Where Preparation Meets Opportunity

California Real Estate Outlook 2014

Intro: The last two years were filled with opportunities and success stories across the board witnessed by significant price appreciation, unprecedented buyer demand, historically low interest rates, and inventory levels that couldn’t keep pace with demand. We believe that 2014 is going to continue to bring tremendous opportunities for buyers, sellers, and investors, but thoughtful preparation and strategic execution will be the key to unlocking opportunities in this rapidly recalibrating real estate market.

Inventory Rebalancing

While prices are a function of demand and supply, the market often resorts to focusing on supply as it is much easier to track changes in inventory (number of homes available for sale) levels. While shortage of inventory is clearly an issue, we believe the root cause for the
price appreciation is the unprecedented buyer demand influenced primarily by economic growth where people are feeling richer in their jobs and investment portfolio growth, and also by access to capital with historically low interest rates. We saw proof of this when there was an abnormal spike up in rates in the Fall of 2013 which priced many buyers out of the market instantly, causing home prices to self-adjust without a change in inventory levels.

Inventory levels in the core luxury markets of California that we serve have increased 20-30% year over year, but buyers are still sorting through the quality (inventory mix) of what is available to them. The price appreciation over the last 2-3 years will continue to incentivize sellers to take advantage of what is still a sellers market married with a perfect storm of unprecedented (qualified) buyer demand.

Focus on Financing

In 2013, 54% of all transactions nationwide were completed on an all-cash basis. Over 33% of transactions in California were completed on an all-cash basis compared to the historical average of approximately 15%. A large portion of these all-cash buyers were investors and international buyers. We believe that 2014 will mark the return of the traditional buyer. A lender-friendly buyer who has relatively high household income, savings and liquid assets to show, and a high credit score. And the lenders are going to reward that with the gift of low interest rates and several options on financing products since Wall Street’s loan-related securitization is back! With the Fed promising to hold the target rate at current historical lows to support the overall economy, we project more financed purchases across the board. It may be time to hug your lender!

Cross Market Domino Effect

During an economic recovery, it is normal for different price segments of the market to return to equilibrium at different times. This generally happens bottom-up as we saw the lower-end markets come back first and then the middle tier, but we didn’t see much movement in the higher- end market. The “move up” buyer in essence has had nowhere to really go and neither did the sellers and buyers already in the high-end.

Even though there was demand, the lack of inventory in the high-end markets didn’t allow for a lot of the move-up buyers to sell and move up, which forced them to stay put and wait, which forced a lot of the immediately “below” rungs to have minimal options and created the cascading effect of inventory shortage across price points. We are starting to see this higher-end of the market ($3 million and upward) thaw, and with clients feeling richer from the economic growth and the lower interest rates landscape, we are seeing more deals happening in this segment. The impact of the higher-end thawing should not be marginalized; think of this as the mouth of a fountain and once that section opens up, it will do wonders to rebalance the rest of the market providing options and opportunities for move up/down buyers and sellers alike. We project that 2014 is going to witness the beginning of this rebalancing and the healthy domino effect that it will bring (an increase in total number of transactions) across different price points.

Active Yet Disciplined Investors

Investors are still active but they are extremely disciplined. It is important to understand the investor psyche as they generally have a higher Real Estate IQ than the Average Joe, and they often know how to unlock value in recalibrating markets.

We see three factors that draw investors to real estate: (1) Market Sell-offs, burst bubbles, etc. that result in a drop in prices and allow for smart value acquisitions. (2) Low cost of capital gives investors options to raise capital, build, refinance and profit in risk-adjusted ways. (3) Prolonged Seller’s Market like characteristics excites investors as it allows them to acquire, develop/restore properties all while knowing they still have the advantage as sellers for the disposition of their investment.

If there are immediate changes to one of these factors, investors still stick around but they become very disciplined and hug their math. The only thing that has changed in this equation so far is the year over year price appreciation (affecting overall cost of property acquisition), but as long as the characteristics of a seller’s market exist (low MSI, low inventory, high demand, continuous price appreciation) and cost of capital (general interest rate environment) stays low, investors will remain active but will stay close to their spreadsheets.

Distressed Market Recalibration

A rising tide does lift all boats. The tremendous multi-year price appreciation of 40-60% has rescued several underwater homeowners and pushed them into positive equity. Many of these homeowners will now became traditional sellers vs. short sales. This also includes investors that started with negative-equity properties and institutions with portfolios of assets that have achieved necessary internal return hurdles and might be time for strategic disposition (a term used by consultants and institutions that basically hopes that banks and institutions will refrain from shooting themselves in the foot by mindlessly dumping homes and instead thoughtfully spread out, across time and geographies, the sales of their appreciated assets.) Regardless, the improvement in the distressed market will add to the traditional supply of homes that comes to the market in 2014 further solidifying our inventory rebalancing theme.

Rent Vs. Home Value Dislocation

If there is only one statistic that you can track, consider the ratio between the change in rents and home values. Annually, rents are up roughly 10% but home prices are up approximately 30%. This dislocation is fascinating because it tells several important stories. Renters are choosing to pay the higher rents as the home values are climbing at a faster rate and that the once buyers still prefer to rent. This is a cue for investors (landlords) as the renters are in effect signaling that based on the significant price appreciation, it is time to seriously consider selling or at least re-finance out a portion to have a risk-adjusted investment in the property. It also tells us that there is some unrealized buyer demand waiting in the wings in the form of tenants, who could realize quickly that they are paying more in rent compared to what they might pay in mortgage and property taxes when they become homeowners. How many of them can and will turn to home-ownership will not only add to the unprecedented demand story but will also be a key determinant of the overall housing market.

Courtesy of Robert Rodriguez.