Have you asked yourself, “What’s going to happen to Silicon Valley real estate?,” or maybe “Is there a Silicon Valley real estate market bubble?”
If so, you’re not the only one.
Silicon Valley real estate is a topic that has been often discussed lately.
Because over the last several years, the real estate market in Silicon Valley has seen dramatic year over year price increases.
If you’re thinking of selling your home, you might be wondering when you should sell.
And if you’re thinking of buying, you may be wondering if you should buy now or wait.
I’m not going to tell you when you should sell or buy. But what I am going to do is educate you a little more about the Silicon Valley real estate market, so that you can make the best possible decision.
I’m going to dive in and discuss three things:
- What’s causing the dramatic increase in prices?
- How does this impact buyers and sellers?
- Where is the Silicon Valley real estate market headed?
My goal is that by the time you’re done reading this, you’re a little more savvy on the Silicon Valley real estate market than you were before.
I’m also going to give my opinion on whether we’ll see a major downturn and when.
More on that in a bit.
So, without further adieu.
What’s causing the dramatic price increase in Silicon Valley real estate?
First things first.
Real estate prices are controlled by supply and demand.
The value of something is determined by the quantity available and the number of people who want it.
- Way back in 2010, a Picasso painting titled “Nude, Green Leaves and Bust”, sold for $106.5 million at an auction in a matter of eight minutes.
- Supply and demand.
There’s only one of them in the world and it’s highly sought after by many collectors.
All it took is eight minutes for someone to make an astronomical offer.
What if there were 1,000 of them?
- Chances are the price would have not even been close to $106.5 million.
The same is true in real estate.
- The supply is the number of homes for sale.
- The demand is the number of buyers.
A low supply of homes for sale, plus high demand, usually means an increase in prices (Also known as a “seller’s market”).
A high supply of homes for sale, with average to low demand, usually means a decrease in prices (known as a “buyer’s market”).
Can you guess which one applies to Silicon Valley real estate over the last few years?
- If you said, “low supply and high demand,” you are correct.
Now that we know what causes this, let’s look at specifics here in Silicon Valley, starting with the answers to these questions:
- Why is the supply low?
- And where is the demand coming from?
First, I will give my reasoning for the low supply. There are few factors:
- Silicon Valley is going through a major change in demographics – something the area hasn’t seen to this extent before.
- As most people know, Silicon Valley is the tech capital of the world. As a result, a high percentage of the jobs here are tech related.
So, why is this important?
- Many people of the generations that have lived in Silicon Valley for 10, 20, or 30 years or more, are not in the tech industry.
- This is one of the main causes for the increase in Silicon Valley home prices.
- Because in order to afford a home here, you need to make a higher than average salary.
- This means that homeowners who are not in the tech industry (or another above average paying field), can’t get a mortgage for a new home.
Meaning they can’t move. Unless…they move out of the area.
This is what many sellers in Silicon Valley are doing. Not all of them, but a much higher ratio than in previous years.
This isn’t like it was in years past where the average person could sell their home and move up to a bigger one nearby after some time.
Compared to the years prior to the great recession, where all you needed to do in order to get a mortgage was be able to fog a mirror, the lending guidelines for a home loan are now more stringent.
The average Silicon Valley home seller simply can’t afford to buy here.
This is why some of the monthly numbers of homes for sale are some of the lowest they have ever been in Silicon Valley.
Ok, now what about the demand? How in the heck are there so many buyers that can afford to live here?
Not only that, but how are some of these buyers offering substantial amounts over asking price?
The answer? Tech.
Just how it affects the supply, it also has a major impact on housing demand in Silicon Valley.
Here’s how: stock options.
But not just stock options. Other things such as:
- RSUs (restricted stock units)
- ESPPs (employee stock purchase plan)
First, let’s discuss how these buyers are qualifying for their new mortgage.
In order to get pre-approved, lenders look at three things:
What exactly do these three things refer to?
- Credit is the credit score.
- Collateral is the down payment.
- Capacity is the debt to income ratio.
The biggest hurdle for most buyers on getting pre-approved is the debt to income ratio.
Most lenders will allow a debt to income ratio of 43%.
This is calculated by taking into account:
- The new principal and interest mortgage payment
- Monthly property taxes and insurance
- The minimum payments that show on the credit report
The sum of these is then divided by the gross monthly income before taxes.
Let me break this down a little further and give you an example. Let’s take a property listed at $1,200,000.
