Even with a housing hangover, Arizona's economy will be strong in 2007

In 2007, Arizona's economy will continue to expand even as the state begins to face the consequences of the 2004-2005 housing frenzy. That's the report from economists Lee McPheters, senior associate dean of the W. P. Carey School, and consultant Elliott Pollack, featured speakers at the 43rd Annual Economic Forecast Luncheon co-sponsored by the W. P. Carey School's Department of Economics and Chase.

In 2007, Arizona's economy will continue to expand even as the state begins to face the consequences of the 2004-2005 housing frenzy. That's the report from economists Lee McPheters and Elliott Pollack, featured speakers at the 43rd Annual Economic Forecast Luncheon co-sponsored by the W. P. Carey School's Department of Economics and Chase.

"The Arizona economy is expected to continue to record solid economic gains in 2007 as the state moves into the fifth year of an expansion that began in 2003," said McPheters.

A leader in job growth

McPheters, who is a professor of economics and senior associate dean at the W. P. Carey School, said that the first indicator of economic strength in Arizona is job creation. Although job creation will slow in 2007 relative to 2006 — the Arizona Blue Chip Economic Forecast predicts an employment growth rate of 3.7 percent in 2007, compared to a rate of 4.6 percent in 2006 — the state will still rank among the top five states, McPheters predicts.

Between October 2005 and October 2006, Arizona ranked first in the rate of employment growth (4.7 percent) among all states, adding a total of 121,000 new jobs — more than every other state except Florida, Texas, and California. "And Arizona's 121,000 new jobs accounted for more than 10 percent of the national total of all jobs created during that 12-month period," McPheters said. He looks for Arizona to rank among the leading job growth states in 2007.

The key to the strength of Arizona's economy, according to McPheters, is strong population growth. "The job creation that we see here in Arizona is in sectors that serve our expanding population. Business expansion linked to population growth is the main reason that unemployment rates in Arizona are among the lowest in the country," McPheters said.

Despite Arizona's strengths, the state is not immune to economic slowing — the kind of slowing projected for 2007. McPheters says that the factors behind the economic slowdown nationally are at play in Arizona, too, including a weakening of consumer spending and gasoline prices that remain relatively high.

Consumer spending may be weakened by the fact that consumers piled on debt during the economic expansion and are now beginning to feel more strapped — and are therefore reluctant to spend. Uncertainty about the effect of slower housing appreciation may also work to temper consumer spending, McPheters said.

And while gasoline prices have "receded from their 2006 highs, consumers still have to make choices between gas and other purchases such as food away from home and entertainment," said McPheters. The bottom line, McPheters said, is that 2007 will be another strong year for Arizona's economy. "It won't be better than 2006, but it won't be in any way a recession or a hard landing — it will simply be a more moderate growth year," he said.

The housing hangover

The outlook for Arizona's housing market is not so optimistic, said Pollack, president of Elliot D. Pollack & Co., an economic and real estate consulting firm in Scottsdale, Arizona. Even as job growth and personal income growth remain strong in Arizona in 2007, and even as the population of the Phoenix metropolitan area continues to increase, Greater Phoenix should begin to face the consequence of the housing frenzy that began in 2004, Pollack said.

According to Pollack, that consequence is an excess of homes. He says that the explosion of single-family homes built in the Greater Phoenix area in 2004 and 2005 exceeded actual demand by about 20,000 homes. He estimates that there are currently about 6,000 homes under construction that are not spoken for by buyers, and about 18,000 more homes for sale than normal.

Why the excess inventory? Pollack said that there is a demographic demand — demand created by people moving to the Phoenix area — for between 42,000 and 45,000 new single-family units per year. But in 2004 and 2005, roughly 61,000 new home permits were granted each year. "Builders attempted to meet what appeared to be substantial demand created not only by those moving to Greater Phoenix, but by investors, second home buyers, and people moving from apartments to single-family homes," Pollack said.

