A brief history of local real estate, part 7: conclusion.

A brief history of local real estate, part 7: conclusion.

Let's review what we've learned so far about the reliability of real estate's market indicators. How well do they tell us what we want to know: are prices going up or down, and does the market favor buyers or sellers?

Days on market (DOM): the average number of days homes are on the market before they go into contract. DOM is one of the more reliable indicators. Usually, but not always, if DOM goes up, home prices are going down or soon will. And by now we know that "usually, but not always" is as good as it gets with market indicators. Because in this case, rising DOM can also mean that an older stock of inventory—not just newer inventory that's presented well and priced right, right off the bat—is starting to sell, a sign of a recovering market.
Inventory: not as reliable as DOM. A growing supply of homes may well indicate declining prices, now or in the near future, but only if demand for homes declines or fails to increase proportionally to supply.
Sales: the most followed, and perhaps least reliable, of real estate's indicators. Its unreliability comes from two sources. First, sales are highly seasonal. Declining sales may mean only that the market is in one of its typical seasonal lulls. And second, declining sales may simply mean that there's a shortage of good inventory on the market, a typical characteristic of an overheated market.
Bid: how much over or under list price homes sell for in a certain period. Bid is an interesting indication of buyer sentiment, but it's backward-looking, known only when the transactions for the period analyzed have closed—and by then, we're in the next period and quite possibly the next phase of the market.
Sales price: certainly a vital indicator, at least to buyers and sellers, and to a great extent less an indicator and more the Holy Grail of real estate statistical analysis. After all, the hope is that an intelligent reading of real estate's leading indicators—DOM, inventory, sales and absorption (which we'll get to in a moment)—will reveal the short-term trend in sales price. But sales price shares bid's limitation: it's known only after transactions for the period have closed, typically thirty to forty-five days after their initiation, and much can happen in our volatile real estate market over that time.
Absorption: a fancy name for a simple formula—sales/inventory—that I've often said measures the pulse of the market. We've learned that two of real estate's most followed leading indicators, sales and inventory, can be less than reliable signals of where the market is now and where it will be in the short term. On the other hand, divide sales by inventory and you'll know instantly how eagerly inventory is being snapped up by buyers, which will tell you whether you're operating in a buyer's or seller's market. Which should tell you where home prices are headed. Which is probably all you want to know.

Let's wrap up this series by determining whether absorption has historically paralleled sales price. Do absorption and sales price rise and fall together, as you'd expect? If they do, we've got a winner, because absorption for the most recent period can be calculated well before the transactions initiated during that period close and sales price trends are revealed. Which should give you as good an idea as you're likely to get, going into the current period, as to whether home prices are rising, declining or stable, and whether buyers or sellers hold the upper hand.

Here's an example of how absorption can work for you. Let's say that you're a buyer who's sequestered yourself in your home office the evening of March 1, 2010 to analyze the Wonderfulville real estate market. Let's also say that Wonderfulville had thirty sales in February 2010, down from thirty-five sales in January 2010 and forty sales in February 2009. Unfortunately, you don't know February 2010's sales prices, because they haven't closed yet. But you do know that Wonderfulville sales are falling, both month over month and year over year, which means that you can wheel and deal in the marketplace. But maybe not. Because inventory in Wonderfulville also went down, from 100 homes in January 2010 to 88 in February 2010, while in February 2009 there were only 75 Wonderfulville homes on the market. So the absorption rate for all three months is an identical .4, and that's not a market any buyer can wheel and deal in.

What do absorption numbers mean? Generally, a monthly absorption rate of .4 or above (and I've seen it as high as .7, although that was only once, at dot-com's peak) means a seller's market. Rates between .3 and .39, give or take, indicate a market balanced between buyer and seller. Rates in the 20s show a buyer's market, while anything under .2 means real estate's on life support. And anything under .1 means that the Four Horsemen of the Apocalypse have definitely been sighted.

Bear in mind that the meaning of these rates varies, not only from local sub-market to sub-market, but also according to the period measured. Quarterly absorption numbers will be higher than monthly. And both low-end and top-end SFR tend to have lower absorption rates, at least in this area, probably because a) there are relatively fewer buyers for multi-million dollar properties, and b) our local low end moves at the same pace as California real estate as a whole, which is a whole lot slower. Which suggests that most real estate markets across this country, particularly in the heartland, see absorption numbers far lower than ours, even during what passes for boom times.

Okay, now let's see how the absorption/sales price relationship plays out in real life. First we'll look at local condo absorption and sales price per square foot from early 2000 to December 2009 and see how well they've tracked each other.

Pretty darn well, I'd say. Only during a brief period in mid 2005 are absorption and sales price/sq.ft. disconnected, as absorption plummets while price stays level. But note that the relationship between the two indicators usually isn't one-to-one: often it takes a large rise or fall in absorption to produce a relatively small rise or fall in price, and the rise or fall in absorption needed to have an effect on price varies. Which is kind of a shame, because anyone who could come up with a formula that said that for every one point rise in absorption there's an X point rise in sales price (and vice versa) would be onto something.

Next let's look at local townhomes over the same period.

Much the same story, even to the disconnect in mid 2005, although there's an even bigger one through most of 2007. What's up? I'm not sure anyone has the answer, but I'll make a guess or two. It's possible that buyer sentiment was so robust in 2005, even after the typical spring buying frenzy had played out, that a price floor sustained itself temporarily even though other indicators suggested that price should go down. You'll see in this and the following charts that both absorption and price tend to rise dramatically each spring, but that price often sustains itself even as absorption declines the rest of the year. The spring market sets the price benchmark for the rest of the year, barring some sort of catastrophe—Lehman Brothers, for example—something most experienced agents know. 2005 may have been an example of this benchmarking, but on a heightened scale.

And finally, there's a saying in real estate that "prices are sticky", at least early in the down part of the cycle as the market is just beginning to lose momentum. This chart may be graphic proof.

Was it easy credit or, more specifically, bad loans to bad borrowers, that propped up prices in 2005 even as absorption declined? That's easy to say, and many have said something like it, and it's true that in some places the condo and townhome market has been hip deep over the past two years in the obvious consequences of bad lending, short sales and foreclosures. But this hasn't been true of the market we're studying here, the mid-Peninsula market.

Next let's look at the local poster child for the consequences of bad lending, the low-end single-family residence (SFR) market.

And just to prove that every price range here marches to its own drummer, now there's no period of glaring disconnect, and there's even a period when price continues falling long after absorption begins to recover. It's probably no coincidence that we're looking at the one local market hit early and often by the subprime lending crisis, to the point that bank-owned homes and short sales still make up the bulk of its inventory. What we see, unfortunately, is how deep a hole—and late 2007 is a mighty deep hole—the subprime lenders dug for this market when they were most active in 2005 and 2006, and that climbing out of that hole took over a year of steadily improving absorption.

Next, the local midrange SFR market.

Again, there's that disconnect in mid 2005, although it's brief. Easy money and sloppy underwriting again? Sure, money was easy in 2005, but this is another market almost untouched by short sales and bank-owned homes. Hellacious momentum? Probably more like it.

Finally, top-end SFR.

Again, absorption and sales price track each other consistently, exception for a brief disconnect in 2007.

So I think we're onto something, which means two things. First, I don't have to find a new favorite indicator. It also means that I'll be revising my monthly newsletter, as time permits, to highlight the most reliable indicators and combine them into what I hope is a more effective and streamlined presentation.

Between that and a few more tweaks I'll mention when the time comes, I hope to give you a more readable and effective insight into monthly trends in local real estate. And, as always, the price will be reasonable: a few moments of your time.