"Sound investment strategy" or snare and delusion?
Every once in a while someone who stumbles across my Web site sends me an email that neatly sums up the current state of mind or state of the market or both. Responding to these emails gives me a chance to wax eloquent, and by the time I look up I've written myself another article.
The email I just received is logical, short and to the point. The sender—no names please, I never reveal my sources—seeks my opinion on the potential of neighborhoods within a short radius of a certain South Bay location.
It's the kind of email I hope I'd send if I were a buyer just starting out. After all, I choose my new car with one eye on the depreciation table. If it turns out that Brand A keeps 70 percent of its value after three years and Brand B only 40 percent, that's good information. It's exactly like the potential a neighborhood offers, only different.
Like night-and-day different.
As I answered the email, it dawned on me that the bewildering—even improbable—variety of real estate market conditions I was describing—cold markets, hot markets, Goldilocks just-right markets—all within a five-mile radius typify the micro-markets found throughout the South Bay and mid-Peninsula and, I suspect, in a large minority of markets throughout this country. If your area saw above-average appreciation over the past few years, most likely it's the kind of heterogeneous market we have here.
I also saw my chance to riff on one of my favorite subjects, the eternal alluring search for "upside potential", that snare and delusion to the unwary.
It just so happens that the center of my questioner's radius, a block where he most likely lives, is on an expressway that serves as an unofficial dividing line between widely differing markets.
Just to the west, neighborhoods are almost always above-average, schools always well above average, prices always slightly above average, and the market currently hot. It's an area that's always been extremely popular with middle-class buyers highly focused on their children's education. And, obviously, it still is.
Just as obviously, Prudent Buyer should avoid this area, because Prudent Buyer refuses to pay too much for a home, and buyers always pay too much for homes in an extreme seller's market. But hold on, there's a good reason this area is an extreme seller's market: it's popular. And there's a good reason it's popular: it has what buyers, including Prudent Buyer, want. Then obviously Prudent Buyer should bide his time and wait for prices to go down, as he knows they must. Except that the people who've been waiting for prices to go down since 1998 prove that there's downside to waiting for prices to go down. As much downside, perhaps, as the downside to paying too much.
Well, that certainly clarifies things, doesn't it?
Just to the east of this expressway, neighborhoods and schools are almost always dead average, prices always average, and the market currently warm to tepid. It's an area of what I call "second-choice" neighborhoods. They meet the typical buyer's needs adequately, and I'd be happy to live in any of them, but no one has ever knocked themselves out to buy a home here. And, obviously, they still aren't.
Just to the north of the questioner's location is a small neighborhood that's slightly above average, has schools well above average, and prices slightly above average. This market is currently red hot. No, it's blistering hot. Why? Well, what would you think if you found a neighborhood that looks as good as or better than South Palo Alto (the Holy Grail in this area for "entry-level" families with only $1.2M or so to spend on a home), sells for about 60 percent of what South Palo Alto sells for and, oh yeah, the local elementary school tests almost as well as anything you'll find in South Palo Alto. Does this sound like a bargain? It does to me, even though I don't believe in bargains, and it sounds like a bargain to lots of other people too. The only thing that keeps prices in this neighborhood only slightly above average is that it's not in a brand-name city. So what's in a name?
Continuing our survey to markets further east and north, but still within that five-mile radius, we find that things change.
Big time.
Now we're in some of the most affordable mainstream neighborhoods in the West Bay. Some have a modicum of charm but are held down by poorly-testing schools. Others are light on the ol' charm but have better-testing schools. A few have both measurable charm and decent test scores but are held down by the lesser neighborhoods and schools that surround them. Not that these are bad neighborhoods. In fact, some of them sell for what that "adequate" neighborhood I mentioned a few paragraphs above, the one that's in a warm to tepid market, sells for. A handful sell for even more.
Yet all are mired deep in a slump. Sales barely have a pulse, foreclosures and "short sales" are a significant part of inventory, price reductions abound, homes linger unsold and unwanted, and many are taken off the market unsold. It's everything bad the bubbleheads predicted and yet, with homes in these neighborhoods taking an average of thirty days to sell, this'd be a red-hot market in many parts of the country.
Obviously Prudent Buyer should focus on this area. Why? Because it's an extreme buyer's market, with good deals in abundance. But just how good are these deals really? Why do I ask? Because does anyone really know how much longer this area will slump? Does anyone really know long prices will continue to decline? And by how much? Does anyone really know if this year's screaming deal won't be next year's he-paid-too-much bummer? And even if it really is a screaming deal next year, does Prudent Buyer really want to live here? Will Prudent Buyer be happy, a year or two or five from now, even if prices go down? Or will he be kicking himself for getting head-faked by the illusion of value?
And while we're at it, Prudent Buyer would doubtless want to know why it is that neighborhoods within a five-mile radius, with the same type of housing stock, can range from extreme buyer's markets to extreme seller's markets.
Where'd I put my soapbox? Okay, here it is. What the media and bubbleheads and apparently most of the academic real estate economists don't understand is that neighborhoods five minutes apart can be driven by market forces worlds apart.
Every real estate boom and bust (or non-boom and non-bust) is different.
The neighborhoods I've just described—in fact, every market I could describe from experience—have been driven by different market forces and different buyers. Sometimes the differences were subtle. Other times they've been dramatic.
