Desirable Yes, Immune No

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For years, people claimed that because San Diego was such a desirable place to live, local real estate was immune to price declines. We know how that turned out. Yet these days that same argument is often applied to San Diego's more upscale areas.

It seems, at first blush, to hold up. High-end San Diego homes have certainly weathered the housing bust far better than their lower-priced counterparts. This can be seen in last week's Case-Shiller home price graphs, which show that the high end of the housing market has fallen in price less than half as much as the low end. And the Case-Shiller high tier -- which aggregates price movements of the most expensive one-third of San Diego homes -- understates some notable resilience in swankier sub-markets such as Point Loma, Mission Hills, La Jolla, and much of the North County Coastal region.

The relative strength in these areas has led to the widespread conclusion that the high-end markets are desirable enough to be more or less invulnerable to the housing bust.

I am skeptical of this interpretation. There are better explanations for why the high end has held up so well. And there are some looming threats -- overvaluation, high-end foreclosures, job loss, and pressure from lower-end price declines -- that put San Diego's more desirable areas at serious risk of losing their "invulnerable" status.

Let's start with the idea that there are better explanations for the high end's resilience. As noted at the beginning of this article, saying "prices in Area X will remain high because Area X is so desirable" sounds a lot like a repackaging of the "everyone wants to live here" mantra that pervaded the market during the boom. In this new version, Area X has been narrowed down to include only certain parts of San Diego rather than San Diego as a whole, but the thrust of the argument remains the same.

As such, it suffers from the same flaws. It offers no explanation for why prices increased so vastly within a period of just a few years, nor does it offer any compelling reason why those huge price increases should stick now that the props of speculative enthusiasm and easy lending have been removed. (A more thorough treatment of the "everyone wants to live here" fallacy and other assorted home price rationalizations can be found in a housing bubble overview I wrote last year).

A big part of that resilience has to do with the fact that prices in that part of the market never got so out of whack in the first place. The heavy influence of the subprime mortgage securitization boom led to much larger proportional increases in low-tier home prices than in the high-end markets. This is illustrated in last week's price update, but to put some quick numbers on it: in the five years leading up to the price peak in November 2005, the Case-Shiller low-tier index increased by 144 percent versus a much smaller -- though still enormous in absolute terms -- increase of 88 percent in the high tier. (The middle tier split the difference at 116 percent).

The subprime boom also led to a preponderance of risky mortgages in the low-cost areas. Many of these risky loans have since gone into foreclosure, forcing a glut of must-sell inventory onto those markets and accelerating the price declines. The areas that typically host the higher-priced homes are not subject to nearly as many foreclosures as the lower-cost areas.

In short, the high end's relative resilience throughout the downturn is pretty adequately explained by the disparate boom-era price increases between different property tiers and by the lower incidence of must-sell foreclosure inventory. There is no inherent invulnerability at work.

I can say that last part pretty confidently because the the high end was anything but invulnerable during the last housing downturn. The accompanying chart, which measures the ratio of the Case-Shiller high-tier index to per capita San Diego income, shows that the ratio of high-priced San Diego homes to incomes fell by 33 percent during the last housing bust. Once again, this index is lumping together a lot of different sub-markets and that some nuance is surely being lost. But the graph does clearly illustrate the point that as a whole, the most expensive one-third of San Diego houses can still be subject to price declines despite their obvious desirability.

As for the housing bust now underway, I believe that high-tier homes -- and here I am including even the areas that have been relatively unscathed so far -- are very much vulnerable to further price declines.

To begin with, have another look at that last graph. Even after the decline that's already taken place, the price-to-income ratio for the high tier is still above what it was at the tippy-top of the region's prior real estate bubble. (More detailed thoughts on home valuations are available for those interested).

I realize that this graph only provides a broad-brush approach. As mentioned above, it lumps together multiple sub-markets, and on top of that it is comparing prices of high-end homes with the per capita income across all of San Diego. Still, the level of the price-to-income ratio is so historically high that I have a hard time believing that it could be accounted for by changes in income distributions or by valuation differences between sub-markets. High-end homes in general look very overpriced, and now that the bubble is over, it seems reasonable to believe that they will return to being somewhat closer to fairly priced based on their historical relationship with incomes.

There are some more immediate risks, as well. I've often written here about the fact that reckless lending and borrowing wasn't just a subprime phenomenon. The bulk of foreclosures so far have certainly occurred in the lower priced areas that were more dependent on subprime financing, but that doesn't mean that the high end is out of the woods. Many analysts believe that the payment shock is still to come among the more creditworthy borrowers who took on risky loans.

Foreclosures are the primary source of must-sell inventory these days, but unemployment can play that role as well. Part of the reason that the high end fared worse than the lower tiers in the 1990s was that job loss was a big factor during that downturn. This time around, the bust so far has been driven more by financing getting abruptly tighter, so it makes sense that the lower-end areas that are more dependent on financing would suffer more. However, if job growth continues to stagnate or starts to shrink -- and especially if job losses continue to be concentrated within some of the higher paying sectors -- there could be more forced selling in the expensive markets.

Finally, the serious price downturn taking place in the lower tiers could itself negatively affect the high end. If prices get beaten down enough outside the high-priced areas without an adequate decline within those areas, there could be a substitution effect wherein buyers decide that the more expensive sub-markets aren't worth the price premium. There is so far no evidence that the price relationships that historically prevailed between different areas of San Diego should be thrown out the window.

Price declines in the current market, whatever their cause, tend to be self-reinforcing -- just as price increases were self-reinforcing during the boom. The premium that people pay to live in the high end areas has, ironically, increased because of the widely held belief that those areas will not be subject to price declines. As goes that belief, so goes that increased premium. And falling prices would put more owners underwater, leading to increased likelihood of foreclosure and thus yet more downard price pressure. Any of the risks mentioned in this article could cause San Diego's finest sub-markets to enter the kind of downward spiral that is taking place throughout the county.

San Diego as a whole is a very desirable place to live, but there are nonetheless upper limits to how much people are willing or able to pay to live here. The same reasoning applies to the extra-desirable areas. Every part of San Diego participated in the bubble, to a lesser or greater degree. There's little reason to believe that they won't all participate in the bust.

-- RICH TOSCANO