Real Estate Numbers That Don’t Get Enough Love
You’ve definitely heard about the saying “location, location, location” so I won’t beat the dead horse to emphasize how important this is. I often hear friends and clients rave about how much an area has appreciated but I rarely hear people comment on how well an area held its value during economic downturns. The combined effect of high inflation, supply chain crunch, and record-low inventory have pushed the home prices to all time high. However, it’s anybody’s guess on how much home prices will correct once the planned rate hikes take full effect (expect 6 more hikes this year). Therefore, it is critical to understand the amount of protection we can expect in a given locations. There’s a basketball saying that “defense wins championships”, (04' Pistons for any NBA fans out there) and I think there’s definitely some truth in that in real estate.
In this article I will touch on the following:
- How Bay Area home prices are supported
- Growth rates and downside performance
- Thoughts for home buyers
How Tech Innovation Affects Real Estate Value
Value creation in the Bay Area hinges on tech innovation and venture capital funding. As tech startup journeys from A series to late stage funding to IPO, tremendous monetary value is created for the shareholders as well as the employees through stock compensation (either ISO or RSU). Millionaires are born whenever a company takes itself public. Companies that are already public aren’t doing too shabby either. FAANG (Facebook, Apple, Amazon, Netflix, Google) are still seeing 15% to 20% revenue growth YoY and doubling their revenue/profit every 3 to 4 years. This growth is reflected in their stock price and employees who stuck around long enough to vest all their stocks are surely very happy. There are, of course, other smaller tech companies growing at over 30% YoY so just imagine how quickly wealth accumulates.
It’s interesting to note when the stock market corrects the Bay Area homes generally sees a correlated correction too (see second half of 2018). The stock market correction in Q1 2022 is not reflected in the Bay Area real estate market, however. This could be because the tech companies already made so much money in the past two years and housing inventory is at all time low. If you are a buyer, don’t be discouraged and exit the market. There are a few signs of weakened purchasing power.
I came across a re-listed home in Newark, CA in this February and asked why the previous contract fell through. The listing agent said the previous buyer could not close their financing because their Facebook stock fell 40%.
Proximity to Jobs
The reason value creation and company stock performance matters so much in Bay Area real estate is they represent a significant chunk of the purchasing power. This increase in purchasing power results in elevated home prices near the high paying jobs, because nobody likes to sit in dry and mundane commutes everyday. The map below shows the 2019 median income in each zip code in the Bay Area. The darker the blue, the wealthier the zip code is. For those who are not familiar with the Bay Area it should still be relatively easy to spot the correlation.
P.S. I left omitted Atherton (94027) on purpose because the median income in that zip code beats every other zip code by miles! Anyone want to guess what the median income was in 94027? Answer is at the end of the story.
If you look real close, you might wonder why high earners don’t flock to zip codes like 95050 and 95112, where a lot of companies are located? Enter another home value factor: school rating.
School Ratings
We naturally, as do most people, want their children to receive the best possible education. This is especially true in the Bay Area where academic competition can be felt at an early young age. So understandably the high income earners are willing to pay more to live in areas with the best school programs. Once you look at the map below it will become evident that school rating is one of many reasons 95050 and 95112 do not attract the super high income earners. Palo Alto, Mountain View, and Cupertino on the other hand, have some of the best school programs and are highly desirable for people with school age children.
It’s worth noting there are many other factors including zoning, overall feel of the neighborhood, and proximity to amenities that also affect real estate value and this article should not be taken to understate their significance.
Take a look at the three maps again and it’s not hard to see why cities like Palo Alto, Mountain View, Cupertino, and some parts of Sunnyvale attract the highest income earners in the Bay Area, and hence drive up the home prices. As you move further out from those area, home prices become cheaper because buyers compromise for commute time and in some instances, school ratings. The same logic applies broadly as you move up north in the peninsula towards SFO airport.
I remember seeing a summer camp program in Cupertino that focuses on languages for age 7+. I thought they teach French or Spanish; instead they teach python and C++. That’s when you know how serious the competition is.
Value, Growth, and Protection
Not surprisingly, Palo Alto and Mountain View have the hight price on the per square foot basis. The price drops as you move southeast towards San Jose and up north towards Newark / Fremont, where commute time starts to stretch. The logical choice for the buyer will be trading off home size and type (single family home vs. townhouse or condo) when it comes to picking between the listed areas.
On the other hand, home appreciation rate on the compounded basis strongly correlates to the price of the home. Palo Alto and Mountain View again have some of the highest CAGR (Compounded Annual Growth Rate) in the Bay Area. As you move further out of those prime locations the GAGR drops along with home value, as shown in the stats below for Santa Clara, Fremont, and Newark.
The attractiveness of the home’s location and the aforementioned growth drivers played a huge role in protecting the home owner’s asset during the 2008 Global Financial Crisis (GFC for short thereafter in this article). The 3 most desirable places in this article ranked by $/sq ft (Palo Alto, Mountain View, and Cupertino) each saw around a 17% depreciation during the GFC while a much less desirable place like Newark suffered a whopping 42% depreciation in home value!
Just let that sink in for a minute. A home only needs to appreciate 20% to make up for the 17% depreciation. But a home will need to appreciate 72% to breakeven after a 42% loss in home value. Now that will take some time, even with the growth rates the Bay Area has enjoyed. This is not to say buyers should avoid Newark, but simply to demonstrate the relative performance in the Bay Area. In fact, Newark still enjoyed a higher appreciation rate from 2004 to 2021 (4.5% CAGR) compared to the US median home price in the same period (2.7% CAGR).
There will be black swan events throughout our lifetime that we cannot foresee and nobody can accurately predict how home prices will react. The last thing we all want is having our hard earned money tied to a home that has to dig super hard out of a hole. To make the matter worse, an area that has poor downside protection is more susceptible to a downward spiral caused by foreclosures. When the home value drops below the mortgage balance, buyers may be inclined to walk away and let the bank seize the home. This in turn puts additional pressure on the homes for sale in the same neighborhood.
Past history again shows the more expensive area tends to recover faster from an economic downturn. The downside protection these areas offer therefore deserve more premium, despite how expensive they already are.
Thoughts for Home Buyers
The current market condition is extremely difficult for home buyers but don’t be discouraged. Although the cost of home ownership continues to rise, real estate is still one of the best assets that hedges inflation and provides an opportunity to build generational wealth. If you haven’t had luck winning in your ideal location, zoom out on the map and consider other locations or home types that you may not have thought of. Stick with the fundamentals and you might find hidden gems.
The monetary return of home ownership should really be measured on the order of 5+ years because of its correlation to macro economic cycles. When evaluated at a 10-year period, most homes are worth much more than they were in the past decade. This is not to say near term fluctuations are not important; one just need to look further out. Even if you bought in a weaker performing place just before a correction, the pull back is usually overtaken after an economic cycle. Meanwhile, your home cost is locked in while everything becomes more expensive. A real estate ownership journey should be treated as a marathon rather than a 100-meter race.
“Don’t wait to buy real estate, buy real estate and wait.” — Will Rogers
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Hit me up if you would like to understand the performance in your area of interest or exchange thoughts on the current market condition.
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The 2019 median household income for Atherton (94027) is $511,127!! Now you can see why I chose to omit this zip code on the median income map.