The problem, Pollack says, was the frenzy during 2004 and 2005 that caused home buyers to be overly zealous about buying investment properties and second homes, and moving from apartments. "Investors aren't evil people from California who came in and ran up artificial demand for housing in Phoenix," Pollack said.

"They're the police officer and teacher who earn $100,000 a year who contracted to buy another home, assuming that once the home was built a year after contract, it would have already appreciated dramatically — just as their own home was appreciating dramatically. Those investors cancelled their contracts, though, when prices stopped increasing as they had hoped." Today, cancellation rates on home contracts are at about 40 percent, Pollack said.

To remedy the problem, Pollack says, builders will have to construct fewer homes than are demanded in the coming years, using the current excess inventory to make up the difference. The more quickly builders do that, Pollack says, the more quickly the excess supply will be depleted and the more quickly the housing market will return to normal.

The Phoenix Blue Chip Forecast predicts that the number of single-family housing permits issued will decrease by 5,000 in 2007, which Pollack says won't make much of a dent in the inventory of 20,000 excess homes. Pollack thinks that the decline will be more dramatic. That, he says, would actually be positive for the economy. "The worse 2007 is in terms of housing permits, the quicker we resolve the problem," Pollack said.

But Pollack is generally optimistic about the long-term future of residential real estate in Arizona. He foresees that demographic demand will remain strong as people continue to move into the Phoenix area. And he thinks that the relative affordability of homes in the Phoenix area will improve over the next few years compared to cities like Dallas, Austin, and Denver. And strength in the market for commercial real estate, Pollack says, offsets to some degree the difficulty in the single-family market.

While there is some concern that office, industrial, and retail vacancy rates will increase as a result of weakness in the housing market, Pollack says that the economy looks like it will be strong enough in 2007 to support continued strength in those commercial real estate markets. Nevertheless, "the market for housing is likely to decline in 2007 more than the market for commercial increases," Pollack said. But a strong economy in other sectors besides real estate should "keep things going" in 2007.

Losing steam in the global race

While McPheters' and Pollack's long-term outlooks for the future of Arizona are positive, there is one long-term trend that gives McPheters pause. That is Arizona's decreasing participation in the global economy. Looking at Arizona's share of U.S. employment compared to its share of U.S. exports, the state's share of exports has declined over the past five years, even as its share of employment has risen.

The reason may be, in part, that the sectors expanding fastest in Arizona are not export-oriented sectors. For example, job growth in Arizona has been strongest in the trade, leisure/hospitality, health services, and construction industries — all industries in which Arizona is a national leader. In industries like manufacturing, in contrast, Arizona ranks 17th among all states and posted relatively small job gains in 2006 (less than 1.5 percent compared to 4.7 percent for all Arizona jobs).

"I'm not running up a red flag here," McPheters said. "I'm just saying that we're missing out on a trend that will determine economic growth for the next 100 years. We're letting other states take our share of the global pie." The fact is, McPheters admits, that Arizona's economy will always be strongly dependent on population growth — and that's okay, he said. "But we shouldn't forget how important hi-tech manufacturing is to Arizona's economy, too," McPheters adds.

He suggests that the state take advantage of its hi-tech manufacturers in the electronics, semi-conductor, and aviation industries to raise awareness of the global markets for Arizona businesses. Nevertheless, at the end of the day, Arizona's economy will remain strong in 2007, perhaps primarily because it is still an attractive place to live — and population growth means job growth as well as demand for real estate.

Bottom line

• Using employment growth as a measure, Arizona's economy will be strong in 2007, though not as strong as 2006.
• The state will continue to rank among the top five states in terms of job growth in 2007.
• Both nationally and in Arizona, economic growth will slow due to weakened consumer spending and still relatively high gasoline prices.
• The housing market in the Greater Phoenix area is weakened by an excess of homes. To recover, the market will have to under-produce until the excess supply of homes is absorbed.
• Arizona's commercial real estate markets will be strong in 2007, but not as strong as the residential markets will be weak.
• Arizona's share of the nation's global exports is smaller now than in 2003.