The practical advice file
Making sense of market indicators, part 1: sales.
We're bombarded by numbers these days, particularly when the media and pundits focus on real estate.
It's easy to repeat someone else's numbers and make it pass for reporting. Let's look at some typical recent headlines:
National home sales down 1%! California home sales down 40%! Bay Area home sales down 25%! Santa Clara County home sales down 30%! San Mateo County home sales down 19.5%!
Numbers? Check. Drama? Check. Insight? Never showed up.
What's insight got to do with making sense of a market indicator like sales? Isn't "insight" essentially subjective, often just another word for "spin"? Aren't plain old numbers all you ever need? Well, with home sales crashing about our heads, you'd naturally expect to see home prices crashing too. After all, it just makes sense. If fewer widgets sell, the price of widgets must go down. If fewer homes sell, the price of homes must go down. And how many readers of those headlines differentiate between "sales" and "prices"—aren't they just different ways of saying the same thing?
Yet my buyer clients are finding that crashing home sales don't necessarily mean crashing home prices. Some are finding the real estate landscape no friendlier than it was in 2005. Less friendly, in fact.
To illustrate the effect of sales on prices, let's compare the real estate markets of two adjacent cities, Palo Alto and East Palo Alto. Despite their similar name and location, Palo Alto and East Palo Alto differ markedly in history, infrastructure and reputation. Palo Alto is an upper-middle class community long known nationally and even internationally for quality of life. East Palo Alto is a relatively new city struggling to overcome a long history of discrimination and neglect.
I mention these differences not to persuade or dissuade you from living in either city, but to explain the often stunning differences between these two neighbors. Inevitably, the differences extend to their real estate markets as well.
Since we're talking about sales, let's compare sales trends in Palo Alto and East Palo Alto from 2005 to 2008. I've annualized 2008 sales for both cities, based on the number of 2008 sales as of May 27.
Pretty straightforward, isn't it? Sales are down 24 percent in Palo Alto from 2005. East Palo Alto sales plummeted 59 percent from 2005 to 2007, then doubled on an annualized basis early this year. If we "naturally" assume a positive correlation between homes sales and home prices, we'll expect Palo Alto prices to also have skidded 24 percent since 2005. We'll also "naturally" expect to see East Palo Alto prices, after cratering early in the period, rebounding strongly this year.
Okay, let's see what really happened. Let's look at the trend in the median price of a single-family home in Palo Alto and East Palo Alto over this period:
How about that? Palo Alto home prices have risen steadily, well into 2008, despite sales numbers that have fallen just as steadily. In fact, the numbers crunchers out there will notice that Palo Alto prices rose about 2 percent for every 1 percent decline in sales. Sure looks like a negative correlation to me.
East Palo Alto home prices, on the other hand, after staying flat through 2007, have dropped off the table in 2008.
So much for that "natural" positive correlation between declining home sales and declining home prices.
What's happening? Quite a few things, all of them important lessons for anyone trying to make sense of a real estate market.
Let's look at Palo Alto first. Home sales there have fallen, yes, but not necessarily because demand has fallen. In fact, demand for Palo Alto homes has remained high enough to keep prices rising. 2008 annualized total dollar volume in Palo Alto is down 10 percent from 2005, a record-breaking year in most parts of the country, but that's a negligible loss compared to East Palo Alto's 45 percent decline. What's going on? For one thing, the economic circumstances of the people who buy homes in Palo Alto differ from those of most people, including people who buy—or did buy, until recently—in East Palo Alto.
So demand for Palo Alto homes has stayed strong, even as Palo Alto home sales inexorably decline. How can this be? Because real estate is an imperfect market.
