How Much Longer Can Real Estate Hold Up?
financialsense.com
by John Finger
The Money Management Firm, Inc.
June 3, 2003
Most all of us would agree that real estate is one of the few legs left to hold up our economy. Stocks have crashed, millions of jobs have been lost, and bankruptcies continue to hit record levels. Real estate joins health care, security and government as the only active growth industries at the moment. But that has already started changing.
This is not a subject I am thrilled to write about, since I own quite a bit of real estate and wouldn’t want to see it tumble in value. Nonetheless, this month’s newsletter is my assessment of what is happening and what is about to happen.
The last growth stage of real estate started in 1991, after the first Gulf War ended. The country was emerging from a short but steep recession. Demand picked up quite nicely in the residential market. California and New York joined the boom in 1993, the same year that commercial real estate nationwide started to take off.
By late 1999, the economy, the stock market and real estate were burning on all cylinders. The Y2K fear was overblown, and nothing could stop the relentless climb. Then, in March 2000, the stock market started heading downward, a move that persists. The real estate market held steady at first. Then, in late 2001, most real estate markets started to cool off, with commercial real estate feeling the pinch the most.
The Office Market
That pinch is getting worse now. Vacancies in large markets, reflected by Central Business District (CBD) rents, are falling. Naturally, markets will vary in their vacancy and rental rates, but we can still put together a national trend. Office rents are measured on a per-square-foot basis. In 1996, the average rental rates were $16.00 per square foot. They peeked in 2000 at $20.00 per square foot. At the end of 2002, the rental rate had dropped to less than $18.00 per square foot. According to Cushman & Wakefield, nationwide office vacancies were less than 10% during 2000. The firm now reports a 14% nationwide vacancy rate in large, Class "A" office buildings. In fact, Reis, Inc. reports a 16.3% vacancy rate.
During the first quarter of 2003, forty-two markets containing 92.5% of national office inventory saw their effective rents decline, according to Reis. San Jose saw a 7.7% decline in rents. Boston lost 5.5%. Denver lost 4.4%. San Francisco saw a 3.7% decline, while Austin dropped 3.5%. In fact, the 7.5% of markets experiencing a rise in rents, Norfolk, Palm Beach, San Diego, Fort Worth, Sacramento and Tampa, tend to have a heavy concentration of national defense and security companies.
It seems that one can find a "for lease" sign in front of a majority of office buildings now. As of December 2002, at least 150 Class "A" office buildings in the Denver area stood empty. Just imagine the upkeep, utilities, mortgage payments and property tax bills on your building when you produce no revenue from it. Ouch.
Builders are still busy with new construction as well, despite obviously clouds on the horizon. Between March 2003 and June 2005, New York City is scheduled to add 5.4 million square feet to its already-saturated inventory of office space. Washington, D.C. will add 9.8 million square feet. Chicago will add 3.7 million. Boston will add 4.4 million.
The Retail Market
If it seems that your neighborhood mall is quieter recently, your senses aren’t deceiving you. In 2002, approximately 13,550 stores were closed, representing 3.6% of the total supply traced by the MAX-SI Spatial Index. Closings, believe it or not, are well below levels incurred during the 1997-2000 boom cycle. New supply, though, is projected at 77,000 stores this year. With consumers finally pulling in the reins of spending, most stores are reporting little if any profit.
During the first stage of the recession, most store closings were concentrated in the stores of yesteryear, such as Kmart and Montgomery Ward. The second wave is claiming value retailers, whose superstore formats had redefined competition and shopping behavior in the previous decade. Per-square-foot rents nationwide have actually been declining since 1992, when they were just under $36.00. Now they’re under $31.00 and still falling. Retail sales per square foot have fallen steadily since 2000. Many large stores are staying open despite their unprofitability in expectation of an economic recovery. If the recovery doesn’t start soon, the eventual closings will cost the companies more, and likely will take the landlords down with them.
The Apartment Market
The apartment market is weakening everywhere except in California. The first quarter of 2003 saw negative absorption of 25,000 units. Negative absorption is great if you’re a tenant but lousy if you’re a landlord, because it means less units are being occupied. Negative absorption began in the third quarter of 2001. Since then, the nationwide market has seen a negative absorption of 81,200 units.
