FRBSF Economic Letter
99-24; August 6, 1999
 Economic
Letter Index
Hot and Cold Real Estate Markets in the San Francisco Bay Area
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-MagnŮ 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.
Conclusion
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
Economist
References
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 this newsletter 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. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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