California home prices continued to increase in the second quarter (Q2) of 2016, but at a more gradual pace than experienced in 2013-2014. Home prices are 6%-10% higher than a year earlier. The gradual increase is expected to continue through the rest of 2016 and into 2017 as homebuyers capitalize on better access to mortgage money, via an improving jobs market and low mortgage rates for the time being.

However, when mortgage rates begin their sustained rise — expected in 2017 — home sales volume will decrease and prices will decline 9-12 months later. Thus, the rise in prices will lose momentum in the tail-end of 2017 and fall toward the mean price trendline. The next price peak will occur around 2019-2021 in response to fully recovered employment and rising home sales volume.

Updated August 8, 2016. Original copy posted December, 2011.

The black, orange and green lines track sales price fluctuations within the three single family residence (SFR) tiers in California’s largest cities. The blue line is the mean price trendline. The mean price trendline represents the historical equilibrium level to which property prices cyclically return.

Grey bars indicate periods of recession.

A comparison of current prices with the mean price trendline tell us how far prices have deviated from their historical norm, and the level prices will return to in the years ahead.

The intersection of price illusion and reality

My house is worth how much? A property’s value seems to constantly change based on local market conditions. Is there any way to measure a property’s innate dollar value over time?

Indeed there is—by using the mean price trendline.

Boom periods are times of economic plenty. Sellers of property happily embrace them as prices skyrocket to produce excess profits on a sale. Builders rush in.

Boom-time markets, flush with cash and rising real estate prices, become momentarily untethered from historical price trends. During these short-lived virtuous cycles, sellers and seller’s agents dominate real estate transactions.

The momentum and volatility of boom times appear strong on balance sheets. But they rarely last long.

Eventually, sales volume evaporates, and prices dip. The boom slips into a bust, a process known as the vicious cycle.

At some point, demographics and economic conditions drive buyer demand back up. Momentum builds and prices rise again and exceed the trendline – a return of the virtuous cycle

Neither a boom nor a bust is sustainable in the long-term. They are, by their nature, short-term divergences. As such, they’re an unfit measure of long-term stability. However, as the booms and busts create their peaks and valleys, a trend develops between them. This is the mean price trendline for real estate.

The mean price trendline: Consumer inflation

Through the turmoil of booms and busts, prices repeatedly return to the mean price. Mean pricing is dictated by the path of consumer inflation, as measured by the Consumer Price Index (CPI) in California.

How does CPI affect housing price trends? There are two major ways:

1.  The CPI affects the fundamental measure of a property’s value: the replacement cost.

2.  The CPI also reflects the changes in costs of other goods. To compensate for these increased costs, employers typically increase staff income in step with the CPI. As a potential homebuyer’s income increases, so does their purchasing power through their capacity to borrow money.

In the long-term, housing prices will fall back to prices dictated by replacement costs (reflecting the price of the property) and income (the ability of the homebuyer to buy). Thus, the mean price trendline represents the long-term value of property at any point in time, adjusted for consumer inflation.

The mean price trendline is the benchmark to which prices return after a boom or bust. The big picture of California price movements can be understood by viewing the disparity between low-, mid-, and high-tier sales. These tiers vary based upon our population’s housing demands.

To best present a statewide view of price movement, we look to California’s three largest metropolitan areas: Los Angeles, San Francisco and San Diego. Each area’s sales prices are then segmented into three price tiers; low, mid and high.

Homes sales classified by price range show a clearer picture of how prices move in each tier of the market over time. Each tier’s pricing accelerates and decelerates at significantly different degrees. Typically, pricing in the high-tier does not fluctuate as much as in the mid- and low-tiers.

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California tiered home pricing

The crossover moment

When home pricing is momentarily level with CPI, this crossover moment is akin to passing over the equator of a pricing sphere. You leave the buyer’s market and enter the seller’s market.

Seller’s markets are periods in which prices exceed the mean price trendline. During these periods, sellers realize excess profits on the sale of their homes. In turn, families who enter the housing market as buyers overpay.

Of course, if the real interest rates on a fixed rate mortgage (FRM) is below 2.5%, a low nominal interest rate of say 3.5% will compensate for some excess price over the life of the loan. Cheap money allows for payment of a higher price – simple buyer purchasing power. However, this calculation only works if you do not sell for a decade or two.

Yet, once market prices reach that crossover moment at the mean price trendline, market prices do not hold stable.

As has always been the case, irrational exuberance, lax lending regulation and irregular monetary policy, all cause sales prices and the mean price to diverge after they cross paths. They are driven apart as though pushed by polar magnetic force.

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Homebuyer purchasing power pushes the recovery

As evidenced by the past

A quick review of the recent past is needed to move understanding forward.

Prior to 2000, California real estate began experiencing the formation of a long-term pricing bubble. The experience commenced during the stagflation years of the late 1970s. These years saw the highest interest rates experienced since the creation of the Federal Reserve (the Fed) in 1913 to manage such things.

A 30-year bubble grew with the Baby Boomer (Boomer) invasion of the 1980s and 1990s. The period started with mortgage rates receding from the peak 18% range to a more normal 6% range. Eventually, rates moved to essentially zero.

