SF Chronicle housing ~ SUNDAY'S FRONT PAGE~

HOUSING -- JUST COOL OR GOING COLD?
As Bay Area sales continue to drop, questions about the market's cycles are taking on a new sense of urgency

Sunday, February 19, 2006

Chronicle Graphic Real estate agent David Aimes of Zephyr Reality in San Fr...

This spring, Bay Area homeowners are likely to know whether the housing market has merely paused before resuming its upward climb or has truly downshifted to the slow lane and, if so, how dramatically.

Last month, the number of homes sold declined for the 10th month in a row and hit its lowest level since 2001, and price gains slowed markedly as well.

Now, the question is, will the market simply cool or will it dive into negative territory?

Each housing cycle in the past has had its own set of twists and turns in which a multitude of factors comes in to play.

As the current housing frenzy exhausts itself, variables ranging from interest rates and employment growth to affordability, new home supply and sellers' willingness to part with their No. 1 asset will help determine the swiftness and magnitude of any downshift.

"Making this cycle more unique ... is that there's been a big increase in homeownership since the early 1990s," said Celia Chen, director of housing economics at Moody's Economy.com. "We've brought a lot more people into the market, and it's uncertain how these people will react in a down cycle."

The Bay Area real estate market typically runs in cycles, forming almost a stair-step pattern of multiyear price increases followed by periods of stagnation or even mild declines.

So far, 2006 is off to a slow start, with fewer houses and condos changing hands than in the past five years. But, historically, January and February don't offer strong data for predicting trends. By spring and summer -- typically the strongest buying seasons -- it should be clear whether this winter's pronounced sales slowdown is here to stay or not and whether it will spread to prices.

At the end of the last two major housing booms in the early 1980s and 1990s, prices in most areas did not collapse.

Even amid job losses, soaring interest rates and worsening affordability, the region's huge price gains of the late 1970s were followed in the early 1980s by relatively small declines before resuming their upward trajectory.

The next cycle saw a more striking correction. The median Bay Area home price crested at $225,000 in January 1990, then dipped as low as $205,000 -- almost 9 percent -- before climbing to $229,000 in the middle of May 1996, according to DataQuick, which releases a monthly report based on county recorder data on new sales. The drop was steeper when adjusted for inflation over the years of the downturn.

"On the coasts, you see price run-ups, and then instead of having large price declines, you have mild declines and flattening for a period -- it's what you'd call a stylized fact of the industry," said Andrew Leventis, economist at the Office of Federal Housing Enterprise Oversight, the overseer of mortgage titans Fannie Mae and Freddie Mac.

The question is: "Where are we in the cycle?" It's not entirely clear, but most observers think we are closer to the end of a booming cycle than the beginning.

Jobs and incomes

The 1990s downturn was accompanied by the crash of the aerospace industry and the loss of hundreds of thousands of jobs statewide.

In Los Angeles, the then-epicenter of the defense industry, employers jettisoned nearly three-quarters of a million jobs within just a few years, sparking a rash of foreclosures and a nearly 30 percent plunge in home prices.

Yet Bay Area real estate weathered the dot-com meltdown -- this region's version of the aerospace industry bust -- remarkably well, considering the area lost about 450,000 jobs in three years.

According to research by the federal government, price appreciation for most of the region dropped from above 20 percent in 2000 to between 5 and 10 percent in 2002 and 2003. The only metropolitan area to dip into negative territory was Santa Clara County, where prices fell by several percentage points in 2001 and 2002.

Though job levels have not returned to their lofty Nasdaq-era heights, the region is expected to add 40,000 new jobs this year and 55,000 in 2007, suggesting that the economy, though not raging, appears to be on solid footing.

"Nothing leads to big declines in house prices except job destruction," said John Krainer, economist at the Federal Reserve Bank of San Francisco.

Interest rates

One important factor that helped offset the steep dot-com job declines, however, were rock-bottom interest rates.

As companies such as Pets.com and Webvan imploded, interest rates were steadily sinking to levels unseen in decades, providing a cushion for a housing market.

In contrast, the benchmark 30-year fixed mortgage interest rate jumped north of 18 percent in the early 1980s, squashing demand for housing and pushing prices lower.

"We would have had a (housing) correction in 2001, 2002 and 2003 if interest rates hadn't been cut as they were," said Ken Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at UC Berkeley.

Rosen believes low rates and easy credit have borrowed demand from the future and guided many recent buyers into riskier loans.

Last year, about half of Bay Area home buyers took out interest-only loans, according to San Francisco's LoanPerformance.com. These loans require no principal payments during an initial period. At the end of the period, however, monthly payments jump as principal payments start coming due. With interest rates expected to rise gradually through the year, payments could soar even higher, putting some borrowers into precarious financial positions.

Affordability

The high use of interest-only loans illustrates the eroding ability of many consumers to buy ever-pricier homes, which some experts liken to a balloon that eventually hits the ceiling.

While the average pre-tax household income in San Francisco between 2000 and 2004 grew about 16 percent, from $64,818 to $75,390, home prices rocketed nearly 43 percent -- and probably more in some desirable areas.

According to the California Association of Realtors, only 12 percent of Bay Area households can afford the median-priced home.

