Supply-Side Economics in Action: How the lack of housing supply will prevent price declines in Bay Area housing

After seeing recent volatility and declines in the stock market, some are questioning whether a seven-year cycle of appreciation in Silicon Valley housing is ending and whether we are headed into a period of depreciation. These arguments have focused on the potential decline in demand as tech companies experience less growth, and even some layoffs, as the world economy slows down. While I do not forecast a large drop in demand since larger tech companies like Google and Facebook are still doing well and hiring, the real key to the equation is not housing demand. Instead, the true factor is housing supply—more accurately, the lack of housing supply that is currently driving the housing market.

For most economic goods, the higher the price goes, the more supply is provided until an equilibrium is reached and prices eventually peak and decline. However, Silicon Valley housing has paradoxically seen a decrease in supply as prices have risen. In fact, empirical data illustrates that, generally, the larger the increase in price, the greater the decrease in supply.

The four local cities of Los Altos, Menlo Park, Mountain View, and Palo Alto are examples of cities that have experienced both high appreciation and declining inventory since 2012 (see tables pulled from the MLS, recently).

Taxes, particularly increased capital gains taxes and subsidized property taxes, are the main cause of this declining inventory and why the supply is declining most acutely in the most rapidly appreciating markets. In 2013, capital gains taxes went up on both federal and state levels (in California, the top bracket went from a combined 24.3 percent to 37.1 percent) and this disincentive discouraged sellers from selling. Reflecting the strong effect this had upon housing, the number of sales in Palo Alto dropped from 556 in 2012 to 451 in 2013, a drop of nearly 19 percent in just one year.

The rise in prices also makes the protections offered by Proposition 13 more valuable, another reason sellers are less inclined to move. With prices increasing by double-digit appreciation in these four local cities for all of the years in this timeframe, the two-percent cap on increasing property taxes due to Proposition 13 encourages owners to avoid moving, thereby losing their low property tax basis. Any projected drop in housing demand due to the softening economy seems dwarfed by this trend of declining supply, which shows no signs of subsiding short of lowering capital gains tax rates.

A fundamental tenet of supply-side economics is that lowering tax rates may actually generate more sales, and therefore more tax revenue, than otherwise expected as the lower tax burden will incentivize more sellers to sell. It appears that only a reduction in capital gains will reverse this trend of declining supply, and this is unlikely to occur. If most polls are accurate and Hillary Clinton wins this year’s election, the federal tax rate on capital gains will likely go up another four percentage points, further demotivating sellers from selling if their appreciation is over the $500,000 capital gains exemption allowed for primary residences.

Unless savvy sellers utilize the estateplanning tools we mention in other articles in this newsletter, such as the 1031 exchange to avoid capital gains, or Proposition 60 to carry low property tax bases, this continued trend of low supply is projected to continue. This has historically resulted in higher prices, creating a feedback loop of even lower future supply and even higher prices.

While news headlines may focus on the possibility of a drop in demand and therefore housing prices, the larger issue—and one that will mitigate the lessening demand—is the large, continuing drop in supply that will buoyantly propel Silicon Valley housing through the turbulence in the world economy.