According to the California Association of REALTORS^® (C.A.R.) "2004 – 2005 State of the Housing Market" report, home sales and the median home price reached record high levels in 2004, while supply conditions and the share of first-time buyers in the California housing market fell to historic lows, showing a trend toward more of the same for 2005.

Since 1995, with the exception of a slight pause in 2001, California's housing market has been on a roll, and has set records for the third year in a row.

"The market performed in a somewhat paradoxical manner in 2004," said C.A.R. President Jim Hamilton. "Home sales and prices continued to advance despite declining affordability and weakness in the labor market, primarily due to low mortgage interest rates, the wealth effect among repeat homebuyers, increasing use of adjustable-rate loans, and both near-term and long-term supply constraints.

"Across the state, regional housing markets seemed to be moving in slightly different directions," he said. "Whereas sales were up moderately in all regions of the state in 2003, the picture was mixed in 2004, even as home prices continued to climb at a pace that was double, and in some cases triple, the national rate of increase."

C.A.R. economists say the outlook for 2005 is largely dependent on the trajectory of interest rates, which in turn will dictate the extent to which the wealth-effect driven market conditions, driven largely by Baby Boomer buyers and sellers, will continue.

They predict mortgage rates to increase by 50 to 75 basis points as the economy grows in 2005, with the fixed-mortgage interest rate expected to remain comfortably under seven percent for the year.

"If job growth, which is expected to accelerate throughout the year, is seen as a precursor to inflation, mortgage rates may increase more quickly and cross the 7 percent threshold," said C.A.R. Vice President and Chief Economist Leslie Appleton-Young. "This is the biggest risk facing the housing market in 2005."

As reported earlier, affordability is a huge factor as first-time homebuyers have dropped to below 30 percent of home buyers while the wealthier Baby Boomers have 40 percent of the market.

"First-timers are locked out of homeownership for two reasons," Appleton-Young said. "First, with rapidly rising home prices, it has become increasingly difficult to come up with a downpayment of any size if one relies on conventional forms of savings. Second, higher prices also translate into higher monthly payments, which puts additional stress on household budgets."

Appleton-Young also predicts that price appreciation will continue to be strong again in 2005, and the trend of buying for investment and tax considerations will grow. The share of all buyers who indicated that they bought primarily for investment and tax considerations increased to a historic high of 16.2 percent in 2004, surpassing the previous record of 15.3 percent set in 1991. This trend will be driven largely by repeat buyer Boomers who are diversifying their portfolios with rentals, acquiring vacation homes, and planning for retirement.

While more than four out of five homebuyers (84.3 percent) bought their home to be used as a primary residence, 15.7 percent of all homebuyers bought a home in 2004 either for investment purposes or as a second home. This includes 10.7 percent who acquired a home as an investment or rental property and 5.0 percent who bought a vacation or second home. The overall share of investment, vacation, and second home purchases has risen since 2001, when they accounted for just 9.8 percent of all purchases. The median purchase price for repeat buyers increased significantly from $411,250 in 2003 to $506,250 in 2004.

Housing affordability is a growing concern that could negatively impact the long-term health of the housing market and the California economy. At 20 percent in 2004, affordability in California was less than half that of the nation. With prices and mortgage rates on the rise, affordability will likely plunge to record low levels in 2005, with several coastal regions in the state dipping into single-digit territory for the first time. Conversely, inland areas are expected to rise due to the "substitution" effect, buyers buying what is affordable rather than the properties they prefer.

"The fate of the housing market will be tied mainly to the direction of the economy," Appleton-Young said. "The greatest concern surrounds the current increase in the use of low downpayment and interest-only ARMs. If the economy should weaken and trigger job losses, there is potential for today’s marginally qualified homebuyers to be tomorrow’s foreclosure."

In related news, C.A.R. reported that the median price of homes jumped to an all-time high of $474,480 in December, 2004.

"After peaking in the middle of 2004, the number of homes for sale dropped again last month to a 2.8 month supply compared with 3.5 months in November," said Appleton-Young. "Despite having fewer home to choose from, buyers are becoming more selective and are taking more time before making an offer on a home. The median number of days it took to sell a single-family home reached 43 days in December, compared to 27 days a year ago."