Median housing prices surged 25 percent in Orange County in 2013 and most people agree it was a stellar year for the Southern California housing market. More than a quarter of Los Angeles-area homeowners who were underwater on their mortgages in 2012 emerged out of negative equity. And buyers are snapping homes off the market nearly twice as fast as a year ago.
Now the question is whether this means housing is on a sustainable path or if we’re in another bubble of artificially high prices and demand that’s bound to burst.
Typically, we hear housing prices are going up and think that means recovery. But that assumes there is something inherently good about housing prices being high. Homeowners looking to sell always want higher prices, but homebuyers don’t. Beyond the consideration of housing sales, to understand whether booming home prices really are a sign of market recovery it is critical to consider why prices are increasing.
If the cheap mortgages provided by low interest rates – hat tip to outgoing Federal Reserve Chairman Ben Bernanke – were the source of increasing demand over the past few years then the growth in housing prices may be temporary. When interest rates return to natural levels, the artificially cheap mortgages will disappear too, reducing buyers’ purchasing power and driving down housing prices.
At the same time, as long as Southern California remains a desirable place to live and work, strong demand to live here could continue to drive home prices and sales up.
So how do we determine if Southern California is experiencing the birth of a new bubble or a true recovery? The ratio of home prices to rental costs in a given area is a measure often considered when studying housing bubbles. Rents are closely tied to market supply and demand and are rarely susceptible to bubbles, so they serve as a baseline in determining if housing prices are inflated.
Between 1991 and 1999, the Federal Housing Finance Agency reports that home prices in the Anaheim-Santa Ana-Irvine metropolitan statistical area increased 11 percent (unadjusted for inflation). During the same period, renters in the same area saw their housing costs grow 12 percent, according to the Bureau of Labor Statistics. Translation: the price of homes was not inflated during the 1990s in Orange County – and in fact might have been undervalued a bit.
The story quickly changed, though. From the first quarter of 2000 to the same time in 2006, housing prices in Orange County jumped 155 percent. In the greater Los Angeles area prices spiked 178 percent. But BLS rental prices rose just 38 percent. Translation: the price of homes was significantly inflated relative to rents, signaling the housing bubble.
The year 2006 marked the top of the housing bubble for Southern California, and prices quickly collapsed for more than three years, according to FHFA data. Both Orange County and Los Angeles saw prices stabilize in 2009, and from the summer of 2012 through 2013, prices steadily climbed back to 2004 levels.
The warning sign for today’s market is that housing prices are once again growing much faster than the BLS rental market trend. Entering 2014, homes in Orange County are 20 percent higher than rents by BLS standards. In Los Angeles, home prices are 6 percent higher than rents.
In its most recent Bubble Watch Report, housing price monitor Trulia.com named Orange County and Los Angeles as the two most overvalued housing markets in the United States. And with the Federal Reserve beginning to throttle back on its quantitative easing policy that helped create lower mortgage rates, the air could be let out of Southern California’s new housing bubble quickly.
If the data looks like a bubble and acts like the last bubble, it’s probably a bubble. Orange County homeowners and buyers should consider the recent housing market crash before jumping onto the real estate “recovery” bandwagon.
Anthony Randazzo is director of economic research at Reason Foundation. This column originally ran in The Orange County Register.