December 08, 2003

are bay area housing prices sustainable

I've been doing a little poking around on the topic of bay area housing prices. I've had several people tell me that buying a house in the bay area is like buying a license to print money. Sounds suspicious to me, especially given the arguments they use when pressed for an explanation: most point to the past performance as the indicator -- not the best predictor.

So I was curious what you'd find if you looked at the underlying forces that drive housing prices. According to the Fed, housing prices and rents for equivalent properties are linked -- they roughly follow each other.

Nationwide, the low interest rates have been driving renters into the houseing market and this has generated a modest imbalance. The imbalance is small enough that a year or two of stagnant house prices and average rent increases will return the prices to equilibrium. This is why the Fed has been saying they don't anticipate a housing bubble.

This is not true for the bay area however: rents here have been declining sharply, as salaries decline, the area loses population, and people exit the rental market for the housing market. Economist Ed Leamer, head of UCLA's Anderson Forecast, looked at the home P/E ratio, the ratio of a house's price to the earnings potential of the house via rent. Using that measure, the Bay Area is 7% over it's record P/E from 1989. The same is not true for all areas. For example, LA has seen housing prices matched with rent increases and is currently 17% below its P/E ratio for '89.

I personally don't question that, long term, demand will outstrip housing supply in the area -- its the best place I've ever lived. But, it looks to me, in the short term, the Bay Area is due for a correction. The only question, in my opinion, is timing.

Posted by dapkus at December 8, 2003 11:29 AM | TrackBack