THE LAST GREAT SUMMER FOR CALIFORNIA REAL ESTATE

THE LAST GREAT SUMMER FOR CALIFORNIA REAL ESTATE?

Chris Renner

California Emergency Physician Partners have ask= ed that I produce some articles on changes within the retirement plans, econom= ic forecasts, stock market commentaries, and other issues to keep partners and employees informed. This is t= he first in a series of e-mailed articles.

I am going to broach the unthinkable. I am going to confront the impossible. I believe that 20= 04 will be the last in a succession of years with double digit price increases= and may provide sellers with the last great opportunity to cash in on the extraordinary California residential real estate market. After 2004, real estate prices will stabilize for a few years and th= en, beginning in 2008, drop by at least 10% and as much as 25% over the followi= ng 6 years!

I can hear you all sa= ying, “Sure, that’ll happen when the state falls into the ocean!̶= 1;

California real estate prices have increased virtually non= -stop since 1967. Over that span, a= ccording to the California Association of Realtors, there have only been seven years when the median price for both Northern California and Southern California homes have decreased. When there was a decrease, the dro= p was less than 4%, with the exception of 1991, when the drop was 6%.<= /span>

So, given the fact th= at real estate prices have increased 31 out of the 37 past years, and given the fact that recent prices have increased substantially despite a downturn in the economy, throw in the wonderfully attractive climate that California provid= es, how can I say that residential real estate will fall by as much as 25% beginning later this decade?

Supply and Demand – Supply a= nd Demand – Supply and Demand.

Real estate, like any commodity, is subject to supply and demand. When there are more buyers than se= llers, prices go up. When the revers= e is true, prices drop. Think tulipmania and dotcoms and you can gauge the potentia= l volatile effects of supply and demand. Interest rates, housing starts, and demographics are components of supply and demand= . Over the past forty years, California real = estate prices have continually increased because population increases and the cost of borrowing have been favorably aligned.&nbs= p; In addition, housing starts have not kept up with the population increases and as a result, Ca= lifornia real estate is the most expensive in the country.

Demographics &= Housing Starts

According to the Cali= fornia Legislative Office, Californi= a grew by 18 million people (approximately 5.8 million households) between 19= 60 and 2000. During that same pe= riod, housing starts (single and multi-family homes) totaled 4.2 million homes.[1] For environmental and regulatory reasons, housing starts have lagged behind demand. The Building Industry Association estimates that there has been a shortage of about 500,000 homes since 1995. Given this shortage of = homes, home prices inevitably rise. = In San Diego, housing= prices have increased 108% in the past six years.= In San Francisco, the average median price of a single family home has risen from $321,000 in 1998 to $558,000 in 2003, the highest in the state. Is this an irrational bubble or ju= st a normal market that will continue to increase year over year?

Interest Rates

One argument in favor= of continued price increases is population growth. California<= /st1:State>’s population continues to grow and California’s Department of Finance estimates that California’s population could reach 45 million by the year 2020, an increase of nearly 11 million from 2000. Prio= r to 2000, California<= /st1:place> experienced two periods of population decline in the past 40 years; in 1970= -71 and in 1990-91. In each perio= d, housing prices also declined. However, in 2002, the state’s population declined slightly yet housing prices increased by nearly 20%! 2002’s huge price increases were directly related to the staggering drop in interest rates. Mortgage interest rates dropped from 7% to approximately 5%, a drop = that made houses instantly more affordable for a segment of the population that couldn’t afford a house. (The drop in rates allowed someone who could previously afford a $200,000 home to now purchase a $250,000 home.) Instantly, the pool of buyers was greatly expanded, increasing demand and pushing prices to once unthinkable levels. Continued population increases may continue to push prices upward, but in looking at the population increases since 1990, virtually all of the over 5 million person increase is due to f= oreign immigration and immigrant births. While an estimated 20% of the immigrants are professionals, most immigrants have lower incomes and do not increase the pool of potential home buyers.

There are two ancillary arguments in favor of continuing housing price increases. Regulations from Washington and <= st1:place w:st=3D"on">Sacramento, as wel= l as attitudes from existing homeowners regarding land use and the environment, continue to maintain a housing shortage and of course, high prices. In fact, if you own a home, one su= re method of increasing your home value is to support all zoning laws and envi= ronmental regulations that make it harder and more expensive to build new houses.

So why do I think tha= t this summer will be the last great year for California real estate? Since 1999, California has s= een double digit gains in residential real estate prices each year. Only 24% of the population can aff= ord a median priced home! Interest = rates have bottomed out and are forecasted to slowly rise over the next year. Although rising interest rates hurt potential buyers, there is still such demand that the next few years will continue to see price gains. However, the era of double digit ga= ins will soon end. Throughout mos= t of California (and especially in the major cities), I believe housing prices w= ill rise by the rate of inflation over the next 3 to 4 years and then will begi= n to decline toward the end of this decade because of a population exodus and increased mortgage interest rates.

Here is how it will p= lay out…

Baby Boomers, or that demographic group born between 1946 and 1960, constitute approximately 28% = of the California population. According to the Employee Benefit Research Institute, only one in four Americans is saving enough for their retirement. = When baby boomers begin the retire in 2008, 75% will find that they cannot affor= d to retire. Many will continue to= work but others will think of alternatives so that retirement is not delayed. With many <= st1:State w:st=3D"on">California retirees sitting on homes w= orth $500,000 or more, it is very conceivable to assume that some will choose to sell their homes to fund their insufficient retirement savings.

