Market Influences - My Take

Positive & Negative Influences - Existing & Potential -on Bay Area Real Estate Market Prices, Conditions & Trends

I am often asked how one development or another might affect SF and Bay Area real estate markets - tax law changes, interest rates, soaring stock markets, foreign buyers, migration trends, housing affordability, climate change, new home construction, and so on - but trying to evaluate one factor in isolation is often misleading because multiple factors often gang up to trigger a change, or 1 factor counteracts or ameliorates the effect of another. Or a single development has both positive and negative influences. I created this analysis in an attempt to organize my own thoughts on the possible impact of various factors on the market, and it is very much a work in progress.

I do not know how these factors will ultimately play out, which factors will become dominant and which will fade into irrelevance, or what new factors will arise. Circumstances will change, requiring re-evaluation of the thoughts below. As to market cycles, I have learned that booms can go on much longer than one would expect, or get second winds, and negative adjustments can arrive suddenly from unexpected directions. These adjustments can be of varying scale, in the nature of a dramatic crash (or bubble popping), the slow deflation of an over-pumped football, or some combination of the two. In periods of irrational exuberance - and I am not saying we are in one (though a review of history implies its inevitable arrival someday) - there are always many who insist it is not irrational (this time).

One thing is clear from multiple studies on forecasting: Most predictions made by analysts, economists and other "experts" turn out to be significantly off the mark, get the timing wrong (by years), or are fundamentally mistaken. And the more predictions they make and the more definitively they're stated, the less likely they are to be correct. There are just too many moving parts in the world today - economic, political, social, technological and ecological, many of which are not even on our radar screens at any given point - for any reasonable claims to certainty.

The order in which these factors are reviewed do not necessarily reflect an opinion of their current importance.

The Bay Area Economy

Positive angles: The Bay Area economy is probably stronger than it has ever been, and is possibly the most innovative and dynamic economy in the world. It is the high-tech (bio-tech, fin-tech) capital of the world, as well as being a major financial center. It is home to some of the biggest and most fabulously profitable companies on the planet. Employment and affluence have soared stupendously in past 7 years. In many Bay Area counties, unemployment rates hit historic lows at the end of 2017.

Negative: Not all Bay Area residents have participated in the benefits of the economic boom; income inequality is increasing; and over-exuberance in the local economy could be subject to correction - this could reverse employment gains, as occurred 2001 – 2005, during which SF employment declined by 70,000. I am not implying the situation today is parallel: There are material differences between the dotcom boom and the current high-tech boom, but, of course, there are also similarities. (There is nothing like sudden, spectacular wealth to generate hubris of similar proportions.)

Start-Ups & Possible Future IPOs

Positive: New start-up companies seem to open every week and start-ups add fantastic dynamism to the local economy. The potential for dozens of large, local companies to go public could inject enormous amounts of new wealth into the economy and housing markets. New wealth creation - in the many hundreds of billions of dollars - over the past 7 years has been one of the decisive factors in the Bay Area economy.

Negative: If investor and venture capitalist confidence suddenly collapses due to national or international events, as has occurred in the past, it will have adverse effects on currently unprofitable start-ups with negative cash flows and insufficient reserves.

Financial Markets

Positive angles: Soaring stock markets have been substantially increasing wealth and the sense of affluence, which fuels consumer confidence and housing markets.

Negative: Some analysts see dangerous signs of rational confidence tipping into irrational exuberance, which can have severely negative economic and social ramifications.* Even financial market volatility can have a chilling effect on real estate markets, especially at the high-end since the affluent are generally much more invested in, and sensitive to, financial markets. Such volatility can also stop IPO activity in its tracks. These last two effects occurred in the period of heightened stock market volatility from mid-2015 through mid-2016 (Chinese stock market crash, oil price crash, Brexit vote).

* Note: Confidence itself plays an enormous role in markets. It can be very challenging to determine the point at which rational confidence shifts into irrational exuberance, but when irrational exuberance abruptly shifts into fear, a stampede for the exits can follow - as an old English saying puts it: "They run all away, and cry, 'the devil take the hindmost'." In retrospect, the duration of the period of irrational market exuberance, when gains often accelerate into the stratosphere, typically seems utterly incomprehensible: "How could anyone have thought that this made sense?" Such are the pleasures of hindsight.

Interest Rates

Positive: Rates dropped 40% to 45% from 2007 to mid-2016, and remain very low today when compared to historical norms over the past 40 years. Interest rates play a critical role in the ongoing cost of housing and housing-purchase affordability, and lower rates have subsidized much of the home price increases since 2011.