Here on the mid-Peninsula, I could drive you from one market, South Palo Alto, that acts like it's still early 2005 (or March 2000), with a crush of buyers elbowing each other aside as they drive up prices in frantic competition for virtually no inventory, to an adjacent market, East Palo Alto, that's buried under a landslide of real estate calamity the likes of which we haven't seen since the early 1990s, with a crush of sellers elbowing each other aside as they try to get out of town while the gettin' is good, slashing prices as they frantically compete for virtually no buyers. One market is manic, the other depressive. And a drive from one market to the next would take all of about five minutes.
You can see these different worlds even in the condo and townhouse market in one local city, Mountain View. Midrange and top-end properties there sell quickly, as do single-family homes, while low-end properties, mainly old small condos in less sought-after neighborhoods, just sit. At a recent open house for a nice well-located Mountain View townhouse I heard a young woman gloat to the listing agent that "if people can't get loans, prices have to go down". No doubt she'd been waiting years for her moment of triumph. But what she didn't understand is that buyers like the ones I was with, typical buyers for that townhouse, can easily still get a loan, because people who have money can always get more. She happened to be in the right city but at the wrong open house. She needed to drive down the street to the open house for the forty-year-old one-bedroom condo with orange shag carpeting, the condo she'd never buy in a million years. Then she could gloat. But I bet she was surprised when that nice well-located townhouse sold the next week.
Different markets, different buyers, even within the same city.
These differences are fairly subtle in the South Bay neighborhoods my questioner is interested in, because differences in neighborhood wealth there are fairly subtle, although I suspect they're more dramatic than in many parts of the country.
The neighborhoods hardest hit in the South Bay and on the mid-Peninsula are the neighborhoods that relied heavily on, yes, you guessed it, 100 percent financing and Alt-A and sub-prime lending. This riskier lending peaked in 2005 and 2006, when in some neighborhoods it accounted for most market activity. It also seems that "flippers", that other group of risky borrowers, were more attracted to these neighborhoods due to their lower prices.
I'm a little vague on where flippers bought, and what they used to buy with, because I've never worked with one—the flippers I've met barely had enough money for gas—and with the exception of one listing last year in a low-income neighborhood, I can't remember the last time I've seen a sub-prime, Alt-A or 100 percent financing loan. The loan agent I work with is no help either. She's done plenty of loans over the past few years but only one, a refinance for homeowners in a low-income neighborhood, was below prime. Prime is the world she and I work and sell in.
Different buyers, different market forces, different neighborhoods, different worlds. If you want proof of how stratified Silicon Valley society is, just look at how the stratified its real estate markets are, each with virtually its own real estate and mortgage industry, its own salespeople, loan agents and lenders, its own buyers and sellers, its own customs, and its own (sometimes here-today-gone-tomorrow) financing tools. When the flood of sub-prime, Alt-A and 100 percent loans suddenly dried, it was quickly and startlingly apparent which markets they'd been driving since 2005 and which buyers had been fueling those markets. They were buyers I typically don't work with, not because I don't want to, but because they were buying in neighborhoods I typically don't work in, again not because I don't want to, but because I typically don't have buyers for those neighborhoods. That's how real estate, a business based largely on social networking, works.
Different buyers, different market forces, different neighborhoods, different worlds. That bears repeating.
Because what's ironic about this—and one of the entertaining things about real estate is that it has plenty irony—is that, given the demographics of the people most likely to post on blogs, the bubbleheads predicting catastrophe for real estate were right—but most likely not right about the neighborhoods in which they lived. One of the most popular bubble bloggers lives in a neighborhood where the real estate market continues to go from strength to strength because local techies like him are well-paid, well-employed and love the neighborhood. Sometimes you can be right, and not be right.
"Spreadsheets, how could you fail me?"
That's how real estate works.
Here's more irony. What's happening in Silicon Valley these days is the exact opposite of what happened during the last market correction, the tech bust. The markets that boomed back in the days of dot-com irrational exuberance were also the hardest hit in 2001 when that exuberance suddenly disappeared, yet these markets are doing relatively well now. And the markets hardest hit now are the markets that shrugged off the tech bust. In fact, neither the tech boom nor the tech bust made much of a difference in Silicon Valley's most affordable neighborhoods. Different buyers, and you know the rest.
Which finally brings us, as promised, to the topic of potential: that snare and delusion.
If "potential" in real estate is defined, as it logically might be, as a neighborhood that holds its value through thick and thin, with fantastic upside and minimal downside, then where do all these booms and busts and zigs and zags within booms and busts I've just described leave us? Markets that tanked in 2001 are doing just fine, thanks, in 2007. Markets that came through 2001 like troopers are 2007's casualties.
Know what? It's no surprise. The reason you're encouraged to diversify your stock market portfolio is because today's high-flying sector is tomorrow's disaster area. A chart in the latest Vanguard newsletter shows that since 1997 no one type of investment—bonds, international stocks, large- or small-cap growth or value stocks—has led the market for more than two years straight, and often what was way up one year was way down the next.
That's also how real estate works. That's the unpredictability, the seeming randomness that trips up the bubbleheads, the media and anyone else who thinks real estate is one monolithic market always propelled in the same inevitable direction by the same simple and grossly simplified market drivers. That's what trips up the market timers, either in real estate or in the stock market, who think they know where the market is going before it gets there.
Potential? I'll define potential. Potential is buying the house you like and can afford, and then living in it—not such a bad thing, if you didn't buy it just for its potential—for the next five to ten years. Because, at least in this area, you can be sure, as sure as you can be sure of anything, that by then real estate will have been good—and often very good—to you.