Feature

It's the Nasdaq, Stupid!

by Jim Forbes

It’s a good thing real estate prices don’t move as quickly as the stock market. If they did, I suspect property values would be much lower right now. After all, stability is one of real estate’s chief attractions. It provides capital preservation, inflation protection and capital growth during times of prosperity.

Which is not to say that real estate prices are impervious to a slowdown. They just drop in value at a slower rate, and often well after more volatile markets on Wall Street. This is especially true in apartment ownership, and by far the truest in areas where supply is limited, such as San Francisco.

Thus, rather than waking up one morning with your entire net worth in the trash basket like some recent dot-comers, with real estate it is a slow tortuous drop. Starting with higher vacancy rates, followed by a decline in rents, and then the ultimate painful real estate experience: negative cash flow. By the time the market is at its bottom, the real estate owner is sometimes so weary of writing checks they will sell at any price, or even turn the keys over to the bank. This often occurs during economic recovery, because real estate prices tend to lag behind the fast moving financial markets.

Back in 1992, the country technically moved out of recession, but real estate prices in the Bay Area had only begun to drop. As banks and savings and loans became the biggest landlords, an economic environment not seen since the sixties emerged: soft rents, high vacancies and zero down deals. Once again, the adage of appreciation as a bonus to ownership became true.

This economic malaise lasted some four years, but for some it seemed like an eternity. For others, it disappeared all too quickly with the high-tech supercharged recovery we are disengaging from now.

Without a doubt, there were factors then that do not exist today. Excessive nationwide building, caused in large part by tax incentives, had created real estate over-supply far in excess of what the country could absorb. Meanwhile, huge tracts of land and newly unemployed were added to the market by the closing of military bases. Demand from overseas, especially from the Pacific Rim, dropped dramatically as those regions saw their own economic bubbles burst.

This time, although there might be just as much wrong with the economy, it’s better hidden. While in the late eighties and early nineties prices of real estate continued to rise despite income stagnation, now we have income to justify the increases. But where is the income coming from? In the Bay Area much of the discretionary wealth has been from stock options on highly inflated share prices. Much of the employment has been from money-losing venture-funded start-ups. Now both those sources are shrinking. Share prices are dropping back to a more normal 30 times earnings for the high growth companies and the money losing IPOshave all but disappeared. Thousands of 20-somethings with six-figure incomes have become unemployed and the coffeehouses are once again filling up during the day.

What this is translating into is a drop in real estate demand. Single-family home prices in San Francisco, which are some of the highest in the world, have basically gone flat since the pinnacle of the bubble last April. Rents, although lagging behind the slow down of houses and the NASDAQ, have dropped 8% from their high of 2000 while supply, in the form of vacancies, nearly doubled in the last couple months of the year. This later fact normally precedes dropping rents as landlords (who are often unwilling to lower their rents too quickly in San Francisco, where rent control makes the initial rent a long term commitment) adjust to declining demand more slowly than a home seller who often must sell.

Something else seems to be in play in this cycle versus the last one. San Francisco may no longer be the undisputed economic center of the Bay Area. San Jose, or more accurately Silicon Valley, may actually have taken the baton from the City. Rents and home prices suggest a fierce battle for supremacy, with Santa Clara County having won the last round, both in terms of rental increases and home prices.

What’s even more interesting is how these adjustments in prices relate to what seems most important to the economic health of the Bay Area: the NASDAQ composite index. Since January 1997, as good a date as any to earmark as the beginning of the supercharged economic recovery in the Bay Area, the following has happened: the NASDAQ at one point tripled, and as of the January 11, 2001, was 85% higher than it was four years ago. Home prices in San Francisco and Santa Clara are up roughly 75% and 86% respectively. And rental rates have outperformed them all, roughly doubling in both places over this period.

Does this mean there is a correlation between the NASDAQ index and the value of Bay Area real estate? Probably not in the short term, but it is true that stock investments compete with real estate investments and over time one should not outperform the other by too great a margin. So in this regard I think the alignment of these indices is encouraging. Where we are today is probably right about where we should be.

Since rents have risen more than the others an argument could be made that they should also fall more then they have. However, one forgets that it is easier to rent then to own, especially here in the Bay Area where homeownership is so prohibitively expensive. Therefore, since people have to live somewhere, there will be more demand-type pressure on rents. The only way this will reverse is if people start packing their bags and moving to Colorado or Grass Valley, and taking their jobs with them. We haven’t yet seen this, although these indicators must also be watched closely.

Add to the mix the new slate of political liberals on the Board of Supervisors, who will do what they can to increase tenant rights, and more and more renters will likely continue coming to what must seem like a housing activists’ wonderland. It won’t help landlord rights, but it will definitely keep market rents sky-high.

If we were anywhere else, I’d say Chicken Little was right, the sky should be falling. Instead, I see a slight additional softening in rents over the next few months followed by a long period of mostly flat rents. But, of course, I’m all for that.