"We're really shrinking the number of people who can buy in the marketplace," said Keitaro Matsuda, senior economist at Union Bank of California. "If the market conditions weaken, that could show up more dramatically because there are so few people who can step in and play the game."

On the other hand, affordability indexes don't present the full picture. For one, roughly three-quarters of all home buyers in California are trade-up buyers who can spin equity into down payments on bigger, pricier houses.

Renting vs. buying

As home prices rose at a record pace, rents have lagged far behind -- a fact that alarms some economists who believe monthly prices in the two markets cannot remain far apart for too long.

The cost of the good, in this case the selling price, should reflect the potential income, rent, for the same property.

According to DataQuick, the typical Bay Area home buyer committed to a monthly mortgage payment of $2,867 in December. Meanwhile, the average apartment rent in the region in the fourth quarter was just over $1,324, according to RealFacts, a Novato firm that tracks the rental market.

To some, that discrepancy is yet another sign of an overvalued purchase market.

"There's a disconnect between the fundamental value of the asset and the value the market is producing," said Ed Leamer, director of the prestigious Anderson Forecast at UCLA. "It's just like the dot-com period."

Feathering the nest

But assigning an arbitrary upper limit on the value of real estate may not accurately reflect consumers' nuanced views of their abodes, particularly compared with a rental apartment.

In the aftermath of the Nasdaq nosedive (and accompanying low interest rates) and Sept. 11, there was a noteworthy shift to real estate as a safe investment haven. Refinancings and second home purchases soared, and streets were clogged with contractors' trucks and appliance stores' vans as homeowners beautified their nests to boost value.

Still, there is some concern that too many consumers are devoting exorbitant portions of their incomes toward housing, and therefore remain vulnerable to a slackening in the market. A 2005 Public Policy Institute of California study found that 1 out of every 5 recent home buyers in the state is spending 50 percent or more of his or her income on housing costs -- twice the national average.

Flipping

There is a certain class of home buyers who are in the market strictly for the profits. But in the Bay Area that percentage is fairly low when compared with Las Vegas or Phoenix, or even Hawaii.

Early in 2005, DataQuick reported that the percentage of San Francisco properties "flipped," or bought and sold within the previous six months, had risen from less than 2 percent between 2001 and 2004 to nearly 5 percent.

In other markets with a larger supply of land and freewheeling building environment, however, that percentage can be well into the double digits. Economists keep a close eye on the number of pure investors in a given market, because their lemming-like movements into and out of housing can often prompt a rapid change.

It appears the portion of Bay Area real estate owned by investors is a far cry from those in Southern California in the late 1980s, just before the market tanked.

"We'd drive through new developments, and we'd see no landscaping, no cars in the driveway," Matsuda said. "We asked the builders what was going on, and they were people waiting to flip."

Stickiness

Money poured into a home is unlike any other investment -- people are loathe to make less on a sale than their neighbors.

In official economic parlance, that's called "stickiness."

In other words, even in a slackening market, sellers often resist losing money on a property or simply not making as much as the Joneses next door. Sometimes that can mean sales volumes will decline, but prices will stay resilient; it's a phenomenon that could play out as this cycle wears on.

"We love our homes -- we don't love our shares of GM or Microsoft," Leamer said. "We have a personal valuation of the home because of a vague understanding of the marketplace."

In a booming market, buyers love your home more than you do, Leamer said. But in a downturn, you love it more than they.

Supply and demand

Another factor that may help support the market, some experts argue, is the region's chronic shortage of new homes.

In the past few years, the number of houses and condos built in the region has topped 25,000 per year -- the number California Building Industry Association economist Alan Nevin says is necessary to keep up with job growth and new households. But that number has slipped as low as 15,500 in recent years.

"San Francisco may have more of a chance to not have a severe (correction) because it's so hard to build here," said UC Berkeley's Rosen. "The difficulty in putting on new supply protects home prices from big adjustments."

Though it's probably safe to say the Bay Area doesn't have a glut of new homes on the market, there are some signs of softness. Building giant Centex recently offered buyers in communities from Benicia to Brentwood discounts of between $40,000 and $100,000 on selected models for a limited period.

"People are rejecting higher prices, and in single-family homes in particular, prices have gotten so high that it's pretty hard to qualify," Nevin said.

Superstar status

A tight supply of available land and housing supply is one hallmark of what Columbia University real estate professor Christopher Mayer calls a "superstar city," one in which price declines are relatively rare.

The other is what he calls the concentration of "high human capital workers" -- or a wealthy, educated labor pool. The argument goes that as San Francisco and New York and Boston shifted from manufacturing centers to technology and service hubs, they grew more expensive and attracted people who can afford to live there -- people whose incomes (or maybe wealth) are going up at faster and faster rates.

"The rich can outbid the poor for the limited slots," Mayer said.

The cycle feeds on itself, and these cities draw people from all over the country and the globe.

"People ask why are home prices so high in California, and my response is: 'Everybody in the world wants to live in California,' " said Michael Carney, real estate professor at California State Polytechnic University at Pomona.

In the end, prices are likely to slow and even dip as we enter the end of this real estate cycle. But in the past, it has taken wrenching changes in the economy to seriously rein back the housing market.

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