The collapse of the residential markets in the United States has been dramatic, with spiking foreclosure rates, plummeting home values and sharply lower sales volumes. This turmoil has produced severe losses for almost every business involved in the creation, sale or financing of housing. A significant number of these businesses have been unable to sustain these losses and have failed. Those that remain are frozen by the lack of credit in the market.
So, in the face of these grim realities, what will draw investors back to the housing market? How will the risk in the housing market be re-priced to attract new capital?
Our thesis is that the housing market of the near future will look a lot like it did earlier. That is, it will look like it did before the incredible credit and speculative bubble that existed from 2003 to 2006. We are now enduring the very difficult aftermath of the popping of that bubble, but once the bubble has been fully deflated and the pain has been absorbed, the fundamental determinants of the housing market will be the same as before: supply and demand, job growth and income. Because these fundamental forces are specific to location, the housing market will revert to a pattern of prices that vary from place to place — a situation that pre-dated the bubble — which was a sea lifting all ships indiscriminately.
The nine-county Bay Area market, for example, has its urban cores, inner-ring suburbs and exurban areas, all unique markets that behave differently. For the Bay Area as a whole, the inevitable population growth will beget the formation of new households, and with it, a likely return to positive job growth. The demand for housing generated by growth in population and jobs will burn off excess housing supply in the region over time, though the performance of geographical submarkets will vary greatly.
Portions of southern Marin, San Francisco and the Peninsula have relatively restricted reservoirs of available housing for future development as a result of legal, political and environmental constraints. These same areas are highly desired by both employers and households, though the ability of potential buyers to actually purchase a home is often constrained by supply shortages. Because the available supply is smaller in these areas, we can expect them to lead in price recovery as demand driven by increasing job levels and desire for housing recovers. As this demand recovers, these areas will see higher rates of purchases and a corresponding diminishment of housing supplies, and therefore they will revert to their chronic state of undersupply and its related upward price pressure.
In contrast, the more remote suburbs of east Contra Costa county — Brentwood and Antioch — historically have issued permission for larger quantities of new housing. The far East Bay is negatively affected by its distance from — and long commute times to — the region’s job centers. While the recovering demand in the region will eventually migrate to these areas, the increase in the rate at which homes are purchased — or “absorbed” — will be less, and the time to burn off excess housing supplies, including the large number of foreclosed homes, will be greater. Housing prices and absorption will be constrained in these markets by the overhang of supply for a far longer time than they will be in southern Marin, San Francisco and the Peninsula.
Historical Trends
Between 1987 and 2002, the Bay Area population increased by 18 percent. The growth was spread out over the nine counties, with Solano County having the highest growth rate of 28 percent and San Francisco having the lowest growth rate of 6 percent. The largest population growth in terms of total residents occurred in Santa Clara county, which added 301,000 people, followed by Alameda County and Contra Costa County, both of which added approximately 250,000 people.1
Bay Area housing development has not kept up with demand. Even during 1999 to 2006, the development of housing fell nearly 19,000 units short of the American Association for Bay Area Government’s projected demand of 231,000 units needed to house the region’s rapidly growing population.
According to the Association of Bay Area Governments, Bay Area housing development was not able to keep up with demand arising from this population growth. Even between 1999 and 2006, when housing was being built at unprecedented speed, only 92 percent of the housing units ABAG determined were needed in the region, based on population and demand, were constructed. All of the counties built less housing than ABAG determined they needed, with the exception of Contra Costa County. The extreme case was San Mateo County, which was underbuilt by 37 percent.2
This population growth and undersupply of housing resulted in strong increases in home prices. There are numerous data sources to measure home price values, but one common industry tool is the Standard and Poor’s/Case-Shiller Home Price Indices, a set of comparisons that measure the growth in values in specific regions. The S&P/Case-Shiller Index for single-family home values shows a 6.85 percent compound annual growth rate in the San Francisco Metropolitan Statistical Area between 1987 and 2002.3 From its year of inception in 1995 to 2002, the S&P/Case-Shiller Index for condominium values in the San Francisco Metropolitan Statistical Area shows a 10.83 percent growth rate. These home-value growth rates far outstripped the S&P/Case-Shiller Index for the top 10 metropolitan areas, which were 4.65 percent for single family homes and 8.79 percent for condos. Clearly, Bay Area home prices have been affected by a fundamental supply and demand imbalance even before what many consider the real estate boom cycle of 2003 though 2006.
