I get a variation of this question nearly every day. Bay Area home prices are nuts. Both rents and values are rising. It seems out of whack with reality and sustainability. The other day I answered a question on Quora and I thought I would repeat it here.

The short answer is that exorbitant home prices and rents are, generally speaking, sustainable.  The three home price bubble bursts of the last 25 years have, in retrospect, been amazing buying opportunities for Bay Area real estate.

The longer answer is more nuanced, because the “Bay Area” is a big place, and as we experienced in the 1991-1993, 2001-2003, and 2008-2011 real estate busts, home prices acted VERY differently across this big geography both in collapse and recovery.

So for brevity – I will call your attention to what we at Altos Research regard as the single most important variable for “unaffordable” price sustainability in a given market.

We created a metric called Inventory per Capita because it turns out we can measure Supply vs. Demand in a way previously impossible (due to the byzantine US real estate industry). For further details about Altos Research real estate market data, see our main site.

Inventory per Capita is the number of homes currently for sale in a market divided by the population. Or inversely, the number of potential buyers who have to compete for a given home for sale.

Let’s compare three cities of similar size (~30,000) and high-end demographics – Los Altos, CA; Winnetka, IL; and Southlake, TX – to see how this works.

As of August 7, 2015:

  • Southlake has about 255 homes for sale and a median home price about $800K.
  • Winnetka has about 190 at $1.3M median home price
  • Los Altos has exactly 17 homes for sale and a $3M median home price

We hear about how “median home prices are unaffordable to the median income” in the Bay Area. But in a place like Los Altos, they don’t have to be affordable to the median income. They only have to be affordable to 17 people!

Bay Area home prices are high because demand is moderate and supply is infinitesimal.

When marginal demand tanks, as it did in 1991, 2001, and 2008, prices adjust down rapidly. But they tend to recover quickly with demand.

California has a chronic shortage of available housing for two reasons:

  1. Restrictive zoning prevents new construction
  2. California’s goofy Prop 13 tax law that acts as a giant rent control. People can’t move without resetting their tax basis, so they don’t. So fewer homes are for sale and they cost more to people who don’t already own.

Both of the legal structures were explicitly designed to favor existing home owners over outsiders who want to buy. “I’m already here. Screw you.” They are unlikely to change.

Incidentally – rents and prices do not move counter to each other, but in tandem. Both are driven by household formation (economic growth), so demand increases for each simultaneously.

So when you want to know if a market is due to an over-pricing correction back down, like Vegas in 2005, I suggest you look at Inventory per Capita. It tells the tale you’re looking for.