How to Make Sense of Bay Area Home Prices

23454 Sunset Drive, Los Gatos Mountains, sold for $3.325 Million in May 2016

If you’re like most people, you’re probably wondering how to make sense of Bay Area home prices? These are crazy times for the California real estate market, there’s no doubt about it. We just hit a new record median home price in Santa Cruz county – the median home price in May 2016 for single family homes was an even $800,000. In Santa Clara county, the median home price in May was much higher – $1.1 million!

A lot of people are in fact very nervous and unsettled by what’s going on with the bay area real estate market – both home owners, and would-be home buyers. That’s why I wanted to put my thoughts down and hopefully lend some perspective to folks.

Bay Area Real Estate Prices are Very Real

I’d like to start out by saying that the strong price rises we’ve seen over the past few years are not smoke and mirrors. The bogus no-down, liar-loans of yesteryear are not fueling this boom. It turns out, what’s fueling our local boom in home prices is, actually, a booming economy. In fact, California recently re-took its place as the 6th largest economy in the world.

And as a side note, the BEA also estimated that California’s economy grew by 5.7% in 2015 – the second highest growth rate in the US, just behind Oregon’s 5.9%. – Business Insider, June 15, 2016

The California economy has been on a roll for a number of years, driven in no small part by the rampant success (excess?) of Silicon Valley. Soaring rents, gridlocked traffic, packed beaches and shopping malls, and surging home values are all manifestations of an ebullient economy. But for how much longer? California Governor Jerry Brown recently remarked:

By the time the Budget is enacted in June, the economy will have finished its seventh year of expansion, two years longer than the average recovery. The next recession is getting closer — even if we cannot tell exactly when it will hit. – Southern California Public Radio, May 13 2016

Santa Cruz County Median Home Price since 1990

Real Estate Prices will Head Down

It’s not a question of if, but when, the next recession will hit. And when it does, home values will sink. Contrary to popular belief, home prices in the Bay Area have dipped (and sometimes plunged!) many times over the years. Obviously, if you’re a home owner thinking of selling, you’d want to sell before the next price drop. If you’re a buyer, you’d rather that prices drop before you buy. What’s more, prices may well keep rising before they fall – but for how long, and how much higher might they rise? And when they fall, how low might they go?

Of course, nobody knows when the market will peak and start heading down. If only we knew, life would be so much simpler. But we don’t know, and this not knowing leads to considerable angst on everyone’s part.

Santa Cruz Home Price Boom and Bust, 2003-2009

What we do know for sure is that right now is, without a doubt, the hottest seller’s market we’ve ever seen.

This being the hottest seller’s market, possibly ever, begs the question: should I really be buying a house right now? To answer that, let’s take a step back.

Bay Area housing cost is cheaper than it was

Consider the fact that today’s $800,000 (the May median home price in Santa Cruz) is not the same $800K as it was in 2005. The prior Santa Cruz median home price record of $789,500 – set in November of 2005 – would today equate to a median home price of $967,212. In real terms, housing prices today are 17.2% lower than they were back at the prior peak.

Not only that, but mortgage interest rates today are about 3.75%; in 2005, the interest rate was about 6.5%. That means if you were paying a $600K mortgage in 2005, you would be paying $3,160 per month. However, $3,160 in 2005 dollars equates to $3,887 in 2016 dollars. Today, that same $600K mortgage debt would cost you just $2,315 per month – a whopping 40% cheaper in real dollars.

Renting is Costlier than Owning

Next, consider the cost of not buying a home. If you love where you live, and plan to stick around for, say, the next 10 years or more, not buying a home will be a very costly choice. Let’s say you’re renting a home for $3,000 a month – not an exorbitant rent for a single-family home in most parts of the Bay Area. In ten years of renting, you’d be out $360,000, with nothing to show for it – and not a penny of that paid rent would have been tax deductible. Had you bought, even if your home increased by $0 over a ten year period, you would surely walk away with more than $0 when you sold your home, assuming you hadn’t refinanced it and continually sucked all the equity out in the interim.

Net worth of Homeowners vs. Renters

That helps explain why, according to the U.S. Federal Reserve Survey of Consumer Finances, home owners have up to a 46 times greater net worth than renters. We could go on and on about why that is and how renters could be just as rich, or richer, than home owners if they would just follow x-y-z investment strategy. But the fact is, for many people, buying a home just makes good sense, even when the price seems ridiculously, ludicrously high.

So go ahead – buy that house. And it could be that home prices sink down in a year or two. But if history is any indication, it won’t be long before home prices start marching right up again, and you should continue to build wealth the old fashioned way: slowly, over time.

In conclusion, I want to share a great episode of NPR’s On Point Radio which aired a couple weeks back. The episode is titled American Housing Prices Going Big, Again. If you’ll take some time to listen to it, you’ll hear that what’s going on with the housing market is by no means a regional phenomenon.