Usually if demand for a good rises, production of that good also rises as more producers are drawn to the market to provide that good. But let's think about who the largest producers of real estate inventory are, here on the mid-Peninsula, an area that's essentially been built out since 1960. Who produces Palo Alto real estate inventory? Not home builders, at least not nearly as much as they do (or did, until recently) in areas with fewer natural or legal restrictions on home building such as eastern Contra Costa County, Solano County and the Central Valley—all areas, not coincidentally, now hammered by the effects of overbuilding. No, here most of the real estate market's inventory is produced by current homeowners, bringing their own homes to market. (I suspect this is true of many of the most sought-after communities on both coasts.) Severe building restrictions mean that the number of local homeowners is essentially fixed, and, increasingly, they're declining to produce their homes as inventory for homebuyers. So Palo Alto inventory levels sink lower and lower.
If fewer and fewer homes come on the Palo Alto market, the Palo Alto market will have fewer and fewer sales, even though demand for Palo Alto homes rages.
What causes this shortage of Palo Alto inventory? No one knows for sure, but my guess is that it's due to several factors:
the mass media, which can't and won't differentiate among differing market conditions, bombards Palo Alto homeowners with the message that it's a terrible time to sell, even though Palo Alto homeowners live in one of the most extreme seller's markets in the country
years of rising prices have made it increasingly difficult for the average homeowner to make the customary move to a larger home in a better neighborhood (in fact, I wonder how many Palo Alto homeowners could afford to buy even their own home at today's prices) just as an increasingly affluent elite drives up the price of homes in a handful of sought-after cities and neighborhoods; faced with this, many Palo Altans chose to expand and remodel their current home rather than sell
the combination of rising prices and Prop 13 restrictions on property tax increases means that homeowners will pay substantially higher property taxes if they move up to a more expensive home, taxes that, again, increasingly only a well-paid elite can afford
even with the $250k/500k capital gains exclusion, many Palo Alto homeowners would face a substantial tax burden if they sell
for many Palo Altans, there's no compelling reason to sell: tech isn't crashing; subprime was never a factor in Palo Alto, so foreclosures aren't either; and many locals, residents and non-residents alike, think Palo Alto is about as good as it gets, so why move?
Which is why people beat down doors to buy a home in Palo Alto these days. Call it "flight to quality": in a declining market, people instinctively retreat to proven investments with historical staying power. Think of Palo Alto as a blue chip you can live in and you won't be too far wrong.
On the other hand, the broad market apparently considers East Palo Alto a less-proven investment. The charts tell us that East Palo Alto sales fell dramatically from 2005 to 2007—but that this decline had no effect on home prices, another contradiction of the "natural" positive correlation between sales and prices. How could falling sales have no effect on prices? One of the truisms of real estate is that home prices go up quickly and go down slowly. Until recently, most East Palo Altans had no urgent reason to sell at a steep discount. Home not selling? Well, East Palo Alto homes usually take a while to sell, so no need to get worked up about it. Yes, faint signs of impending collapse could be seen well before the subprime meltdown of late 2007, as sales slowed to a crawl while inventory ballooned not just in EPA but in related markets, but the number of ultra-motivated East Palo Alto sellers—short sellers, for example—was miniscule well into 2007, and bank-owned properties were rarer still.
This year East Palo Alto sales have rebounded just as—and only because—prices have tanked. This still isn't the "natural" positive correlation between home sales and home prices, but there is a correlation: thanks largely to a flood of bank-owned properties, East Palo Alto prices have sunk to levels not seen in years. Buyers, many of them investors, are beginning to show interest in East Palo Alto homes, but only at steeply discounted prices.
So to review, this exercise has shown us:
home prices can go up as home sales go down
home prices can go down as home sales go up
home prices can stay flat as home sales go down
The exercise hasn't shown us home prices go down as home sales go down, although, if we hang around long enough, we'll probably see that too.
So maybe sales isn't such a great market indicator after all. Maybe the real estate market is a lot more complicated than the numbers suggest. But undoubtedly the headlines will continue to focus on sales numbers.
In part 2, we'll look at another number, more arcane, not as well known, and just as potentially misleading: days on market.
But that's in two weeks. Next week, I revert to type and kick sand in the media's face.