Are some areas better investments than others?
Recently a client told me she wants to buy a home in Palo Alto, one of the San Francisco Bay Area's most desirable cities, because "it's a better investment. Prices will go up more in Palo Alto."
You also hear this from agents: "this city appreciates more" or "that neighborhood holds its value better".
It's an attractive theory, but a buying strategy almost impossible to execute. I call it the "jackpot theory", as in, "buy here and you've hit the jackpot". Is it true? The short answer is "no". The better, more comprehensive answer is "rarely, but it depends".
Let's use Palo Alto as an example. Palo Alto has many sterling qualities, but "jackpot" isn't one of them.
Statistics tell the tale. The price difference between Palo Alto and nearby cities has been fairly constant—overall—in recent years. For example, the difference in average sales price between entry-level Palo Alto and the similar neighborhoods of adjacent Mountain View has held steady since 2000. And just as significant, both markets go up and down at the same time, in reaction to the same market forces. Palo Alto isn't an island, and it won't be until they discover oil in every back yard.
But there is a short-term difference between these two markets that explains Palo Alto's reputation for outstanding performance: Palo Alto breaks away from the pack for short bursts. The price difference between entry-level Palo Alto and comparable Mountain View widens suddenly and dramatically when real estate heats up, but returns to normal when real estate cools. The "jackpot theory" hangs around because apparently people remember only when Palo Alto rockets off the launch pad, forgetting or just not knowing that gravity sooner or later brings Palo Alto hurtling back to Earth.
Palo Alto is a wonderful place, but it's muddled through sluggish real estate markets of the past no better than less-admired cities. 2007 has been an exception due to historically low inventory, but during the slumps of the early 1990s and 2001 a Palo Alto house was just as likely—or unlikely—to sell as a comparable Mountain View house. In fact, less-expensive cities like Santa Clara and Campbell weathered the 2001 tech bust better than Palo Alto—just the opposite of what's happening now during the subprime crisis.
Some neighborhoods also break away in a hot market. A sought-after school or other nearby amenities can bump a neighborhood's prices into the next higher tier, especially if the inventory of acceptable substitutes is tight, as so often happens in a hot market.
Palo Alto's Green Gables neighborhood, with its highly-regarded elementary school and its location near a first-rate community center, is a great example of a breakaway neighborhood. During the dot-com boom, Green Gables homes sold for as much as neighborhoods normally one rung up the price ladder.
But when real estate runs out of gas, breakaway cities and neighborhoods go into price free fall. Almost invariably, home prices revert to the mean, although in this area the historic trend of that mean has always been up.
I say "almost invariably" because once in a blue moon a neighborhood does pull itself permanently up the ladder of real estate respectability. Much-improved test scores in the local elementary and middle schools has made Sunnyvale's Cherry Chase the new hot area for young families. But don't waste time looking for the next Cherry Chase. That's like looking for the next Microsoft, and just as likely to happen.
Buy in Palo Alto or wherever you dream of. But buy there because you'd like living there even if your house is suddenly worth less than you paid. That way you'll never be disappointed.