For some strange reason, we still see apartment buildings going up everywhere. I don’t know why. Of the 20,000 new units that came online during the first quarter of 2003, 48.2% of them remained unoccupied. The owner gets red-faced when her brand new unit just collects dust while mortgage payments, insurance, taxes and upkeep must be paid. The banker who lent the money in the first place probably winds up with as red a face.
The vacancy rate in the top 50 U.S. markets in the first quarter of 2003 stood at 6.8%, a rate not recorded since 1989. Effective rents declined by 0.3% and are lower than they have been at any time since the third quarter of 2000. Does this sound like a disaster? Certainly not. What it does show, though, is that builders haven’t learned the lesson from the 1980s: when the demand falls, don’t build until it turns around.
Houses
Housing sales are tending to show slight increases in price throughout the nation. Sales of existing homes dropped 5.6% in March 2003, the biggest drop in more than a year. The median home price, however, increased to $163,100 in March, compared with a revised $161,300 in February. The key to the housing market’s survival has been low interest rates. Bankrate.com reports that, as of May 21, the average 30-year fixed mortgage rate is only 5.40%, the lowest since before recordkeeping started in 1964. The best guess is that Ike was in the White House when we last saw numbers like that. Most "experts" guess that rates will stay this low for a while, since the Fed is more concerned about deflation than inflation right now. Of course, one counter-measure is the falling dollar, a danger which could spark either inflation or stagflation despite weakness in the economy. Nationwide, the seasonally adjusted annual rate of total existing home sales reached a record of 6.68 million units in the first quarter, up 2.2 percent from a pace of 6.54 million units in the first quarter of 2002, according to the National Association of Realtors. The previous record was a rate of 6.59 million units in the fourth quarter of 2002; NAR started tracking the total state resale series in 1981. The south experienced the highest increase in existing home sales.
The median price paid for a Bay Area home was $426,000 in April 2003. That was up 1.7 percent from $419,000 in March, and up 6 percent from $402,000 for April last year, according to DataQuick. The Bay Area has the most expensive real estate in the country. Even most real estate agents agree that this has to change: only 28% of Californians can afford to buy a median-priced home.
Most areas of the nation are experiencing a glut of houses on the market. We can all see that by driving around our own neighborhoods. A record 24,972 unsold previously owned homes clog the Denver-area housing market, but prices remain at record levels. And only 2,597 homes have been placed under contract this month, making it the worst April for home sales since 1990, according to data released on the last full week of each month by Metrolist Inc. Colorado Springs listings are up 28% from a year ago. Santa Clara County, which includes Silicon Valley in California, reports twice as many homes on the market today compared to a year ago.
Some areas, though, are still quite hot. Charlotte, NC and northwestern Washington state, for example, are still going strong.
So what are we to make of all this? I’d summarize it by saying that single-family homes have held up better than all other areas of real estate during this economic slump. Housing prices are defying gravity by virtue of low interest rates. When rates rise, however, that trend will change, causing housing prices to fall.
One fact about real estate that is both positive and negative is that you can’t quickly change your mind and go the other way. If you own a stock and suddenly decide to sell it, no problem: you can be done with the whole thing in a matter of seconds. That’s not the case with real estate. Either you own it, or you don’t. It will take months if you want to sell it, and you have to be in a pretty stable market in order to get rid of it. Moreover, you can’t go short real estate, either. But the positive side is that you can’t make hasty blunders in your real estate decisions.
It used to be that you could buy a rental house, take out a mortgage, rent it out, fix a toilet once in a while, and wait for your tenant to pay off your mortgage. Nowadays, it’s not that easy. When tenants get laid off, they can’t pay your mortgage. If you advertise, you pay money to compete with other landlords who are in your same category. And the bank doesn’t want your excuses: they just want the money, whether or not you have a tenant from whom you can collect rent.
Investors who bought during the latter stages of the 1980s real estate bust made fortunes when the economy turned around. Will it do the same thing this time? Of course. But the key is: when?
© 2003 John Finger
The Money Management Firm, Inc.
www.moneymanagementfirm.com
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