The Boom Cycle — 2003–20064
From a finance and investment perspective, the boom cycle of 2003-2006 blossomed out of changes beginning in 2001. The dot-com bubble, coupled with the September 11, 2001 terrorist attack, threatened to pull the United States into a deep recession. In response to the threat of recession, the Federal Reserve System dropped the federal funds rate — the interest rate banks charge each other — by 37 percent in one year.5 This move dramatically affected mortgage rates and construction loan rates. After the rate decrease, the 30-year annual average mortgage rate dropped to 6.97 percent, a 14 percent drop in one year. Mortgage rates continued to drop through 2003 to a level of 5.83 percent.
During this time, national policies sought to expand homeownership to a greater percentage of the population. The low interest rates and new policies, in particular lenient lending standards, are thought to have cut short the 2001 recession and fueled the residential housing market. People who were previously priced out of the home market due to high interest rates were able to afford to buy a home based on the combination of new rates and low or nonexistent down payments. This increased demand created a surge in housing prices nationally. In the Bay Area from 2003 to 2006, the S&P/Case Shiller Index reflects a rise in single-family and condo home values of 14.74 and 13.59 percent compound annual growth rate. In many markets the appreciation was far greater.
Real estate investors took notice of the strong price appreciation. Hedge funds invested through the public markets, private equity firms placed capital with developers, and construction loans were readily available with low equity requirements. The increase in capital allowed developers to entitle and build larger projects. Single-family home communities and condominium projects sold out before they opened, and the absorption rate of units was phenomenal.
Then, in the second quarter of 2006, the outer edges of the Bay Area began to unravel — and in mid-2007 the inner region fell apart.
From its year of inception in 1995 to 2002, the S&P/Case-Shiller Index for multi-family home prices in the Bay Area shows a 10.83 percent growth rate. These home value growth rates far outstripped the S&P/Case-Shiller Index for the top 10 metropolitan areas. Clearly, Bay Area home prices have been affected by a fundamental supply and demand imbalance even before what many consider the real estate boom cycle of 2003 though 2006.
The S&P/Case-Shiller Index for single family home values shows a 6.85 percent compound annual growth rate in the San Francisco Metropolitan Statistical Area between 1987 and 2002.
In the Midst of the Bust
The immediate pain is real and pronounced for real estate investors. Developers are plagued with unsold product and stalled projects, as consumers have all but vanished due to job losses (real or feared) and a tightening of credit. In the Bay Area this has manifested itself in a precipitous decline in housing values — 42 percent from the peak in 2006.6
Builders have slashed prices to bring buyers back to the market, but the lending standards have dramatically changed, making it difficult to close deals. Even though interest rates are still at historical lows, banks are often requiring a 20 percent down payment or more, particularly if the buyer wants to purchase a condominium. Most lenders have withdrawn from the new construction condominium market completely, showing extreme risk aversion. Fannie Mae, the government-sponsored entity with its self-proclaimed mission “to provide liquidity and stability to the [United States] housing and mortgage markets,”7 has been unwilling to provide mortgages to buyers or purchase mortgages in the secondary market for condominium projects that have less than 70 percent of units sold. The new thresholds are highly problematic for developers trying to liquidate supply.
Looking Forward
According to ABAG, the nine-county Bay Area population will grow by 22 percent through 2035. With a weighted average of 2.7 people per household8, this represents a demand of approximately 22,000 units per year over the next 25 years. Current market conditions will constrain housing supply, allowing this demand to eventually consume surplus housing stock and drive housing prices back up. New projects will become financially feasible, even with conservative underwriting standards. But when, where, and how will development projects begin to emerge again?
We believe that investment capital will be drawn first to those housing markets that have been historically undersupplied. In the Bay Area, for example, this means San Mateo County before east Contra Costa County. We also believe that pricing spreads will be more differentiated among markets, reflecting the differing risk profiles of those markets. Across all markets, though, pricing will reflect the higher returns demanded by risk averse equity investors and lenders. These returns will be calculated with conservative underwriting assuming lower rates of absorption, inflation and leverage — the use of debt to increase potential investment profits — along with higher interest rates when compared with those investments underwritten in the boom cycle.