Let’s assume, b= ecause of the need for assisted living, or because they simply choose to buy a less expensive residence elsewhere, 25% of the baby boomers choose to sell their homes between 2010 and 2015. = That means that 7% of all California homeowne= rs will not turnaround and buy another home in California. Currently, in any one year, new ho= me buyers constitute about one-third of all home purchases or about 1.5%[2] of all homes in California. If, over the course of 5 years, 7%= of the baby boomers sell their homes and move to Arizon= a or Utah or Texas<= /st1:State>, California will be at equilibrium and housing prices will neither rise nor fall. In other words, first time home bu= yers (traditionally about 1.5% of California’s population) will match up with the last time home sellers (est. 1.4%) and s= upply and demand will be equal.

By itself, then, if i= nterest rates and housing starts remain static, home prices may actually edge up because housing starts are still behind demand. But interest rates are not static = and in fact, since baby boomers constitute the largest demographic chunk of the population, there aren’t enough workers to fill their positions. Consequently, because there is a shortage of labor, companies will need to pay more to fill positions with preferred workers. When compa= nies are forced to increase wages, it increases the cost of goods and increases = the overall cost of living (i.e. inflation).&n= bsp; As in the early 1980’s, inflation begets interest rate increas= es to slow down borrowing. Mortg= age interest rates in 1981 actually reached 20%, double the same rates in 1979 = and four times the rates of 1975. If inflation returns, even modestly, we could see mortgage interest rates of 10 – 15% in the early part of next decade.

Currently only 24% of= California’= ;s population can afford to purchase a median priced home in the state. One needs an income of just over $= 91,000 annually to afford a home of $395,000.&nbs= p; With any increase in inflation, the affordability index will decrease even more. As an example, were interest rates to increase immediately to 10%, the affordability index would decrease to around 18% of the population, thereby decreasing the available = pool of first time buyers to about 1% of total homes. With ¼ of those baby boomers selling their houses (1.4% of total homes), the supply of homes being sold = will be higher than demand, driving down prices. The nearest precedent to this pote= ntial occurred in 1981-82, when housing prices dropped about 5%, but population increases as a percentage of the existing population were much higher then = than now. I believe that this scen= ario could lead to a 10% drop in C= alifornia housing prices between 2008 and 2014.

So, you ask, where do= es my 25% forecasted drop come from? Consider these potential occurrences.

In periods of high in= flation, companies also experience layoffs to reduce their costs of production. In 1981, unemployment reached 10%.= With many households in California spend= ing over 50% of their paychecks on mortgage payments, how many foreclosures will occ= ur when individuals lose their jobs? With foreclosures come an increase in homes being sold, increasing supply even further.

California has the second highest state income tax rates i= n the nation. Unless you’ve b= een in an ecopod, you also know that we have a $38 bil= lion deficit that will inevitably dictate higher business and income taxes and further send some jobs to other states or overseas. With disappearing jobs come more h= ome sales, again increasing supply.

The third potential occurrence, and the most difficult to gauge, is panic selling. Remember the dot com bust when phr= ases like “How low will it go?”, “I can’t afford to lose= any more!”, and “@#*&#%$@!” were prevalent at every water cooler conversation? If home = prices drop continuously over 3 or 4 years, how many homeowners, especially retire= es, will sell their home to “get out while the getti= n’s good”? Most homeo= wners use their homes to live in so panic selling for investment purposes may only affect landlords and vacation home owners.= However, Americans are notorious short term thinkers and continued d= rops can elicit irrational decisions. With housing, I don’t believe panic selling will be a factor because homeowners are very resistant to sell their houses below their purchase pri= ce so this potential effect will be minimal (… but you never can tell?).=

So how should you pre= pare for the impending drop in Califor= nia real estate prices?

If you’re happy= in your home, stay there. Look at your house as the place where you live, not as an investment. If, however, you want to move out = of California, cons= ider selling your home sooner rather than later.

If you wish to move yet remain within California but s= till need to prop up your retirement fund, do so sooner rather than later. As you age and become an empty nes= ter, consider buying a less expensive house that meets your needs. If the market drops 10% on a $1,00= 0,000 home, it’s worse than dropping 10% on a $500,000 home.

Invest in land in other states. When Californians move out of stat= e, most move to one of the adjoining western states. Businesses that move also are more likely to move to other western states.&nb= sp; Real estate values are more inclined to increase in adjoining states because demand (there's that word again) will be heavier!=

The aforementioned arguments are based on sound economic principles. However,= there are an endless number of variables which can accelerate, delay, enhance or soften the ultimate result. I believe that California real estate will drop in value during the first half of next decade. However, income tax rates, governm= ent regulations, energy crises, earthquakes, environmental laws, immigration, social security, terrorist attacks, delayed retirements, and other factors = may precipitate the drop in 2008 or delay it to 2014. The next few years should bring mo= re stable real estate prices but eventually, the aforementioned factors associ= ated with the baby boomers will cause California real estate to decline. It= 217;s up to you to determine how you wish to benefit.

If you wish to discus= s these principles, I would be most happy to discuss them with you. Call me at (510) 835-7450.