California in Context

Posted on July 23rd, 2010

When it comes to the market for California real estate, one thing most people want to know is:   Where are we now and where are we going? This article examines several key factors affecting the forward price trend in order to provide context to the current market.  The basic conclusion is that we have seen the bottom in terms of price and the key factors affecting the forward trend (it’s always supply & demand), suggest upward, not downward pressure on prices at this time.

We have just been through the largest price spike and subsequent crash in over 30 years and probably much longer.  The peak of the market was in May 2007 when the MSP (median selling price) of an SFR (single family residence) in California was $595,000.  That fell to $245,000 in February 2009 and has since recovered to $312,000 in June 2010.

Median prices for SFRs sold in CA from 2001 through 2010


The Previous Price Recession (1991 – 1997)

The point of inflection from the last real estate price-recession was in February 1997.  At that time, the MSP for an SFR was $168,000.  Since then we have had a 10-year rise that took us up 254% followed by a two-year crash that saw prices decline by 59% from the peak to the trough.  Most recently, prices appear to have “bounced” off the bottom and are up 27% from the recent low.  And yes, I did say “the bottom” which in my opinion, we have now seen.  I base this on several key metrics that I believe are fundamental to real estate price trends:

  • The Unsold Inventory Index (aka “Supply”)
  • The Affordability Index (a key factor in “Demand”)
  • Interest Rates (one of the three key elements of affordability that affects “Demand”)

Let’s look at these and track them through the last price recession, the following 10-year price surge, and the subsequent crash.  But first, here’s what the last real estate price recession looked like.  Prices rose modestly in the early and mid 80’s and then surged in the late 80’s.  They formed a peak in ’89, dipped modestly and then re-peaked in 1991.  After that we experienced a relatively long but mild price recession that lasted until 1997.

Median selling prices, SFRs in CA from 1988 - 1997


Unsold Inventory Index (UII)

This statistic is really a measurement of supply in the context of demand.  Specifically, it measures the amount of time it would take to sell all of the homes currently on the market, based on the seasonally adjusted run-rate of sales over the past several months and years.  The following two charts show us the unsold inventory index (UII) over the past price recession and then show us what happened through the surge and crash that occurred most recently.

Unsold Inventory Index, 1991 - 1999

While there is high monthly variance, we see market inventory was consistently greater than eight months during the period of declining and flat prices that occurred from May 1991 through February 1997.  Prices inflected and began their 10-year rise starting in March 1997.  In April 1997, the UII dropped below eight months and stayed there consistently for the next ten years!  In fact, it was less than four months for virtually all of 1999 through 2005.  Take a look:

Unsold Inventory Index, 2000 - 2010

Clearly the inventory of homes for sale began to increase in 2006 and surged in 2007 in advance of the price declines.  In the mild price recession of the 1990’s, we saw inventory levels consistently greater than eight months for many years.  In this past cycle, prices did not begin to fall until inventory levels crossed this same 8-month threshold.  Currently we see unsold inventory well below that point.  In fact, the market low price-point was February 2009, when the UII had dropped back to 6.5 months from a peak of more than 16 months in 2008.  The most recently reported number for June 2010 is 4.8 months, which does not suggest that inventory (supply) is putting downward pressure on prices.


First Time Buyer – Housing Affordability Index (FTB-HAI)

While the UII is a measure of supply in relation to current demand, the Housing Affordability Index (HAI) attempts to measure demand.  In fact, it is a proxy for demand since what it really measures is the size of the potential buyer pool for homes.  Nevertheless, this is an important window into market dynamics on the buy-side.  The three key elements that combine to make up this index are:

  1. The Median Price of a Single Family Home in California
  2. The Median Family Income for the State
  3. Interest Rates

Here is how the California Association of Realtors (C.A.R.) defines this index:

C.A.R.’s First-time Buyer Housing Affordability Index(FTB-HAI) measures the percentage of households that can afford to purchase an entry-level home in California.  C.A.R. also reports first-time buyer indexes for regions and select counties within the state.  The Index is the most fundamental measure of housing well-being for first-time buyers in the state.

The minimum household income needed to purchase an entry-level home at $246,270 in California in the first quarter of 2010 was $41,540, based on an adjustable effective interest rate of 4.33 percent and assuming a 10 percent down payment.  First-time buyers typically purchase a home equal to 85 percent of the prevailing median price.  The monthly payment including taxes and insurance was $1,380 for the first quarter of 2010.  At $41,540, the minimum qualifying income was $3,910 greater than a year earlier when households needed $37,630 to qualify for a loan on an entry-level home.

Let’s track this index through the price recession of the 90’s, the 10-year price surge in the ’97-2007 period, followed by the crash, and then look at it today.  Please note that C.A.R. changed the way they report this index starting in 2006.  Instead of tracking it monthly, they switched to calendar quarters.  The data in the second HAI chart reflects this.

Housing Affordability Index, 1991 - 1999

The data is fairly intuitive.  As prices decreased in the early 90’s, the percentage of households that could afford a home increased.  Then, as prices increased starting in 1997, the percentage of people who could afford them declined.

Housing Affordability Index, 1997 - 2010

In some respects, this last chart documents an incredible fact that most people now know anecdotally.  If we consider affordability in 2006 and early 2007, we see that nearly 90% of the market could not afford to buy or own an entry level home.  But we also know that this did not stop them from buying them!  Obviously something had to give and it did… prices dropped by nearly 60% and affordability has since recovered.

The most recent measure published for Q1-2010 shows an affordability index of 66%.  This is higher than it has been for most of the last 22 years for which C.A.R. has kept records on this index.  This in turn suggests there is not only price support at these levels, but in fact applies upward pressure on prices.


Interest Rates

While interest rates are an inherent component of the HAI, let’s quickly review where we have been and where we are now.  For almost the entire decade of the 90’s, the national average interest rate was over 7% for a 30-year fixed rate loan.  In 2000, rates began to decline after the tech bubble burst and dropped from the 8% range to the 6% range by early 2003.  Since then they have channeled, for the most part, between 5.5% – 6.5%.  Currently (late July 2010), the national average “spot rate” for a 30-year fixed loan is roughly 5%.

When compared with the interest environment of the 90’s era price-recession and the most recent price surge of the last decade, interest rates are more favorable and, if anything, are providing price support and/or price stimulation.


Conclusion

The state wide supply of housing is down very substantially as measured by the Unsold Inventory Index.  The current UII of 4.8 months is characteristic of a market in which prices are increasing, not decreasing.  The Affordability Index and Interest rates are also characteristic of an advancing market.  The core measures of Supply and Demand suggest that prices in California will increase, NOT decrease, going forward.

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