Within the first markets to come back, the initial projects will be smaller in size, cheaper to construct and generally less complex. While new construction of single-family homes and townhomes would seemingly lead the recovery, the lack of land for low-density projects in the most housing-hungry markets eventually will lead to a comeback for multi-family projects.
While denser multi-family housing is desirable because of environmental and social advantages, it is riskier to investors. The greater risk associated with multi-family projects when compared to less dense projects is associated with greater upfront capital requirements; longer timeframes for entitlements, construction and absorption; higher exposure to product liability lawsuits; and larger carrying costs. Public policy created to speed up multi-family project entitlements could significantly help reduce the inherent risk involved with such projects. Additionally, reducing the fees and exactions placed on new housing could increase the number of financially feasible residential projects.
When developers finally move back into multi-family housing, they will reevaluate project size. The total number of units in one building will match demand and conservative absorption assumptions. Additionally, buildings will be designed with the greatest number of units in the cheapest construction type, and wood frame construction is likely to be seen prior to concrete. For example, if 80 units are planned to be built as a six-story concrete building, the units might be shrunk in order to fit 80 units into a wood framed four-story building — a difference of 15 to 20 percent in price per square foot.
As we try to look past the current difficult residential investment market to anticipate the characteristics of any future recovery, we believe that key determinants of past market performance will reassert themselves over time and shape the coming recovery. We note that the “bubble” of 2003-2006 was a distortion of the market that resulted from policy changes by the federal government (reducing interest rates, increasing home ownership rates) in response to the financial shocks of 2001. When the distortions of 2003-2006 are ignored, the key determinants of residential market performance have been supply and demand, job growth and income. We anticipate that these same factors will influence the residential markets when a recovery commences.
In the Bay Area, these market factors explain the differing performance of submarkets before the bubble of 2003-2006, and may predict the performance of submarkets prospectively. The residential markets in southern Marin, San Francisco and the Peninsula have been chronically undersupplied, and attract relatively high-income homeowners. In comparison to the supply abundant in the far East Bay, the areas of southern Marin, San Francisco and the Peninsula held their home values later and fell less from their peaks. We expect these markets to lead in the recovery, as their very modest levels of available homes are quickly eliminated as the markets firm.
We also expect the investment market to return to conditions that existed before the 2003-2006 bubble. Before hedge funds and other Wall Street vehicles entered the markets, residential investments were underwritten with a goal of matching absorption to construction, and properly pricing the risk in a market perceived to be cyclical. Specifically, leverage was lower, interest rates higher and goals for equity returns greater, all of which led to the construction of smaller projects than have been typical over the past five years. We believe these more conservative underwriting standards will represent the norm going forward.
While investment in housing in the future is likely to be a more constrained, sober business than it has been for the past several years, it is important to remember that it was a sound business before the bubble. In places like the Bay Area, demand is driven first and foremost by the great quality of life.
Between 1987 and 2002, the Bay Area population increased by 18 percent. The growth was spread out over the nine counties, with Solano County having the highest growth rate of 28 percent and San Francisco having the lowest growth rate of 6 percent. The largest population growth in terms of total residents occurred in Santa Clara county, which added 301,000 people, followed by Alameda County and Contra Costa County, both of which added approximately 250,000 people.
ENDNOTES
1 State of California, Department of Finance, Demographic Research Unit. http://www.dof.ca.gov/html/Demograp/druhpar.htm. Data compilation by MTC staff. Estimates for 1991-2000 were updated (April 2002) to include the DOF's revised intercensal (1990-2000) population estimates. Updated Dec. 28, 2008 to include revised population estimates.
2 Association of Bay Area Governments. A Place to Call Home. Housing in the San Francisco Bay Area. 2007. Available at www.abag.ca.gov.
3 Case-Shiller Home Price Index. May 2009. Note that the metropolitan statistical area excludes Santa Clara County.
4 Based on the Case-Shiller index, the market peaked in 2006 and started to trend negatively in 2007.
5 The Federal Reserve System. 2009. http://www.federalreserve.gov/releases/h15/data/Annual/H15_FF_O.txt.
6 Case-Shiller Home Price Index. May 2009.
7 Fannie Mae. May 2009. http://www.fanniemae. com/aboutfm/index. jhtml?p=About+ Fannie+Mae.
8 2007 American Community Survey. U.S. Census Bureau.