John M. Lee: Real Estate Reality

We are currently living in an extremely interesting dual economy with some industries, such as real estate, mortgages and defense doing extremely well while high tech, telecom, Wall Street and the airlines are doing extremely poor.

With Wall Street doing so bad, all the financial publications are wondering when real estate is going to fall, like the financial markets did, and when the bubble in the real estate market will burst - like the Dow Jones Industrial Average, which has declined about 30 percent, and the NASDAQ, which decreased 70 percent from its peak in March of 2000.

However, the latest numbers released at the end of May show median prices in the Bay Area continuing to climb while sales activity has declined moderately.

In last year's October column, I felt that the risk was greater that our prices would decrease in the short term rather than rise because of the uncertainty of war, terrorist attacks and, perhaps, an increase in interest rates. In this year's February column, war was imminent, but the effect of the war was more quantifiable. Terrorist activity seems to be under control and the feds have promised to keep interest rates low, leading me to believe that the real estate market will be fine this year.

Several interesting real estate studies have come out recently, concluding that there is no real estate bubble.

Professor Edward Leamer, from UCLA's Anderson School of Business, constructed an economic model looking at real estate values much like stocks. He examined the P/E ratio, where P is the sales price and E is the annual rental-income stream if the property were to be rented. For example, if a property sold for $500,000 and rented for $25,000 per year, the P/E ratio would be 20. The higher the P/E ratio, the riskier the investment would be, leading to a possible bubble.

Leamer examined prices in California and concluded that in northern California, prices are high compared to rents, leading him to conclude that property owners are betting on an early tech recovery to overcome the high P/E ratio. His conclusion is that we do not, and will not, have a real estate bubble.

The Federal Reserve Bank of San Francisco also conducted a real estate study in March. It looked at the situation in two ways. First, it calculated a purchaser's cost of housing capital, which is dependent on the after-tax mortgage rate, and expected appreciation. The study reasoned that those are the two factors which affect the cost of ownership fluctuating the most over time.

The feds came to the conclusion that the user cost is extremely low at this point in the business cycle because interest rates are low and prices have been rising. Thus, no bubble.

They also looked at price versus rent, very similar to the UCLA study.

Using this method, the feds concluded that prices are slightly high, but if prices were to stay flat, and rents were to rise by 4 percent per year, we would be back to equilibrium by 2005. If prices were to drop slightly, at 4 percent per year, and rents go up by 4 percent per year, we would be back at equilibrium by the first quarter of 2004. Thus, the conclusion is no bubble.

The SF Center for Economic Development did a comprehensive study on San Francisco's real estate by reading economic reports, analyzing economic factors and interviewing leading economists in the Bay Area. They came up with the same conclusion - no real estate bubble.

These reports have confirmed my belief that the real estate market is out of the woods and that we will not suffer a substantial decline, like the recent stock market and the 20 percent to 25 percent decline we had in the real estate market between 1989 and 1995.

Currently, the war with Iraq is over and the United States won decisively. Recent numbers show a cost at about $70 billion to $100 billion, a large sum, but manageable given the size of our economy. The economy is showing some signs of a turn-around, the stock market has gone up, the employment picture is starting to look a little brighter and interest rates are still low. And the feds are starting to worry somewhat about deflation, leading it to vow to maintain the low interest rates until we have a clearer picture.

This means that we have survived a very minor recession the past two years and that within the next six to nine months, our economy will be recovering and will be growing once again. Through it all, real estate has been the stabilizing force, with consumers purchasing homes, refinancing at low interest rates and spending to help our economy even though businesses stopped investing. Without real estate being so strong, our economy would have been in a much deeper recession.

Through these last few years, real estate has become the central commodity in our lives, as an investment, a bedrock of our financial planning and as a place to live. It is a real asset that we can cling onto in the face of uncertainty and one that we can see, touch and feel; which adds psychological value when we see economy indicators falling around us.

It is no wonder that people are in love with real estate once again.

John M. Lee is a top selling residential broker at Pacific Union's California Street office. If you have any questions regarding real estate, call him at (415) 447-6231 or e-mail him at johnlee@isellsf.com.