- Let’s assume the normal 20% down, which would be $240,000 in this scenario.
- That leaves a mortgage of $960,000.
Now let’s say the interest rate is 3.75%.
Here’s how the monthly mortgage payment would break down.
- $4,446 for the principal and interest payment
- $1,250 for property taxes (sales price x .0125% /12 months)
- $100 for homeowners insurance
This brings a total housing payment of $5,796.
Now let’s factor in $500 for the minimum payments on the credit report.
- This gives us a total monthly outgoing of $6,296, if the maximum debt to income ratio is 43%
This means in order to qualify on the income portion for the loan, the gross monthly income would need to be a minimum of
- $14,700 a month
- Or, $176,400 a year
At a minimum.
Most people in Silicon Valley aren’t making that much unless they have a great self employed business or are in tech.
And this example is based on a $1,200,000 purchase price.
Many homes are much higher than this.
Now that we know what’s needed to qualify for the capacity requirements, let’s talk about the collateral.
Where are these buyers getting their 20% down payments?
- Stock options (mostly).
If you aren’t familiar with how stock options work, this part is important.
In my opinion, there is a key factor that will impact the future of Silicon Valley real estate: employee stock options.
Employee stock options, also known as ESOs, are stock options granted by the employer to the employee, given as extra incentives.
Here’s how they work:
- Employees are given the right to purchase shares at a predetermined price (usually stock price at time of hire)
- They have the option to “exercise” (sell) them after a certain period of time.
- (Usually this timeframe is every 12 months for four years).
Let’s say a new employee just started this month and the company granted her 4,000 shares.
- With a four year vesting period, this means she has the option to “exercise” (sell) 1,000 shares every year.
Let’s say the stock price was $100 at the time of her hire and after the first year is now $120.
- This means she can sell 1,000 shares for a profit of $20 a share.
This equals $20,000…for the first year.
This is in addition to her salary and other incentives.
What happens if the stock price increases over the next 3 years?
- More profit for the employee.
Let’s dig a little deeper and start seeing the actual numbers.
As you know, many tech giants have their headquarters based in Silicon Valley.
Some of these companies include Apple, Google, Facebook, and Netflix.
Let’s use Apple as an example.
Let’s look at their stock price for the last 5 years.
- Starting in 2013, the price hovered between $55 and $80.
- Towards the end of 2014, it almost reached $120…
And look what it has done since.
Let’s say a new hire started in 2013 when the price was $70.
- She was granted 5,000 shares with the option to cash in 25% (1,250 shares) every 12 months.
- In 2014, after the first 12 months, she cashes in roughly $62,500 (1,250 shares x $50 difference in grant price of $70 and selling price of $120).
- As the stock price increases after the second, third, and fourth years, she has the option to sell the shares and profit the difference of the stock price when she was granted the shares versus the current selling price.
This is just a rough example of how employee stock options work.
The number of options granted to each employee depends on their position, experience, how much the company wants them, among other factors.
If we look at the stock prices over the last four to five years of the tech companies here in Silicon Valley, many of them have been on a persistent upward trajectory.
This is where many buyers are getting their down payments and are able to afford the homes here in Silicon Valley.
There’s no doubt that the tech industry has played a major factor in both the supply and the demand for Silicon Valley real estate.
In fact…I can prove it.
We wanted to compare the stock prices of some of Silicon Valley’s biggest companies with the real estate prices in Silicon Valley over the last three years.
So, we decided to look at the stock prices of three of the biggest tech employers here:
- Google, and
Now, take a look at the home prices in San Jose over the last three years:
Let’s put them on the same graph and see what it looks like.
If that doesn’t show the correlation between Silicon Valley real estate and the tech industry, I don’t know what does.
I’ve been asked numerous times how buyers are affording these prices and how they are offering so much over the asking price.
There are two answers to that question:
- Salaries, and
- Stock options
Remember the three things buyers need in order to get pre-approved?
- Collateral, and
Here’s what is happening with Silicon Valley buyers:
- They’re qualifying for the capacity (debt to income ratio for their loan) with the salaries
- And they qualify for the collateral (down payment) with stock options
- Another factor that doesn’t get talked about that much is the fact that many families who are buying have both spouses working
We’re at a point now where this is pretty much mandatory in order to buy a home in Silicon Valley.
It also helps when buyers make an offer over list price.
There’s an increase in the mortgage payment, but there are two well paying salaries instead of one.
- When a buyer offers over the asking price, they are not paying the full amount out of pocket.