The unrestricted expansion of the bubble caused its implosion in 2005 when home sales volume began a steep decline. Predictably, home prices followed one year later. The mean price of property once again came into stark view.

The causes of the decline in sales volume were many. Primarily, we saw:

  • a lack of desire to own (vs. rent) the family home;
  • price momentum speculation from 2002 through 2005; and
  • interest rates increased by the Fed to fight consumer inflation beginning in August 2004.

Despite the resulting price decrease, home prices have yet to correct sufficiently to dip below the mean price trendline.

Prices in the late 1980s reverted to the mean price trendline after the July 1990-March 1991 recession. Between 1991 and 1999, prices were depressed and the cost of property was low, from a historical perspective. Accordingly, prices dipped below the trendline during this period. This condition is known as a buyer’s market.

Prices began to rise in 1997, growing to intersect the mean price trendline in 2000. At that time, the price index and California Consumer Inflation index were, for a fleeting moment, at the same price point: the crossover moment.

After crossing the mean price trendline in 2000, real estate prices were allowed to begin a skyward trajectory. The 2001 recession was short-lived due to the monetary and fiscal reaction to September 11, 2001.

As a result, the price of homes froze in 2001 at their artificially elevated, pre-recession peak. Instead of reverting to the mean price trendline, prices leveled out.

Similarly, speculators can only pull profits on a flip going into or in a heated market. Speculators need market momentum to profit. For them, prices must be fast headed above and away from the mean price trendline. On the flip, excess money is siphoned from the real estate market, as the flipper quickly unloads their properties at ever-greater prices.

After 2000, prices continued to rise on going into a steep trajectory. This period is now known as the Millennium Boom. Real estate prices peaked going into 2006, then began their precipitous decline.

The organic value (and price) of real estate

Now, the mean price trendline does not set the price of real estate. It sets the amount of change in a property’s price based on the fundamentals of homebuyer income. Similarly, consumer inflation does not directly affect home pricing, but it does affect how prices increase. In other words, as its name implies, the mean price trendline sets the trend for change.

So, what is the realistic, organic value of a particular parcel of improved real estate?  Fundamentally, the organic value of a property is anchored to its replacement cost, not its existing fair market value (FMV). Most typically, FMV is set based on a very short window period of recent comparable property sales, known as comps.

Comps merely buttress the price point in current sales activity, whether dominated by highflying momentum prices or recessive foreclosure and real estate owned (REO) prices. Thus, an appraisal based solely on comps is not helpful to a buyer when determining a property’s organic dollar value for long-term ownership. However, the mean price is.

Replacement cost is the actual cost of replacing the property’s improvements, adjusted for the degree of depreciation, obsolescence and deferred maintenance experienced. In appraisal vernacular, this is known as the replacement cost approach to valuation.

Under the replacement cost paradigm, the innate value of a property equals only the expenditures for land, labor and materials. Any pricing levels beyond this are mercurial and illusory. These price variances are primarily fueled by:

  • speculation;
  • interest rates;
  • ARM lending;
  • predatory lending;
  • failure of builders to build; and
  • external influences unrelated to the physical property, its amenities, location or the demographics of users for the property.

Roughly 75% of a property’s value comes from its improvements at time of construction. The remaining 25% derives from the land it is situated on. The cost of construction (labor and materials) to replace the property should the existing structure be destroyed will only grow at a pace consistent with consumer inflation, no more. The cost of labor and materials are at the very core of consumer inflation measures. Thus, the purchasing power of the dollar is the year to year measuring stick used for dollar-denominated assets.

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The state of real estate pricing

The transient other factors influencing price

The price of land can increase beyond the rate of inflation due to local growth in population density. Also affecting the price of land is any increase in that population’s income beyond the rate of inflation. Increases in price due to demographics are a function called appreciation in value, not inflation.

This increased end user or homeowner demand for space in one location reflects the inherent desirability (and hence price) of raw land, but not the cost of improvements. Also, the discovery of precious materials under or flowing through a parcel of land increases its value. However, such “Eureka!” discoveries are rare in modern California.

Thus, houses are just aggregates of land, labor and materials — the dollar cost of which is the replacement cost approach to valuation. The cost approach limits the price to be paid if comps and income approach methods suggest a higher price.

The mean price trendline forecast

Prices will continue to rise gradually in 2016 after the roller coaster years of 2013-2014. Once mortgage rates are adjusted upward (expected around mid-2016), prices will feel downward pressure as homebuyers are able to qualify for less principal with the same pay check. Prices will begin to descend in late-2017, 9-12 months following the rate increase.

The next big peak in prices won’t be until 2019-2021. These will be the years of the Great Confluence, when Baby Boomers and Gen Y hit California’s urban cores. Gen Y will flood into both rental and homebuying markets, whereas the Boomers will focus their energies almost solely in homebuying.

Related articles:

The demographics forging California’s real estate recovery: a study of forthcoming trends and opportunities, Part I and Part II

Adaptable agents will pursue the long-term and recession-proof occupations of income property management, residential income sales and mortgage financing (private or institutional). These are each consistent moneymakers as they survive turmoil. People always need shelter and someone to arrange it.