Negative: As of early February, rates have been recently increasing and may be poised for further increases - potentially, a major impact on housing affordability at a time when affordability is already flirting with historic lows. (Fear of impending increases can motivate buyers to act now, which played a role in early 2017 market dynamics.) Per Freddie Mac, as of 2/8/18, the average rate for conforming 30-year loans was 4.32%, and it currently forecasts that interest rates for 2018 shall average 4.5%. This would be almost 30% higher than in mid-2016 and about 15% higher than in mid-2017. As points of reference, rates averaged 6.3% in 2007, 8% in 2000, and 10% in 1990. The lowest rates ever, reached in recent years, was about 3.3%.

Note that interest rate changes are extremely hard to predict, and forecasts have been more frequently wrong than right over the past 10 years.

Low Housing Affordability

Negative: A huge social and economic problem that increases poverty levels, puts terrible stress on many normal working people and families, and encourages resident and business relocation. It also discourages relocation into the area by job seekers evaluating options in other locations, and puts local business at a competitive disadvantage when recruiting talent. It can also discourage start-ups from starting up here. There are many other areas of North America, with less expensive housing costs, actively soliciting both start-ups and established businesses to locate there, or relocate there from the Bay Area.

Migration Trends

Positive: The Bay Area has become a magnet for the best and the brightest from all over the world. Local employment growth in the past 7 years (600,000+), generally of high-skill, high-pay jobs, has been nothing short of staggering. This has played a definitive role in the economy and in home price appreciation experienced since the recovery began in 2012.

Negative: More people are now moving out of California to other states than moving into CA from other states, per U.S. census data for 2016 (i.e., before new federal tax law changes). The scale of foreign immigration into the state and Bay Area in recent years has far exceeded the state-to-state deficit - but that was before federal policy turned distinctly hostile to immigration in 2017. As much of the Bay Area’s population growth, and economic and cultural dynamism has been fueled by immigration - currently about a third of Bay Area residents are foreign born - a reversal would certainly be an adverse factor.

High State Income Taxes

Positive: Presumably, improvements in quality of living, educational and social services (above those found in states with lower or no state income taxes).

Negative: Heightened attention to this issue is due to changes in federal income tax law, discussed further below. High state income taxes, especially now that the deductibility of state and local has been greatly reduced, is a substantial financial factor vis a vis competing locations. CA has the highest in the nation with rates generally running in the 9.3% to 13.3% range (this latter rate for incomes over $1 million). Several of the states receiving the highest number of relocating CA residents have no state income taxes: Texas, Washington, Nevada & Florida.

New Federal Income Tax Law

Positive: Residents who have not itemized mortgage interest or state income and local property tax deductions in the past, will probably see reductions in their federal income taxes. New corporate tax law may make local businesses more profitable and more valuable, which might lead to income and/or wealth gains for their employees - which would then feed into the local economy and housing markets. Heightened corporate profitability might also fuel further technological innovation, keeping the our high-tech boom booming, and increase investment in local communities.

The new tax law also has substantial benefits for some real estate investors, depending on their legal structure.

Negative: New federal tax law limiting the deductibility of mortgage interest and state and local taxes appreciably reduces the previously existing financial incentives of homeownership, and for for many Bay Area residents will significantly raise the cost of living, and specifically the cost of housing. Making the most expensive U.S. metro area to live in more expensive - and specifically, more expensive in comparisonto other places - discourages immigration into the area and encourages resident and business relocation to more affordable metro areas. The negative effects of these tax law changes are specifically focused on more expensive housing markets (which also tend to vote Democratic, which his another issue - a federal administration which clearly considers CA and the Bay Area a political enemy). Note: the CA legislature is looking for ways to blunt the effect of these federal income tax changes, however it is unknown to what degree it will succeed in light of the current balance of power prevailing in Washington D.C.

The new tax law will reduce the financial incentive to make charitable donations for many residents, which may reduce social services to those in need. It is uncertain how this will play out, but charitable organizations are very worried.

New Construction Boom

Positive: Accelerating residential and commercial construction in the Bay Area adds employment, investment, and business expansion potential, and, if it continues at the current pace, should improve housing affordability: Indeed, the recent boom in apartment construction in the city has already led to an 8-10% drop in rental rates since they peaked in 2015 (though our rents are still the highest in the nation).

Negative: There continue to be high hurdles for developers to get approvals to build, and already high construction costs are increasing: A recent report, by the UC Berkeley Terner Center, said SF had the 2nd highest building costs in the world (after NYC), much of that due to local resistance to and governmental regulation of development, as well as to labor and land costs. New construction is also historically subject to very dramatic boom and bust cycles. Last but not least, some residents believe that further development itself is a negative factor in quality of living.

