How to Buy Smart in a Housing Downturn

If you've been keeping up with the news, you'd probably think that housing in the Bay Area would be a bargain right now-- or at the very least, much more affordable. After all, many news outlets have reported that median prices for homes sold in April dropped an astonishing 41% compared to last April, and 54% from the peak.

But if you're a buyer, especially in prime areas like Berkeley, Mountain View or Lafayette, you'd quickly discover that home values have not dropped anywhere near that amount. In some cases, like Palo Alto or Sausalito, prices have even gone up slightly. (See this spreadsheet for more info:  http://www.docstoc.com/docs/6177652/Bay-Area-Home-Prices also embeded at bottom of this post)

Why the discrepancy?

 First off, you should probably look at the data. Many news outlets focus on prices of sold homes. The problem is that about half of the homes sold in the past few months have been foreclosures, and sales volumes at high-end markets have been anemic. Both of those factors drag down the median price for homes sold.

A more accurate way to tell how home values in a specific area are doing is through information provided by the real estate data company Zillow, says Assistant Professor Thomas Davidoff at U.C. Berkeley's business school. Zillow uses a complex formula similar to the Case-Schiller Index – often hailed as the gold standard -- to calculate the value of every home in a given region. (You can read more about the Zillow Home Value Index here. According to Zillow, the median value of the top third of homes in the first quarter of 2009 was $840,000 and only dropped 14.3% from the same period last year.

So, why have high-end homes retained their value?

“There's no transaction volume,” Davidoff says.

High-end markets draw a different type of buyer -- people who have greater net worth and whose wealth is not always tied to their paychecks, says Paul Habibi, a lecturer at UCLA's Anderson School of Management. The Bay Area has a higher concentration of entrepreneurs and people who have family money, Habibi adds. As of 2005, 5% of households in the San Francisco and San Jose region had at least $1 million in financial assets, the highest percent of 18 regions surveyed by research firm Claritas, according to the San Francisco Chronicle.

The wealthy can pay in cash or put down substantial down payments, says Amy Bohutinsky, Vice President of Communications at Zillow. So when prices fall, the wealthy are less inclined to sell   and can hold on by cutting back in other areas, like vacations or other types of consumer spending. In contrast, lower-end buyers put down smaller down payments so if their home values have dropped below what they owe, even if they sell their home they can't pay off the mortgage. So, it makes sense for them to foreclose.  

Home prices also remain high in prime areas because there's limited room for new housing development. Stronger markets have finite land and it can be more difficult to get government approval to build. “If you're looking at property value decreases of 40%, obviously those were areas with a ton of new supply,” Habibi says.

So, are high-end homes overpriced and if so, will the bubble pop? It depends on who you ask. There are several indicators of bubbles -- like whether prices out pace median salaries or rents -- and experts value these signs differently.

Habibi says there has been a bubble. “I don't think any market can grow at 20% a year,” he says. “It's absolutely not sustainable. Unless the underlying income (rent) is growing at that same pace, the asset (home price) can't grow at that pace.” If it's cheaper to rent than to own, people will rent and that will drive home prices down. But, Habibi says, it's unclear whether the high-end market will drop substantially. It depends on how long the downturn lasts --  if high-end homeowners don't have to sell until the economy picks up, prices won't drop dramatically. But if the economy remains slow for a long time, there won't be an emerging middle class to buy high-end homes when those owners want to sell, which will force prices to come down.

Davidoff says it's very difficult to know whether high-end homes are overpriced because he believes their values are linked to future rent and appreciation, both of which are difficult to predict.  (see this calculator)

He sees a continued migration to the Bay Area because of its top-tier universities, lucrative industries like tech and biotech, geographic beauty and mild weather. Given the supply constraint of housing in the most prime areas, home prices will continue to rise in the long run, he says. “Anticipating future price increases, people are always willing to pay a lot of money there. If appreciation matches, it's hard to argue that prices are overvalued,” Davidoff says, adding that if someone says there's a bubble, she's claiming the value of a house doesn't look like the present value of rents. “You have to exclude the possibility that rents rise sharply in future. Why wouldn't it?” he says.

If homes are unaffordable to the current population, the poor may move out and the wealthy move in. “The Bay Area should be a playground for rich people. It's not clear why you have to have middle class people in the Bay Area. They can live in Atlanta or Las Vegas,” Davidoff says. “I don't think it's the direction it's going to go, but you could tell that story pretty plausibly.”

Davidoff says it's difficult to predict the future of the Bay Area high-end market – prices could drop 20% or stay the same and eventually go up. “It's hard to know the right price of a home in the Bay Area,” he says.

Whatever happens, know that the overall housing market hasn't bottomed yet. Zillow's Year-Over-Year declines are still growing every quarter. Once that figure drops, the bottom will approach, but economists can't tell when it's hit until after it happens. No one knows how much further the housing market will fall, but Bohutinsky believes the bottom could happen next year.

So, should you buy right now? Only if you can hang onto the property at least seven years, Bohutinsky says, “Home values (overall) will fall and eventually come back. It's not a short-term investment."