Evidence of a Southern California Housing Bubble

Submitted by Rich Toscano on November 27, 2005 - 5:45pm
Contrary to popular perception, the fundamentals underpinning Southern California's explosive real estate boom are actually quite poor. So why have home prices risen so high? Because the local housing market is in the midst of a textbook speculative bubble.

Why Is Southern California Housing So Expensive?

Conventional wisdom goes that Southern California is experiencing a severe housing crisis with no end in sight. A lack of developable land, years of underbuilding, and a huge surge in population due to Southern California's desirability as a place to live have engendered a serious imbalance between housing demand and supply. Adding fuel to the fire is the fact that Southern California's wealth has grown significantly due to its robust and diverse economy. With all these factors at work, we are told, it's no wonder that home prices have risen so spectacularly.

Home prices have certainly risen, as this graph of San Diego home prices over the past decade shows:

San Diego Home Prices

However, the remainder of the above thesis is entirely off the mark:

  • There is no housing shortage.
  • There has been no population boom.
  • Local income growth has paled in comparison to home price growth.
  • Job growth outside the real estate industry has been very weak.
  • While Southern California may be a nice place to live, it was also nice 5 years ago, when homes cost half as much as they do today.

Let's start by taking a look at what hasn't caused home prices to rise to their current heights, with an eye towards identifying what has. I will use data from my own city of residence, San Diego, to illustrate what is and isn't driving the market—but later in the article I will show that the dynamics I'm describing are at work equally in all of Southern California.

Population and Housing

We begin with the most frequent home price justification of all: the alleged population boom and commensurate housing shortage. As always, when in doubt, we are well advised to look at the hard data.

From 2000-2005, the period we will be examining in detail, population increased by an annualized 1.6%. While this is hardly the population boom one constantly hears about, the supply of San Diego housing during the same period increased by an even smaller annualized rate of 1.2%. It is absolutely a fact, then, that population growth outpaced housing growth during this period, as shown in the following graph:

San Diego population and home supply

However, before quitting your job to become a condo flipper, consider the magnitude of the change in the population to housing ratio as compared to the change in home prices themselves:

San Diego population, home supply, and home prices

From 2000-2005, the ratio of population per housing unit increased in total by less than 2%. This means that if just 2 out of every 100 people got a roommate or moved in with the folks, there would actually be more housing availability now than there was in 2000. Given that population grew faster than housing supply, home prices could be expected to rise during this period. But to suggest that a 2% percent change in the ratio of people to housing supply is responsible for a 112% percent increase in home prices is questionable.

The timing of home price increases sheds further doubt on housing supply as a defense of home price appreciation:

San Diego population and home supply

If a housing shortage caused the first period of increase (a claim which is itself extremely dubious, as explained above) why did prices increase by 42% between 2003 and 2005, when the home supply was actually growing faster than the population?

It is crystal clear that, despite the constant arm-waving one hears about a "housing crisis," housing supply has had almost nothing to do with the spectacular rise in home prices.

The Diverse Economy

Another common defense of home valuations is the assertion that Southern California's strong and diverse economy has enriched our citizens to the point where they can afford homes at these prices. This claim is not borne out by reality, as is clear from the fact that since 2000 the median home price has grown over 6 times as fast as the typical income:

San Diego home prices and per capita income

Claims of a "diverse economy" also ignore utterly the fact that, as noted by the San Diego Union-Tribune, 50% of our job growth in recent years has taken place in the real estate industry itself. As this next graph shows, the number of San Diego jobs outside of real estate and construction has grown at an anemic 1% annualized rate since 2000:

San Diego job growth

It is circular to argue that housing is doing so well because of the economy when in fact the economy is only doing as well as it is because of housing. And to claim that home prices are supported by income growth is downright false.

Interest Rates

It is true that the disparity between income growth and home price growth has been mitigated somewhat by declining interest rates. However, there are two problems with the idea that low rates justify current home prices.

For starters, monthly payments have risen steeply even against a backdrop of declining rates. As the following chart shows, the monthly payment on a 30-year mortgage for the median priced San Diego home has risen by 69%, even though the mortgage rate decreased by 28% over that time.

San Diego monthly payments - fixed mortgage

Of course, few people attain fixed-rate loans these days given that adjustable-rate mortgages (ARMs) offer lower payments. However, even the drop in short term rates has not nearly offset the rise in home prices. Since 2000, the rate on a 1-year ARM has dropped 37%—but ARM borrowers still would have seen monthly payments on the median home increase by 59%.

San Diego monthly payments - ARM

To make the most extreme comparison: the monthly payment for a median priced San Diego home using an ARM in 2005 would have been 44% higher than the payment on the same home using a fixed loan in 2000. This, incidentally, coincides with an increase in per capita income of 17.5% during the same period, meaning that, even accounting for switching from a fixed loan to an ARM, monthly payments rose 2.5 times as fast as incomes during this period.

An even bigger flaw with the idea that current home prices are justified by low rates involves the implicit assumption that rates will stay this low. This is a very complex topic that is dealt with in other articles on this site, but suffice it to say that it's likely that rates will rise, and entirely possible that they will rise significantly. As a matter of fact, rates tend to fall during periods of economic weakness and rise during periods of economic strength—so if anything, falling rates would indicate that other housing fundamentals are worsening.

