Bay Area Real Estate: Setting Up for a Fall (March 2003)
Judging by the flood of emails the S.F. Chronicle received in response to my March 1 article on the possible decline of local real estate values ("All Signs Point To A Top"), readers are deeply interested in the topic but largely unaware of the macroeconomic forces which ultimately establish the value of Bay Area homes.
Although realtors tend to focus on demand for housing (that is, the presence of more buyers than sellers) as the sole determinant of home prices, local demand is only one of four fundamental economic forces at work.
Three have virtually nothing to do with the local economy or housing demand: 1) the cost of money; 2) the attractiveness of of Bay Area real estate as an investment in comparison to other opportunities, and 3) the value of the U.S. dollar in relation to other major currencies (the yen and the euro).
A number of factors determine the cost of money: the overall demand for mortgages and other loans, the return investors are willing to accept for bonds and mortgage instruments, and the perceived safety of the assets backing up the mortgage.
As a result of the Federal Reserve flooding the economy with cheap money since 2000, mortgage rates have reached unprecedented lows--5% for 15-year fixed mortgages and even lower for adjustable loans. These declining rates have enabled buyers to pay higher and higher sums for homes without raising their monthly mortgage payments. In effect, the high value of Bay Area housing is being supported by cheap money.
Should rates rise, the trend reverses. Fewer buyers will be able to afford homes at higher mortgage rates, and valuations will eventually soften in response to the lower demand.
But why should rates rise? Although some economists believe the sluggish economy will force the Fed to keep interest rates at historic lows, others point to larger forces which could put upward pressure on interest rates irrespective of Fed policies.
The Federal Reserve finances the $6.4 trillion national debt and future deficits (currently estimated at $300 billion a year) by selling bonds--in large part to foreign individuals and institutions seeking the relative safety of U.S. currency and bonds.
As the U.S. dollar has steadily declined against the yen and the euro, these foreign investors have taken a beating. The Fed's heavy reliance on foreign ownership of U.S. bonds worries many observers; if foreign investors either sell U.S. bonds or simply stop buying them, then the Fed would be forced to raise the bonds' interest rate to entice new buyers.
Such an increase would not occur in a vacuum; interest rates would rise across the economy, pushing up adjustable and fixed mortgage rates.
Another factor that is often overlooked is the linkage between the market price of an asset and its investment value. Many real estate analysts have pointed to the alarming gap between rising housing prices and declining rents; at some point, it makes no financial sense to pay so much for a house which rents for only a fraction of its costs.
As Thailand and other "Asian Tiger" economies learned in the 1997 and 1998 financial crises, investment capital is liquid; money flows away from risk and toward the highest return. Although various "anti-globalization" voices decry this as a new phenomenon, it's hardly a modern development.
As Fernand Braudel details in The Wheels of Commerce (Volume II of his epic trilogy "Civilization and Capitalism"), a brisk and complex trade in commercial loans, currencies and stocks was already integral to trade throughout Europe in the 16th century.
Locally, the influx of capital into Bay Area commercial real estate during the boom days has dried up, for the obvious reason that the return on investment from a half-empty building is negative. Reflecting the local economic doldrums, office complexes which were valued at $60 million in 2000 are currently being pegged at $25-$30 million.
While home and condominium prices are not so visibly tied to the influx or retreat of capital and tenants, there is still a relation between a home's investment value (for appreciation or rental income) and its market value.
Should Bay Area homes begin appreciating more in line with the health of the local economy--say, roughly zero instead of the 15% to 20% per annum owners have enjoyed the past three years--then it will make financial sense to some owners to sell this "topped out" asset and move the capital to higher returns elsewhere.
Real estate is not immune to this "topping out" process; all asset classes experience cycles of increasing sales, just as they experience cycles of increased buying. Once sellers outnumber buyers, prices decline; this erosion of value tends to precipitate further selling, as additional owners decide "to get out while the getting is good."
While this process may be relatively mild in real estate--a house is, after all, a home as well as an asset--it would be irresponsible to claim that Bay Area real estate is immune to the flow of capital, the fluctuations of interest rates, and the fundamental market forces of supply and demand.
While it is possible a perfectly benign financial environment will come to pass--foreigners will continue snapping up low-yield U.S. bonds, the dollar will rise, and mortgage rates will permanently remain low--prudence also demands that we consider the impact of a less benign future on local housing valuations.
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