Should Real Estate Investors Join the Supposed California Exodus?

California is struggling, to say the least. And right now, the big thing is for just about every wealthy person who can to announce they’re leaving to go ahead and do so. The man with one of the most popular podcasts in the world, Joe Rogan, bounced for Texas. YouTube star Graham Stephan “is out” for Las Vegas. Minimalist aficionado Tim Ferris left, too, as did popular YouTubers like Silicon Valley Girl and Nerdrotic.

Indeed, given that Hollywood rarely films movies in Hollywood anymore (only approximately 10%), many famous actors have also left California over the last few years, including Chris Hemsworth, Sandra Bullock, and Mark Ruffalo.

Further, Elon Musk has talked about possibly leaving (and taking Tesla with him) as have Adam Carolla and the popular real estate YouTuber Meet Kevin.

So what is happening to the (once) Golden State? And is there “gold” left for real estate investors to mine?

The Fall of California

Now let’s not get ahead of ourselves. The GDP of California is an eye-popping $3.2 trillion. To put that in perspective, if California were a country, it would have the fifth-highest GDP in the world. California is still a juggernaut, but being a juggernaut doesn’t necessarily make it a good place to live or invest.

California has a myriad of advantages: beautiful beaches and national parks such as Yosemite National Park, good seaports for trade, and huge industries like tech in Silicon Valley, film in Hollywood, and tourism everywhere. California also has some of the best universities in the world and numerous extremely successful sports franchises.

It also has weather that’s hard to describe as anything other than close-to-perfect. San Diego, for example, has a peak high average of 77.5 degrees Fahrenheit in August and a low of 48.9 degrees in December. Living in the Midwest as I do, all I can say is, “**** you California!”

But underneath that veneer, trouble has been brewing for a long time. First comes the astronomical cost of living.

Cost of Living

Other than Hawaii and New York, nowhere can compete with California regarding the almost incomprehensible cost of living. Just look at this chart for the median home price in the last five years.

In 2015, the average home price was $476,300. In 2020, it’s $640,300. Now, while this is only an annual rate of appreciation of 6.89% (34.43% over five years), I should stress the median home costs $640,300.

And that’s for the state on the whole. As Business Insider notes about San Francisco in 2019, for the big cities in California, it’s much worse:

The median asking price for homes in San Francisco was $1.3 million.
Buyers need an annual salary of $172,153 to keep up with such mortgage payments (or about five times more than the median American income of $34,248 and almost three times more than the median Californian income of $63,783).
The median rent for a one-bedroom apartment is $3,690 per month.

Ouch!

And it’s not just housing prices. California has the second-most-expensive cost of living in the country, behind only Hawaii. An analysis by World Population Review found that California’s cost index was 151.7, while the average in the United States was only 104.6. This means California’s prices, on average, are almost 50% higher than the rest of the country’s.

And while wages in California are higher as well, they are not commensurate with the extremely high housing costs. Thus the “functional poverty rate” in California is the highest in the country at a full 18.2% according to the Census Bureau.

While some of the richest people in the world live there, like Mark Zuckerberg, Larry Paige, and Elon Musk (for now), so do a lot of poor people. Indeed, the gap between rich and poor is enormous and one of the highest in the country.

Economists measure income inequality with something called the Gini coefficient, and California comes in at 0.4899. While I’m sure that number doesn’t mean much to most people, to put it in perspective, think of California as a country. It would tie Brazil for the 19th most unequal country in the world and put California just behind Colombia and Rwanda and just ahead of Nigeria and Mexico in terms of inequality.

Taxes, Taxes, and More Taxes

“Just this year alone I’m estimating I’ll pay about $400,000 alone toward California state income tax and last year I paid about $200,000 toward state income tax.”

That’s Graham Stephan’s primary reason for leaving. I’ll remind you, this is not state income taxes and property taxes and federal income taxes and sales taxes combined. It is just the California state income tax, which can go as high as 13.3% (the highest in the country) and may be increased to 16.8% (possibly retroactively for 2020) on top earners.

Furthermore, Trump’s 2017 tax cut did not benefit Californians much because it placed a cap on the amount of state and local taxes that could be deducted. Since California has the highest state income tax, that cap hurts them the most. In the end, about one million Californian households actually ended up paying more in federal and state income taxes taken together.

