The real estate frenzy in Silicon Valley: Can it last?

Real estate markets in Northern California's Silicon Valley are experiencing frenzied bidding for both residential and non-residential properties. Rents are soaring, land prices are out of sight and no one who merely offers a seller the asking price ever gets the property.

This situation is producing a severe labor crunch because many workers cannot afford to live anywhere near their jobs. Operating costs for firms are immensely higher than anywhere else in the nation - yet few firms move out, and more new ones are founded every day. How long can this situation last?

Evidence of a market frenzy According to the CB Richard Ellis first-quarter 2000 Silicon Valley Office Market Index, the Valley has an overall office vacancy rate of 1.8% and an average Class-A office space asking rental rate of $57 per square foot per year. The "ground zero" sub-market (Mountain View) has a vacancy rate of 0.4% and an average asking price of $72. These unusual statistics result from a market with tremendous demand for space fueled by the stock market's relish for Internet and other start-ups, plus an acute shortage of usable land.

Office buildings are being sold for $200 to $400 per square foot. The lower the current rents in such structures, the higher their sale prices because the buyers hope to raise rents and thereby increase property profitability in the near future. And such lagging of existing rents behind the current market is common because office and industrial rents have soared so quickly.

Housing prices are similarly astronomical and rising. The median prices of single-family homes sold in March 2000 were $514,000 in Marin County, $448,000 in San Francisco, $447, 000 in San Mateo County and $420,000 in Santa Clara County, according to the California Association of Realtors. And these prices have risen an average of around 30% in the past year. Many middle-class workers such as teachers and police officers are totally priced out of homeownership, and yet rents are very high, too. Low-wage workers cannot afford decent housing at all; thousands are living doubled and tripled up in overcrowded apartments and garages.

Why does this situation persist? These prices of both commercial and residential properties are far above "normal" reproduction costs, and, therefore, would result in massive new development under normal market conditions. That development would in turn restrict further rent and price increases, and eventually push existing levels downward. But this does not happen in Silicon Valley for two reasons:

First, there is virtually no vacant land available for commercial or industrial development; therefore, land prices have soared, raising reproduction costs - including land - to equal these high sales price levels. There is a lot of land that could be available for housing development, but local governments have zoned it out of the market using a combination of restrictions on lot sizes and building styles and the setting aside of immense amounts of land for open space. Homeowners approve of these exclusionary policies because it improves their neighborhoods and enormously stimulates the market values of their homes.

Second, the demand for commercial and industrial space - and therefore for housing for the workers in such space - is stimulated by the desire of both existing firms and new ones to remain located in Silicon Valley, almost regardless of costs. Again, under "normal" conditions, many firms would depart for cheaper regions.

What might end this super-boom? Two changes in current conditions might end this super-heated market: First, a sudden fall in the stock market's evaluation of many new and other high-tech firms. If a lot of dot.coms go broke because they cannot produce genuine earnings, that would not only reduce the demand for space in Silicon Valley, but might also persuade many existing firms to move their operations to other metropolitan areas where costs were lower and recruiting talent is much easier.

The second change has already started in the labor market but will be more gradual: the difficulty of retaining middle-income workers who cannot afford astronomical housing prices on the one hand, but are not willing to put up with either intense overcrowding or very long commuting journeys on the other hand. Firms that are not in the technology or Internet business already are considering moving elsewhere, since they do not profit from the IPO boom.

Until one or both of these changes occur, Silicon Valley's sizzling property markets are likely to remain overheated. But no one can reliably forecast when those changes will take place. Therefore, smart owners of properties in this region should consider selling now before any "crash" occurs, and moving to some less costly region.

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