- The average buyer makes a 20% down payment with the lender putting in the other 80%.
- This means that if they offer $100,000 over asking, they are putting $20,000 out of their pocket and financing the rest.
Where is the Silicon Valley real estate market headed?
Everyone wants to know what’s going to happen with home prices in Silicon Valley.
Many want to know:
- Will they keep increasing?
- Will they ever come down?
But the truth is…nobody knows.
All we can do is look at the data and trends and make an educated guess.
I’m going to give you my opinion on what I think will happen with Silicon Valley real estate.
But first, I’ll explain the difference between Silicon Valley home buyers now and Silicon Valley home buyers of years past.
In fact, it really applies to much of the United States, and not just Silicon Valley.
So, what’s the difference?
- The majority of buyers get financing when they purchase a home.
Let’s look at the characteristics of a buyer today.
As we know, home buyers need:
- A good credit score
- A sufficient down payment, and
- Well paying jobs
This is what the banks look at when underwriting a purchase loan.
But what about in years past, specifically before 2008. What was required then for each of the following:
- A minimum score of 620.
- Show a business card and state your income on the loan application with no proof of pay stubs or tax returns.
- It simply wasn’t something to worry about. Some banks would lend 100% up to $750,000.
So what did this mean at the time?
- There were buyers who would have less than average credit, no money to put down, and essentially lie on their loan application about how much they made.
Any guesses as to why the great recession happened?
Going back to Silicon Valley today, I’ve seen many articles, posts, and discussions talking about a Silicon Valley real estate bubble.
Can this happen? Technically, yes. Anything can happen.
But in my opinion, this isn’t a bubble.
- Because it’s real money
- The buyers are real
- Their down payments are real
- Their salaries are real
One of the reasons for the housing crisis following the Great Recession was due to a lot of foreclosures and short sales.
Why did these occur?
- Because many buyers purchased their home with little or no money down.
- When they saw their home value decrease, many of them decided to simply walk away.
Some of them lost their jobs and some of them simply never should have been given a loan in the first place, because their real income fell short of what they told their lender it was.
Now let’s compare this to today’s buyers.
Let’s say the Silicon Valley real estate market slowed down and prices dropped by a large amount, like 20%.
- The majority of buyers who have purchased over the last few years made a 20% down payment.
- This means that their home value would be about equal to what they owe.
- What’s more, is that many of these buyers have gained a large amount of equity appreciation as well.
What can we conclude about the Silicon Valley real estate market from this?
If the Silicon Valley real estate market was to decline by a substantial amount, the homeowners would be far less inclined to walk away from their homes compared to home buyers of the pre-recession years.
Now let me tell you where I think the Silicon Valley real estate market is headed.
I think we’re going to keep seeing a steady increase in prices (maybe not as dramatic) because of two things:
- Short supply
- High demand
As previously mentioned, many homeowners who have lived here for 10, 20, or 30 years, would love to sell, but they simply can’t unless they moved out of the area.
But, there are three things that I think could cause home prices to fall in Silicon Valley.
- A big catastrophe such as an earthquake or war
- An increase in mortgage rates
- Stock prices of tech companies in Silicon Valley drop
The first one is unknown if and when it would happen. If it did, home prices usually drop when wars occur out of fear, which causes less demand from buyers.
Regarding the second point, mortgage rates have been very low for almost the last 10 years or so. Eventually they will increase.
When they do, not only does that mean that a potential buyer’s payment will be higher, but it also means that they will qualify for a lower purchase price.
The debt to income ratio has the greatest impact on a buyers purchasing power, and when rates go up, their purchasing power goes down.
- A current interest rate of 3.75% on a $1,000,000 loan amount, equals a principal and interest payment of $4,631.
- At a 4.75% interest rate, the principal and interest payment is $5,216.
- This is a difference of $585 a month.
A 5.5% interest rate would be a difference of $1,047 a month ($5,678 payment).
When interest rates start to have an impact on the payments and qualifying factors for Silicon Valley home buyers, the demand will not be as high.
Thirdly, how will stock prices affect Silicon Valley real estate?
- Stock prices of tech companies will drop.
It’s not a matter of if, but a matter of when.
It doesn’t look like it’s close to happening, but when it does, home prices in Silicon Valley should slow down and may even decline.
- Because there will be less buyers.
How have the majority of home buyers been coming up with their down payment?
- Stock options
The only reason why buyers have been able to do this is because of the increase in their company stock prices.
