an affordable place to live.   Keep in mind that the national average for a house is $158,300.    I would never expect the Bay Area market to be average, but I would expect it to be closer to 5x the norm rather than 10x.

What am I going to do?
I love living in the Bay Area and I love Menlo Park most of all.    The combination of an amazing climate, proximity to fantastic natural wonders like Tahoe, Marin and Napa and last but certainly not least the amazing people who live here.     If I could convince myself that the market won't fall again in the near future I would be happy to buy an overpriced home here.   Unfortunately I'm convinced of the opposite.   I think the market will correct downward at least 25% in the future, but I don't know how long it will take.

Some people called me crazy back in 2006 when I predicted a correction.   They said that real estate in California never goes down and even bet me that it wouldn't.  I won money on those bets, but I was polite enough not to collect since the folks who said it lost a lot in the down turn.    I was complacent in 2009-2010 and didn't buy then, so now I'm in a difficult spot, my mistake.

Barring a happy accident falling into my lap with an under priced gem, I will be renting again.    The rental market is just recently starting to correct closer to ownership prices, but it is still a much better value than owning, it also carries no risk of a massive loss if the market corrects back to normal levels again.

Here is my spreadsheet that has the calculations

Please leave a comment with your favorite theory and prediction for housing prices in the future.