California’s economy continues to expand and improve in 2017. As we head into the next decade, young adults whose careers were delayed during the 2008 recession are now looking to fulfill their potential as first-time homebuyers.

But potential first-time homebuyers face a frustrating obstacle to homeownership: a low-tier housing shortage.

Low-tier homes are valued in today’s market in the bottom third of all homes. In California’s market, low-tier homes sell for less than $540,000 on average as of the end of 2016, according to the Case-Shiller Home Price Index. This segment of homes is where first-time homebuyers usually purchase.

Across much — but not all — of California, low-tier inventory has decreased in recent years. The following table compares the average share of low-tier homes in the for-sale inventory from 2010-2015 against the average share of low-tier homes in the for-sale inventory in 2016, data courtesy of Zillow.

Low-Tier Home Inventory: California Metros

Metropolitan area2010-2015 low-tier inventory: average share2016 low-tier inventory: average share
Los Angeles33.0%26.3%
San Diego32.5%26.6%
San Francisco33.5%32.8%
San Jose36.8%36.6%

As seen in the table above, areas of the state that swing either very expensive or very inexpensive have seen a relatively stable low-tier inventory over the past few years. In fact, high-cost areas of the state, like San Francisco and San Jose, continually experience a relatively stable distribution of inventory across home price tiers (that doesn’t mean low-tier homes are cheap here—they are the most expensive in the state).

However, inland areas where housing is cheaper — like Fresno and Bakersfield — have still seen an upward shift, with less mid-tier inventory and many more high-tier homes for sale.

Three metro areas have been particularly hard hit by the low-tier inventory shortage:

In these regions, high-tier home sales made up almost half of the inventory for sale in 2016. The share of high-tier homes on the market has steadily increased in these three metros since 2010.

Why the starter home crisis is so bad in California

While low-tier inventory is falling significantly in only three major California metro areas — Los Angeles, Sacramento and San Diego — low-tier inventory is rapidly becoming more costly across all of California.

For example — in Los Angeles, low-tier housing encompasses homes valued at less than roughly $521,000 as of December 2016, according to the Case-Shiller home price index. A year earlier, the same property was considered low-tier if it was valued at less than $481,000.

In other words, the same property that may have sold for $481,000 in December 2015 sold for $40,000 more just one year later. Assuming a 20% down payment and a 4% interest rate, this translates to an additional $200 per monthly mortgage payment for the same home. For homebuyers operating near the top of their budget, this increase is unmanageable.

Using this metric, nine of the ten worst markets for first-time homebuyers are located in California, according to Trulia. For example, the typical first-time homebuyer in Los Angeles needed 28% more income in 2016 than in 2012 to qualify for a home purchase.

When homes become more expensive, homebuyers who would have been operating in the mid tier are now relegated to the low tier. This means more buyers are competing for the same low-tier homes, which pushes home prices even higher.

The root of the problem is insufficient residential construction across all of California, particularly in the low tier. Builders aren’t interested in doing a social service — they are interested in making money, and there is always more money to be made in mid- or high-tier homes. But demand for low-tier homes remains high.

Construction continues to increase each year since hitting rock bottom in 2008. But single family residential (SFR) construction is still at one-third of its level during the Millennium Boom years.

What will the segment of first-time and lower-income buyers who rely on low-tier housing do?

The future for first-time homebuyers is less

To forecast the future of low-tier homes, one fact needs to be mentioned: home prices are ultimately set by the amounts buyers are qualified to pay.

In other words, buyers set the price.

Therefore, as long as buyers are able (and willing) to qualify at higher prices, low-tier home values will edge higher. Buyers’ wallets will stretch until they break. Sometimes, this leads to the use of adjustable rate mortgages (ARMs) to edge buyer purchasing power higher. ARM over-use is dangerous for market stability, and is often the precursor to a coming recession.

Will homebuyer purchasing power continue to stretch to meet higher prices in 2017?

A few factors exist today to cause hesitance from homebuyers searching in the low tier:

  • rising prices;
  • steep competition from other buyers competing for a small amount of inventory; and
  • rising mortgage interest rates.

Higher mortgage rates directly reduce homebuyer purchasing power. Homebuyers won’t be able to qualify for as much home principal with the same income and down payment. They’ll either need to acquire more money, or settle for a lower purchase price. Since home prices aren’t falling yet — quite the opposite — buyers will need to settle for a home that:

  • is smaller;
  • has fewer amenities; or
  • is farther away from the nearest city center.

Alternatively, potential first-time homebuyers will give up the search altogether and choose to remain renters. But most homebuyers will avoid this route.

A recent survey of homebuyers by Redfin, a national real estate brokerage, found that if interest rates rise a percentage point or more (significantly decreasing buyer purchasing power):

  • 46% will settle for a less expensive home;
  • 28.5% will continue their homebuying goals as planned;
  • 18% will put off homeownership while they save for a down payment; and
  • 7.5% will give up their home search.

In other words, nearly one-in-three homebuyers believe they have sufficient income and cash on hand to react to purchasing power changes and still buy the same type of home. About half of buyers are willing to settle for a less attractive home.

These survey results tell us the pull of the American Dream of homeownership is strong, even in the young, mobile population that makes up today’s potential first-time homebuyer demographic.

Is there a solution for California’s housing shortage?

The ultimate fix to the housing shortage is more housing, achieved by more residential construction. So where are the builders?

Builders are ready and willing to meet demand. It’s Sacramento and California’s various local governing bodies that are slowing down growth.

Governor Brown’s 2017 general budget has zero dollars set aside for the construction of affordable housing. Instead, he’s kicked the can down the line to local governments, letting them deal with it. It’s important to note that 2016’s budget included a proposal for $400 million to build new affordable housing, contingent on smoothing the building approval process at the local level. This did not pass, and Governor Brown isn’t even trying this year, according to Streetsblog.

Putting the responsibility for building more low-tier housing on local governments is tricky, because they lack the resources the state government has to incentivize builders to create more low-tier housing. Further, they are often hampered by not in my backyard (NIMBY) advocates who want to keep density (and neighborhood “character”) in check.

There are some grass roots efforts taking shape across California to loosen zoning and allow for higher density, which will keep low-tier prices from rising beyond first-time buyers’ means.

The Bay Area Renters’ Federation (BARF) is one such organization rallying for more building in the highly restrictive Bay Area. Some progress is being made in altering low- and mid-tier housing requirements for new developments (e.g. the passage of Proposition C in 2016). But this puts the responsibility on builders, and may actually decrease the number of new residences built.

A better outcome will result from simply changing zoning restrictions to give builders the opportunity to react to market demand.

The only way that will happen is for citizens to get involved, attend city council meetings, and advocate for more housing to be built in their neighborhoods. Brokers and agents have much at stake and can lead the charge.