Since the beginning of July, I have been living in San Francisco while serving as a Visiting Fellow at the Public Policy Institute of California. I have witnessed the “fantasy land” nature of California housing prices. They keep hitting all-time highs, even though California employment has not yet recovered from the bursting of the high-tech bubble in 2000.

In June of this year, the median price of single-family homes sold in California reached $486,020, a 28% increase over the prior year. That was more than 2.5 times the median price of $191,000 for the whole United States. But California household incomes are only about 11% higher than those in the nation as a whole.

A Bellwether State

California is the most populous state, has by far the largest economy and contains the greatest investment in real estate of all types in the nation — so what happens here should concern everyone interested in any kind of real estate. California's housing prices have long been among the nation's highest, apparently because people are willing to pay more to live along the sunny West Coast.

Yet, California housing prices actually declined in the early 1990s during a severe recession. After 1997, California housing prices took off, even though national inflation rates were only about 2.6% per year. From 1999 to 2004, the median sale price of California single-family homes more than doubled in current dollars.

The trend continued even as the high-tech boom collapsed in 2000, causing the Nasdaq composite stock index to plunge 78% from over 5,049 to a low of 1,114 in October 2002. Non-farm jobs in the San Jose region — the home of Silicon Valley — fell by 235,000, or 22%, from December 2000 to January 2004, and were only up 1.4% above that low by July 2004.

California as a whole lost 341,200 non-farm jobs from a peak in March 2001 to the trough in July 2003, a decline of 2.3%. True, two-thirds of that loss was in the San Jose region. The Inland Empire gained jobs. Even the huge Los Angeles-Long Beach area suffered a loss of only 4.5% from peak to trough, or 189,000 jobs.

Dramatic Effects of Monetary Policy

Housing experts, especially those counseling apartment owners, have long declared that employment was the rock supporting housing demand. Yet housing prices in general kept right on rising throughout this traumatic job-loss period.

In contrast, commercial property values in Northern California have plunged, with office and R&D vacancies soaring. As of September 2004, there was more than 40 million sq. ft. of vacant office and industrial space in Silicon Valley, and rents have fallen about 50% after almost doubling in 1999.

California housing prices show how monetary flows can dominate property valuation under unusual circumstances. Why did housing values jump in California while jobs and commercial property values sank?

A key factor was the general boom in national demand for housing. That boom was generated by national monetary authorities pumping massive amounts of funds into circulation and pushing interest rates down in order to counteract the negative impact of a worldwide decline in stock prices on general economic activity.

Homeowners massively refinanced, and investors hastily shifted the capital they had leftover from stocks into real estate, especially residential real estate. They thought values there were a lot less likely to collapse.

Sharp Slowdown Ahead?

The worldwide flood of capital into residential real estate — which The Economist magazine claimed saved Western economies but predicted might lead to a housing bubble — has been especially spectacular in California. From 1999 to 2004, while California housing prices more than doubled in current dollars, household incomes rose only 1% or 2%.

As a result, California's ratio of median home prices to median household incomes, which had hovered between 4:1 and 6:1 from 1979 to 2001 (except 1989), shot up to nearly 10:1 in 2004 — more than double the national ratio of 4:1.

To me, this imbalance foreshadows a sharp near-term slowdown in California housing-price escalation. True, the ratio of housing prices to household incomes in California jumped from around 3:1 to 6:1 from 1977 to 1981, and remained around that level for the next 20 years. But that occurred in a period of rapid general inflation followed by a period of falling interest rates. Yet we are now in a period of much lower inflation and rising interest rates.

So, if you're thinking about selling your California house, consider doing it now before the home-price slowdown occurs.




Anthony Downs is a senior fellow at the Brookings Institution in Washington, D.C. He can be reached at anthonydowns@csi.com.