Federal Reserve Bank of San Francisco

FRBSF Economic Letter

1999-24 | August 6, 1999

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Hot and Cold Real Estate Markets in the San Francisco Bay Area

John Krainer

The San Francisco Bay Area has had a “hot” real estate market for the past four years. The median single family house price in the Bay Area has appreciated by 30 percent to $330,000 since 1995. The rise in house prices has been a great windfall to current owners who, at least on paper, have experienced large returns on their housing investments. But policymakers and affordable housing advocates worry that high house prices might hinder the Bay Area’s ability to attract and retain new firms and labor.

This Letter identifies some of the forces that contribute to hot real estate markets. As Figure 1 demonstrates, rising prices are not the only characteristic of a hot market. There is also an increase in the volume of sales. In the San Francisco Bay Area, sales volume has been growing by an average of 10 percent per year since 1995. Another characteristic of a hot real estate market is that liquidity is good–meaning that sellers do not have to wait long for an acceptable bid once they put their houses on the market. Cold markets display just the opposite characteristics; prices generally are declining, the volume of sales is low, and marketing times are long.

House prices and transaction volume

Over time, the price of housing and the number of housing units exchanged are determined by the interaction between demand and supply. In the short run, however, economists look primarily to changes in demand as a means of explaining price and sales volume dynamics. This choice reflects the fact that real estate construction, more so than production processes for other durable assets, is extremely time-consuming. Hence, the supply of new housing adjusts very slowly in response to changes in demand. This lag is particularly pronounced in the Bay Area, where growth controls, an already dense population, and geography all conspire to restrict the flow of new stock to the market. Indeed, the Bay Area submarkets experiencing the most price pressure are those where there has been limited construction.

The question, “Why is the Bay Area real estate market so hot?” can be answered by identifying the source of the recent shock to demand. One of the primary determinants of the housing demand function is the rate of household formation. New households that demand housing are created in two primary ways. First, households can migrate into (or out of) a region from the outside and add to (or subtract from) housing demand. Gabriel, Mattey, and Wascher (1999) document that outmigration from Los Angeles in the early 1990s had a depressing effect on house prices. Inmigration can be expected to have the opposite effect on prices. The second way that household formation can increase is via the transition of young individuals and couples from apartments into houses (see Ortalo-Magné and Rady 1998 for a theoretical treatment of this process). The timing for both of these types of demand changes depends closely on the job opportunities available in a region, and Figure 2 reveals that job growth has been exceptionally strong in the Bay Area over the past five years. Job growth in a region attracts new workers to fill those jobs and enables young and newly employed households to make the transition into owner-occupied housing. In turn, the rise in prices allows existing homeowners to trade up in the housing market or move to a more desirable location.

The other key variable in the housing demand function is affordability. It is not easy to argue that house prices are “affordable” in the Bay Area at present. However, very few households buy houses outright (although there have been colorful reports in the press about Silicon Valley software executives making all-cash offers on houses and completing the purchase on their debit cards). Since the purchase needs to be financed, the cost of finance, or the degree of financial constraint, will vary over time and across different buyers. Much of the recent heating up of the real estate market has coincided with an across-the-board loosening of financial constraints. Mortgage interest rates have been well below their long-run averages. These interest rates are set in global capital markets, and the mobility of capital implies that lower rates are as valuable for San Francisco residents as for potential homebuyers anywhere in the country. The Bay Area housing market, however, stands apart because, for many, particularly those in the high-tech sector, there has been a loosening of the other primary financial constraint–the down payment. The rapid job growth in the high-tech sector has translated into significant increases in wealth in the form of high salaries and valuable stock options.

Market liquidity

Another characteristic of real estate markets is that liquidity changes drastically between hot and cold markets. Many researchers have investigated this particular phenomenon because, at first glance, it appears to be a violation of efficient markets. Changes in the fundamental value of an asset are generally thought to be transmitted to the market through prices. Evidently, this is not true in housing markets. Krainer (1999) shows that when the fundamental value of housing changes, this change is accompanied by an unequal (smaller) change in prices. Liquidity adjusts to make up the difference. This is interpreted to be a natural consequence of decentralized markets where it takes time for sellers to find the buyers who value their houses the most. In bad times, forward-looking sellers may rationally keep house prices high (or off the market), anticipating that they will be able to sell later when fundamentals are more attractive.

Stein (1995) argues that liquidity is sensitive to the amount of debt in the local economy. If house prices drop, highly leveraged homeowners may lose their equity and become incapable of making a down payment on a new house. One response to this situation is for sellers to take the house off the market. Because houses are durable and provide a flow of housing services, the opportunity cost of waiting out a bad real estate market is relatively low. For those who still want to sell, this low opportunity cost implies that it may be optimal to set a high price and “fish” for a buyer with a high valuation, thereby recovering some of the loss. This fishing takes time, and houses become more illiquid.

In the current hot market, not only do houses sell quickly, but they often sell for more than list price. By historical standards, this is extremely unusual. The standard real estate transaction is for the seller to set a list price, which is then negotiated downwards, on average by 5 percent. The current environment bears a closer resemblance to an auction. The list price is not a seller’s reservation price so much as it is a way to market the house to a targeted group of buyers. When there are a large number of potential bidders in the market, it makes sense for sellers to set low list prices in order to attract more participants to the auction. Faced with this type of competition, buyers are forced to bid their reservation prices or risk losing the bid. Thus, auctions help sellers uncover the true demand for their houses. Evidently, when the real estate market is not hot, there are not enough potential buyers in the market to make an auction viable from a seller’s perspective.


The San Francisco Bay Area real estate market has been an exciting place for existing homeowners and for economists who study the market. The high prices in the market have been cause for concern by public officials who worry that future growth may suffer from the inability to retain workers and firms. In the long run, their concern can be mitigated in part by an increase in the supply of housing, which itself is affected by a public policy relating to development. However, whether or not these fears are well-founded also depends on the Bay Area remaining a productive location for firms. Real estate prices have always been high in the Bay Area compared to the national average, and, in spite of these high prices, the most recent hot market can largely be attributed to job creation. For this to hold true in the future, firms have to be more productive in the Bay Area than elsewhere so they can continue to earn profits and pay employees enough to buy housing.

John Krainer


Gabriel, S., J. Mattey, and W. Wascher. 1999. “House Price Differentials and Dynamics: Evidence from the Los Angeles and San Francisco Metropolitan Areas.” Federal Reserve Bank of San Francisco Economic Review 1, pp. 3-22.

Krainer, J. 1999. “A Theory of Real Estate Liquidity.” Federal Reserve Bank of San Francisco. Mimeo.

Ortalo-Magné, F., and S. Rady. 1998. “Housing Market Fluctuations in a Life-Cycle Economy with Credit Constraints.” Research Paper No. 1501, Graduate School of Business, Stanford University.

Stein, J. 1995. “Prices and Trading Volume in the Housing Market: A Model with Down-Payment Effects.” Quarterly Journal of Economics 110(2), pp. 379-406.

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

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