Home prices are flattening out. Interest rates are going up. Foreclosures are at their highest rate in years. The real estate boom is clearly over. But does that mean California’s high-density/infill/mixed-use boom is over as well?
You would think so. But, in fact, the rush to infill in California depends not just on the overall real estate market, but on two aspects of that market. The first is condo prices. And the second is the condition of the market in two particular parts of the state – the southern half of the Bay Area and the coastal portions of Southern California.
A decade ago, the kind of mixed-use and infill development we are seeing in California today was hardly imaginable. California still seemed like a suburban state, where everybody preferred a single-family house with a big backyard. When we saw higher-density housing development, it tended to be townhouses, often in suburban settings. Accustomed to thinking about real estate markets in a segmented fashion – residential, retail, office – lenders did not want to touch mixed use. The market was slow, and although home prices seemed high at the time – about $200,000 on average – they were not nearly high enough to support the cost of buying land and going through the entitlement hassle in an urban area. That is why Los Angeles County saw only one new housing unit for every 10 additional residents during the 1990s.
All that has changed during the last five years. Partly because of traffic congestion, urban living is more popular. Lenders have gotten their brains around mixed use, and a whole new generation of developers specializing in infill has emerged. But the most important factor in making infill work in California is a market factor – the dramatic drop in interest rates and the commensurate rise in home prices – especially the demand for condos, which, as it turns out, are the key to infill.
Condominium markets were traditionally thought of as “soft.” Nobody would buy a condo if they could afford a house. But almost overnight, the price of a classic suburban house built for a typical middle-class family jumped to three-quarters of a million dollars. Suddenly, a half-million-dollar condo didn’t seem like such a bad deal. Not only did young and/or childless households go condo, so did retirees and lots of investors who thought they could make a killing on appreciation. Suddenly, a condo developer could outbid anybody else for land and still turn a tidy profit.
But the rise in interest rates has turned this whole situation upside down. Mortgage interest rates have gone up one percentage point during the last year – from an average of around 5% to an average of around 6%. That means a family with a household income of $100,000 has seen its mortgage-buying power drop from $447,000 to $400,000. If rates go up another point over the next year – as many expect – that buying power will drop even more, to $360,000.
When interest rates go up, homebuyers can’t afford as much house, which means developers have to lower their prices – and often that means projects will no longer “pencil.” So begins a slowdown in development until something changes – interest rates go down again, or incomes go up, or recalcitrant landowners begin to lower expectations about how much their land is worth. None of that is happening in California yet.
But it doesn’t really matter what is happening in California generally. As far as infill goes, what matters is the trend in certain expensive urban areas.
Despite all the hype about infill, high-density housing development has been extremely concentrated in seven counties — the four counties ringing San Francisco Bay (San Francisco, San Mateo, Santa Clara, and Alameda) and the three counties along the Southern California coast (Los Angeles, Orange, and San Diego). Everybody else has been building single-family homes almost exclusively.
According to the latest figures from the Department of Finance Demographic Research Unit, these seven counties accounted for 40% of the population growth in the state from 2000 to 2005 (about 1.4 million people), but only about 30% of housing production (about 300,000 units). Most striking, however, is the way that the newly constructed housing supply in these seven counties is diverging from the rest of the state.
From 2000 to 2005, only 44% of new housing units in these seven dense counties were single-family homes, whereas 50% of new units were condos and apartments of five units or more. For the other 51 counties combined, 80% of new housing units were single-family homes, while only 13% were condos and apartments. Almost as many single-family homes were built in Riverside County alone (119,000) as were built in the seven dense counties (133,000). Meanwhile, almost two-thirds of all condos and apartments built in the entire state were built in the seven dense counties. This is a big change from the 1990s, when the pattern was much more even across the state.
So the critical question for infill is not what happens to the real estate market statewide, but what happens to the condo market in these two dense and expensive parts of the state. Although interest rates do not vary much from one part of the state to the other, demand and prices do vary – and the early results are not encouraging. In June, San Diego experienced its first year-over-year drop in prices in a decade. And while all prices were down by only 1%, condo prices were down 5%, rekindling fears that the condo market will be softer than the single-family market and, therefore, prices will drop faster.
In the short run, there appears to be little doubt that condo construction will slow – and so will infill development that is highly dependent on condos to pencil. But the countervailing trend may be in rental apartments. Rents have been stagnant for a long time – anybody who could afford an expensive apartment could also afford a house – but with interest rates pushing houses beyond people’s reach, rents are going up too. Apartments haven’t been penciling for anybody lately, but it is possible that if rents increase, apartments will prop up the infill market in the short run.
Then there’s the long run. It looks good for infill, especially in the seven dense counties. The trend toward more urban living in these counties is clearly permanent, so now it is a matter of numbers, not a matter of demand. No matter what anybody thinks about whether condo prices are high enough to make projects pencil today, they are still three times what they were a decade ago. While prices might drop a little, they are unlikely to drop a lot. Whenever interest rates come down – or landowners drop their prices – condos will serve as the cornerstone of infill development once again.