With a Biden presidency, it is unlikely to get any better as some experts believe high-income earners in California could pay as much as 62% with Biden’s tax plan if they earn above $400,000 per year.

By the way, California also has one of the highest sales taxes in the country too.

Indeed, it may not be remarkable that a state could struggle with poverty with such high tax rates, but it certainly is regarding inequality. And perhaps it’s even more shocking that with such tax rates the state’s budget deficit looks somewhat like the United States’ on the whole (and without the ability to print money on demand).

Let us not forget that Stockton, California, declared bankruptcy a few years back. Right now, the estimated budget deficit in California is $54.3 billion, which Governor Gavin Newsom looks to close by temporarily raising taxes as well as few cuts and delayed payments.

Those tax increases might not be so temporary though. Indeed, California legislators just proposed the first-ever wealth tax. It would start at just 0.4% on all net worth above $30 million, but one should be careful about believing it would stay there. For example, the top tax rate for the highest income bracket was 7% when the federal income tax began in 1913. By 1918 it was 77%, though it currently sits at only 37%.

Standard of Living

The high cost of living and taxes might be tolerable if the standard of living was what it once was, but the trend is clearly going in the wrong direction. This was true well before the COVID-19 pandemic and subsequent lockdowns, although those have certainly made things worse.

The high poverty rate has seen a simultaneous tragic growth in the state’s homeless population. LA contains 55,200 homeless people, the second-most of any city in the United States, and California has the highest rate of unsheltered homeless people in the country. Enormous tent cities and homeless camps have been set up in major cities throughout the state.

The cities have also become remarkably dirty, with trash accumulating left and right. Headlines like this one from NBC Los Angeles are becoming more and more common: “Maggots, Rodents, and Fleas: LA’s Garbage Problem is Getting Worse During the Pandemic.”

And then there’s the poop crisis. From 2011 to 2018, the number of “Human Feces Incidents” in San Francisco has increased six-fold. Yes, the situation is a bit crappy.

Crime is also becoming a bigger and bigger problem. California is actually a relatively high-crime state. Its violent crime rate was the 14th worst in the country and going up. For example, in 2020, the murder rate in Los Angeles is up by 25%.

This has inevitably lead to more and more residents feeling unsafe, which Graham Stephan also mentioned as a concern for him and his girlfriend.

Add that to the commutes, which are some of the worst in the country (and the world for that matter). The average commute in Palmdale, for example, is the longest in the country; 85.4 minutes both ways. Assuming you work five days a week and 50 weeks a year, that would amount to 355.8 hours a year, or about 4% of that year, spent commuting. (Trust me, I did the math but it’s too boring to show here.)

These commutes spell bad news for many Californian cities in the long term. More and more people are working remotely and can therefore live anywhere, even if their job is in a major urban area like Los Angeles, San Diego or San Francisco (or other big cities like New York and Chicago, which have also seen problems of late).

Global Workplace Analytics estimates that “56% of the U.S. workforce holds a job that is compatible (at least partially) with remote work” and “25-30% of the workforce will be working-from-home multiple days a week by the end of 2021.”

Indeed, we have already seen the beginning of this as companies such as Twitter (based out of San Francisco) have announced that they will allow their staff to work from home “forever.” Just look at the stock price of companies associated with work-from-home alternatives, such as the video conferencing company Zoom:

Finally, the fires have been getting worse and worse. In 2018, the town of Paradise, California, with a population of 27,000, was entirely consumed. This year we had something called a “gigafire” that turned the sky orange a la Blade Runner 2049.

And while I will try to curb any political arguments here, it doesn’t seem like these issues are being properly addressed by the political establishment as the state spends much of its time passing proposals like banning plastic straws (responsible for all of 0.025% of the plastic in the ocean) and gasoline cars by 2035.

Outmigration

Not surprisingly, these various factors have led to a major outmigration. California saw 691,145 citizens leave in 2018 versus 501,023 come in for a net negative of 190,122. That represents seven straight years of a net outmigration — a 38% increase over 2017 and the largest loss nationally. Indeed, just look at this graph of inventory changes from February to July of 2020 for listed homes in six major American cities. Do you notice any city that seems to stand out?

