The after COVID era seems to be defined by a scarcity of supply that drives prices up. That dynamic creates an affordability crunch across many industries, including real estate, and makes a lot of us pause about the sustainability of such prices.

Why is the supply so low? The main reason as most of you know is the fact that most homeowners now have a 3% interest rate locked in and don’t want to let go of it. But is this phenomenon a temporary factor inflating a bubble, or is it here to stay? Last time prices got so far out of hands was in 2007…

History rarely repeats itself, but it often rhymes. In this case, looking into other areas where similar incentives to keep real estate instead of trading it can help finding out what we are headed towards. California is a prime example that prices can defy the odds and durably stay high despite being out of reach for most.

Don’t believe the headlines! - What happens when the Supply has the upper hand on pricing.

“Prospective homeowners currently in the market would need to make $221,200 annually to qualify to purchase a median-price, single-story home in California, typically costing $843,600.” (Source)

Only the top 15% of the population in California can afford a home (Source). How can California’s real estate durably function under such terrible affordability conditions? These headlines are catchy, nothing like the imminent market crash scenario for a good clickbait. But they are missing the point. They are looking at the demand side of the equation. People can’t keep up with prices. Why does it even matter if there is nothing for sale anyway? When only a fraction of the usual supply available, pricing is geared towards the top of the buyers’ pool.

How did California get there? California has created this low supply monster by enacting proposition 13, and we are headed that direction as a country due to the incredibly low interest rates that were locked in for 30 years in 2020 and 2021. That take law was enacted in 1978 and it’s still ruling the California real estate market: prices are still going up despite depressed demographics.

“Proposition 13 provides three very important functions in property tax assessments in California. Under Prop 13, all real property has established base year values, a restricted rate of increase on assessments of no greater than 2% each year, and a limit on property taxes to 1% of the assessed value (plus additional voter-approved taxes).” (source)

I know that’s a mouthful, but basically property taxes in California, are only going up 2% a year at max as long as you own your property. So if you bought a house for $100,000, 6 years later that house was likely worth $150,000, but you would only pay taxes based on that 2% a year increase. That law was enacted in 1978.

As you can see on the graph above, as time goes by and appreciation far overpasses assessed value, a strong incentive to keep real estate rather than selling it is created. The longer you keep it, the more this incentive grows. The more appreciation, the more you want to keep your real estate, and the more appreciation is generated as supply remains low. Prop 13 is one of the main reasons why California real estate is so expensive. Right now demographics are playing against California with more people moving out than moving in the state. Yet prices continue to climb.

Any more supply coming soon?

Neither interest rates or new construction will change this equation anytime soon. Our 3% interest rate that homeowners were able to lock in a few years ago had a similar “golden handcuffs” effect and will have long lasting consequences on the value of real state in the future. Just like in California, trading real estate means trading a 3% rate for 7% rate right now, and will dramatically increase the cost of owning a similar piece of real estate. The keyword is “stay put” for almost all homeowners right now, like it’s been in California for a long time. When interest rates get back down closer to 3%, it’ll be game on again. But are we ever going to get back there again?

The other way to get more supply is a surge in new construction. But that’s where interest rates have a double effect that most people might not anticipate. If it slows demand, supposing to put in back in line with supply, it also slows supply, since builders rely on debt to build more housing. In this article of the Wall Street Journal, it is explained that lumber prices are depressed because construction of new units is extremely low, and expected to get even lower with new permits and housing start being dramatically lower than last year.

Latest market stats in the Roaring Fork Valley

The “Californication” of real estate is underway. Don’t be surprised if prices stabilize at prices that seem so out of reach. Supply is very low and that is here to stay. As you would expect after reading the above, our local market is defined by low supply, high prices and low affordability across the valley. The fact that most buyers are left behind has no effect on the level of prices as long as the handful of buyers still qualified can scoop up the little inventory available.