The current environment of low rates and easy lending does not explain away housing prices. Home price increases have already rapidly outstripped any offsetting reduction in interest rates, and the necessarily temporary nature of generational low rates and underwriting standards ensures that neither factor can provide justification that prices are sustainable at this level going forward.

"Everyone Wants to Live Here"

Many people choose to ignore this boring demographic data altogether, choosing to focusing on a higher level idea: "Everyone wants to live in Southern California."

This line of reasoning is quite flawed.

First, while it's indeed true that Southern California has a great climate and is a desirable place to live, this is not a situation that suddenly came into being in the late 1990's. Southern California has always had good weather—so how could weather explain the meteoric rise in home prices over the past 5 years? In other words, while SoCal's weather might explain why people pay more to live here than to live in North Dakota, it does not explain why people are paying more to live in SoCal now than they did in the past.

But they are paying more—a lot more. This can be measured by looking at how much Californians typically have been willing to pay for housing in comparison to their incomes. As the following graph shows, the comparitive expense of San Diego housing is at an all-time high, and incidentally makes prior bubble peaks look laughably small:

San Diego home prices to incomes

A second flaw with the "everyone wants to live here" argument is that whether people want to live here is not the issue. While desire to live in Southern California may be a theoretically unlimited quantity, the means to do so is not. There is an upper limit to how much housing can sustainably cost in relation to income, and it's got nothing to do with the temperature outside.

There's one more nail in this argument's coffin. It turns out that everyone does not, in fact, want to live here—not here in San Diego, anyway. Due at least in part to excessive housing-related expenses, more people have been moving out of San Diego than moving in for three years running:

San Diego net migration

Rents vs Home Prices

Let's step back and look at the issue of home prices in an entirely different way. All of the usual suspects—population, housing supply, income, and the desirability of the city—should affect the price of renting a home as well as buying a home. So rent prices, when compared to sale prices, should indicate whether or not sale prices are too high given the demographic factors. Not surprisingly, they do just that:

San Diego home prices to rents

From 2000-2005, sale prices rose over 4 times as much as rents, and the disparity has only gotten worse since 2003. The declining growth in rents concurrent with a phenomenal increase in sale prices provides yet another indication that those sale prices are not justified by fundamental factors.

Other Southern California Cities

I've used San Diego as an example for the above paragraphs, but the following graphs show that same story is playing out throughout Southern California:

Los Angeles home prices to incomes

Orange County home prices to incomes

Inland Empire home prices to incomes

San Diego home prices to incomes

A Classic Speculative Bubble

If current real estate valuations are not driven by population, a housing supply crisis, income growth, interest rates, or nice weather, what's happened in Southern California to have allowed home prices to get to such lofty heights?

The answer lies in the reasons people are buying homes. Let's look again at the graph of San Diego home prices vs. rents:

San Diego home prices to rents

In the past five years, it can easily be seen, people have been willing to pay more and more for an owned home as compared to a rented home. Why? Because now, much moreso than in 2000, an owned home is now considered far more than just a roof over one's head. A home is seen as a way to get rich, and people are accordingly willing to pay that much more to buy a home. Given that there is no fundamental underpinning for the price increases of recent years, it is clearly this "speculative premium" that has driven home prices to their current levels.

When prices are high only because market participants expect prices to go even higher, that's called a bubble. And Californians have bought into this bubble with great enthusiasm. Consider the following statistics, all from 2004:

  • 80% of San Diego mortgages were adjustable-rate, meaning that many borrowers were speculating that their salaries or home equity would increase faster than their mortgage interest payments. (San Diego Union-Tribune)
  • 47% of San Diego mortgages were interest-only, meaning that many borrowers were speculating that their salaries or home equity would increase faster than their mortgage interest payments and the eventual addition of mortgage principal payments. (Business Week)
  • 27% of San Diego mortgages involved no down payment, meaning that many borrowers could (and did) use ultra-low rate interest only ARMs with no money down in order to afford far more house than their incomes would typically allow. (San Diego Union-Tribune)
  • 37% of San Diego condo conversion buyers were investors, meaning that, given the comparitively low rents discussed above, the only possibility of these people not losing money is for condo prices to rise enough to cover the current negative cash flow. (San Diego Union-Tribune)
  • A poll of Los Angeles homebuyers indicated that the buyers expected, on average, that their new homes would increase in value by 22% per year for the next 10 years. (The Economist)

And most importantly, as anyone who has read a newspaper or gone to a party knows, it has become a widely accepted fact both in the media and among the Southern California populace that real estate A) never goes down and B) is the place to be if you want to get wealthy. This entrenched expectation of huge, risk-free equity gains has become priced into the housing market.

Home prices have been driven to current levels not by fundamentals, but by ubiquitous optimism, a complete lack of risk avoidance, a staggering amount of debt accrual, low lending standards, an enormous increase in market participation, widespread misconceptions about what drives home prices, and an utter dependency on continued price gains. Southern California is experiencing a classic speculative bubble.

This article has primarily focused on how prices got where they are. For a discussion of where they might go from here, please read the article entitled Risks of a Serious Home Price Decline.

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