If 'Everyone' Is Leaving California, Should Real Estate Investors Leave, Too? 4 — *Source: Zillow*

It should be noted, of course, that the increase in Los Angeles is quite small and dwarfed by San Francisco’s near doubling. But other major cities are also hurting from COVID-19 and yet the four outside of California have all seen active inventory decline.

Surveys also show this is unlikely to be a short-term trend. A poll from the University of California Berkeley found that, “More than half of California voters have thought about moving out of the nation’s most populous state, citing the high cost of housing, taxes, or its political culture.”

And if you look at the list of names above and guess at their finances, you can pretty much conclude that the people leaving the state tend to be the wealthiest people who live there. This is likely to make the budget deficits even worse, which will require even higher taxes, which will persuade even more wealthy people to leave, and so on in a vicious cycle.

Should You Invest in California?

Having spent almost 2,000 words describing the sorry state of the wealthiest and most populous state in the union, I should emphasize again that California is quite large. The situation in Los Angeles is not the same as in Redding and certainly not the same as in somewhere like Placerville.

Each market is different and each town is different. Indeed, some of the problems listed above are not present or not nearly as present in many of the cities and towns throughout California.

But overall, is investing in California a good idea?

If you do, you will be facing the high taxes as well as the many other issues mentioned above that are slowly but surely crippling the wealthiest state in the union. Anti-landlord sentiment is also quite high and California is in the middle of a twice-extended eviction moratorium that, if not extended again, will last almost a full year by the end of it, from March 27, 2020, to January 31, 2021. And that’s not to mention the state-wide rent control law that was passed at the beginning of this year.

Sure, seeing my property increase in value from $476,300 to $640,300 in the last five years would be quite nice. But the percentage increase in California isn’t actually much different than in the rest of the country. The main difference is how extraordinarily expensive housing was to begin with.

The cash flow is also, as you might expect from such high prices (and rent control), not very good. Cap rates (which measure a property’s net income, with higher cap rates representing a higher net income relative to the price of the property) were quite low. For Class A, B, and C multifamily infill properties in Los Angeles, the cap rates in 2019 were just 4.25, 4.63, and 5.5 respectively. For San Francisco, they were 4.0, 4.25, and 4.5.

On the other hand, a city like Kansas City, where I live, had cap rates for A, B, and C multifamily infill properties of 5.0, 5.5, and 6.0.

None of this would make me particularly enthusiastic to invest in California.

Is It Time To Sell?

There is one noteworthy advantage that real estate investors have that can help avoid some of the issues with high taxes, namely that property depreciation can be counted against your income. (Although it’s important to note that this is only for active investors, or those who spend 500 hours per year or more working on their investments.)

Indeed, this counteracts much of the high state income taxes in California and is the reason that Meet Kevin decided to stay.

Furthermore, while California is seeing an outmigration of its current citizens, its population is still growing (albeit more slowly than before). From 2010 to 2019, its population grew by 7.3% (2.7 million people).

Part of this is just people having kids, but the larger part is immigration from abroad. And California is extremely pro-immigrant. Unfortunately, California is also extremely anti-development. (Which inspired one of Adam Carolla’s greatest rants for those who are into that sort of thing, though warning there is a substantial amount of profanity.)

This is a terrible combination.

Economists Ed Glaeser and Joe Gyourko found that “in coastal metropolitan areas (including San Francisco), …most projects proposed for housing drag on for years because of the state’s onerous regulatory framework.” Their results as reported by the New York Times showed that “where a standard house should cost about $300,000 [to build] — but in reality is more like $800,000 (based on 2013 figures).”

Other California cities weren’t that bad, but they were still pretty bad.

These regulations have choked supply and the coronavirus slowdowns are making it even worse. So what happens when the population keeps growing but supply can’t keep up? Well, basic economics tells us that the price goes up.

Affordability issues will put a ceiling on those price increases, in my judgment. Remember, those moving out tend to be wealthy, whereas many of the immigrants or aspiring Hollywood stars are not.

Even still, I don’t think housing prices are coming down (unless there is a national correction). Instead, I think the middle class (what’s left of it) will continue being hollowed out as poverty grows. Unless, of course, there are some policy changes.

While this is bad for the state, it’s an okay situation for real estate investors. I do not think there is any urgency to sell if you own properties in California—unless they pass that wealth tax, in which case I would get out ASAP.

Are you thinking about moving to the Golden State or hitting the road?

Tell us why in the comments.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.