What happens when the stock price stays flat or drops over a time period of a few years?
- There is no money to be made.
If you remember:
- An employee is granted the shares at the stock price of when they’re hired.
- Then, they have the option to sell them every 12 months for 4 years.
- If the stock price when the employee goes to sell their shares is less than the stock price of when the shares were granted to them, then there is no profit.
This means the employee doesn’t make any money on their employee options, which means they don’t have a big chunk of change for the down payment.
For example, Apple’s stock price today is at $171.
Let’s say a new employee was hired today and was given employee stock options.
- If Apple’s stock is on a decline over the next four years, the employee’s shares will not be worth anything.
The stock market has been on a tear over the last few years, but will eventually take a breather and decline.
It could be next year, five years from now, or ten years from now.
But as of today, the economy is doing well and the tech market is strong. All indications point to the idea that a steady decline may not happen for a while.
In my opinion, as long as the tech market is strong, interest rates remain low, and there aren’t any major catastrophes, Silicon Valley real estate should continue to see a shortage of inventory and a high demand from home buyers.
How Does This Impact Buyers and Sellers?
The Silicon Valley real estate market has been on a roller coaster ride that has only continued to progress over the last several years.
For buyers, it’s a very competitive market. How so?
- They’re going up against plenty of other buyers in the same position that they’re in.
- One of the concerns that a lot of them tend to ask themselves is if they’re “overpaying,” and whether or not they should wait.
In my opinion, “overpaying” doesn’t exist in real estate.
- Because a property is worth what someone is willing to pay for it.
A couple of months ago I sold a house in West San Jose.
- This home was about 1,350 square feet on a 9,000 lot and needed some work.
- We listed it for $1,299,000 and it sold for $1,500,000.
Last week, I wrote an offer for buyer clients on a home only a couple streets over from this one.
- This home was listed at $1,395,000, had the exact same square footage as the one I sold, was on a 8,000 square foot lot, and also needed work.
These two properties were very similar in characteristics, and the home I sold was the best one to compare it to.
So, what happened?
- My clients ended up offering $1,620,000 without any contingencies.
In my opinion, that’s a very strong offer. But we found out that it wasn’t as strong as we thought.
- The seller ended up receiving 22 offers with almost half of them offering over $1,600,000.
As of now, I don’t know what the final sales price is, but I wouldn’t be surprised if it ends up being close to $1,700,000.
My clients really wanted that home and were disappointed they didn’t get it.
They asked me if they should wait for the real estate market in Silicon Valley to slow down.
But if you’re looking to buy, I’ll tell you the same thing I told them: nobody knows when that’s going to happen.
It could be next month, or it could be ten years from now.
As I previously mentioned, in my opinion, as long a she tech market is strong, then Silicon Valley real estate will also remain strong.
For most people, buying a home in Silicon Valley is a long-term plan, not a short one.
Everyone wants to time the market, but nobody knows what’s going to happen.
I’ve had several clients who put off buying in 2014 and 2015 because they thought the market was at its peak.
They ended up buying in 2016 and 2017, but at much higher prices.
I will never tell someone that they “need” to buy now because prices are going up, or interest rates are increasing.
These things are factors worth considering, but there are also others, such as:
- Would the new living situation be better than the current one?
- Are the schools that fall within the boundaries of the new home important
- Is the neighborhood better?
If the pros of buying a home outweigh the cons, then you may want to consider moving forward.
But what if you’re thinking of selling?
Silicon Valley has been in a seller’s market for the last few years and it looks like it’s going to remain that way for some time.
For how long, nobody knows.
Selling a home is a big decision and a major transition for most people.
Similar to buying, I always suggest making sure the pros outweigh the cons.
Sure, maybe it makes sense to wait and see if the market goes higher, but what if doesn’t?
I just sold a home in Almaden Valley and my clients originally planned to sell in the latter part of 2018.
- They’ve lived in the home for almost twenty years and planned on moving out of the area.
- Their home is worth more now than it has ever been and the equity they are walking away with is a big chunk of their retirement.
- They decided to sell sooner than originally planned because they didn’t want to get too greedy.
- They are renting until they leave the Bay Area towards the end of 2018.
Sometimes the decision on when to sell a home is within the seller’s control, but sometimes, it’s not.
Either way, maximizing the returns when selling is almost always a top priority for most homeowners.
For many people, it’s the biggest financial transaction they’ll ever make and walking away with the highest amount for the sale is important.