Infrastructure

Negative: Upgrades in infrastructure have not kept up with the considerable growth in population. This is especially apparent in transportation and the subsequent increase in the time and aggravation related to commuting.

Debt

Positive: Interest rates remain historically low, making debt service less onerous to individuals and businesses.

Negative: In an environment of low interest rates, swelling consumer and business confidence and surging asset values, household debt (mortgage, car, credit card, educational), corporate debt, governmental debt and stock market margin-loan debt are all increasing, while economic optimism and a search for yield has weakened underwriting (risk assessment) standards. Sudden asset-price declines or economic turbulence wreak much greater havoc amid high debt levels. Debt played either a significant or dominant role In the last 3 financial crises: 1989-1990 – junk bonds, S&L crisis, bad commercial-loan underwriting; 2001-2002 – high rates of margin lending coupled with extreme, irrational financial-market exuberance; 2007-2008 – a total abrogation of underwriting standards, debt securitized and widely sold under defective ratings, widespread predatory lending and loan fraud, extreme use of leverage in financial institution investments.

Note that debt and debt levels, and when they reach dangerous levels, are a complex subject on which the writer is very much a layman analyst. Debt levels that seem tenable can abruptly become untenable if asset values suddenly plunge or interest rates jump. Federal governments (or an organization of federal governments like the EU) will sometimes step in to relieve or guarantee corporate or local government debt if default risks destabilizing the general economy.

General International Factors

Positive: The world economy and international financial markets are probably their strongest since 2007 and appear to be improving - with generally positive ramifications for the Bay Area economy.

Negative: International economic and political factors have an increasing impact on national and local conditions, and such factors appear to be becoming more volatile and, recently, antagonistic. Examples of recent negative, but manageable, international events before the new presidency, include the Chinese stock market drop in summer-autumn 2015, the oil-price crash of early 2016, and the Brexit vote in spring 2016, all of which caused significant, though temporary, drops in U.S. financial markets - and led to the SF luxury home market abruptly cooling, venture capitalist confidence and funding dropping, the number of local IPOs plunging, and a decline in local hiring during that period.

Examples of possible future international influences are virtually limitless, from political, social or financial instability in other major economies, to trade wars; technological attacks against our financial, communications, infrastructure and political/election systems; and, worst of all, real wars.

Ecological Factors

Negative: Impossible to predict speed or scale of effects from climate change, but increasing state and local potential for drought, fires and sea level change offers only unhappy longer-term ramifications. Current federal administration maintains policies that will almost certainly exacerbate the problem. And, of course, earthquakes are always a wild-card factor in the state and Bay Area.

Diminishing Frequency of Home Selling

Positive: For existing homeowners: limited supply encourages price appreciation and increases their net worth.

Negative: The considerably reduced supply of homes available to purchase has undesirable ramifications for housing affordability and also dramatically adds to the stress of home buying.

General Local Conditions

Positive: The Bay Area is one of the great economic, social and cultural metro areas of the world, located in a gorgeous setting surrounded by water and park lands, with generally moderate weather, a low nasty-insect ratio, and home to the world-champion Warriors basketball franchise. A great proportion of residents and businesses feel its benefits far outweigh its negatives, and they’re not moving to Texas despite the allure of lower home prices, no state income taxes, a world-class fossil-fuels industry, the right to carry assault rifles in public, and the pleasure of being represented by Senator Ted Cruz in Congress (a lighthearted jab in a longstanding interstate rivalry).

Negative: Significant social and economic changes, including the cost of housing, have, according to several recent polls, increased the percentage of Bay Area residents and businesses considering or willing to consider relocation (though not necessarily in the immediate future). It would be arrogant to argue that other states, and other metro areas such as Seattle, Denver, Portland and Austin, don't have their own legitimate appeal to businesses, working people, and retirees. (As a matter of fact, according to census figures, more Californians and Bay Area residents are moving to Texas than vice versa - a wake-up call against complacency.)

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The writer of this analysis is not an economist or tax attorney and some readers may believe him unqualified to comment on some of these topics. This report reflects the opinions of its author, and does not necessarily reflect the opinions of the agents, other managers or principals at Paragon. These analyses were made in good faith with data from sources deemed reliable, but may contain errors and are subject to revision. It is not our intent to convince you of a particular position, but to attempt to provide straightforward data and analysis, so you can make your own informed decisions.