Reports of the Phoenix real estate market's demise have been greatly exaggerated

Phoenix, now the fifth largest city in the United States, could be the poster child for metropolitan areas where a bursting residential housing bubble has created economic discord. After parsing data from both the commercial and residential sectors, however, the Phoenix real estate market appears much stronger than the national press paints it, according to Larry Seay, chief financial officer of Phoenix-based Meritage Corp., and Crocker Liu, McCord Chair in Real Estate at the W. P. Carey School of Business. Seay and Liu spoke at an April 5 seminar in Phoenix entitled "Frontiers in Real Estate: Hedging Your Bets," presented by the W. P. Carey School's Center for Real Estate Theory and Practice.

Phoenix, now the fifth largest city in the United States, could be the poster child for metropolitan areas where a bursting residential housing bubble has created economic discord. However, after parsing data from both the commercial and residential sectors, the Phoenix real estate market appears much stronger than the national press paints it, report Larry Seay, chief financial officer of Phoenix-based Meritage Corp., and Crocker Liu, McCord Chair in Real Estate at the W. P. Carey School of Business.

Speaking at an April 5 seminar in Phoenix entitled "Frontiers in Real Estate: Hedging Your Bets," both Seay and Liu were optimistic along all points of Phoenix's real estate continuum. The seminar was presented by the W. P. Carey School's Center for Real Estate Theory and Practice.

A builder's view of residential

The national press has jumped hard on the fact that the inventory of Phoenix's existing single-family homes has jumped from about 5,000 homes in early 2005 to over 45,000 today, Seay points out. But he says the statistics look bleaker than they actually are. Phoenix generally has an inventory of about 25,000 homes, he says, and the dip to 5,000 was an anomaly during the height of the bubble.

A lot of this dip can be attributed to speculation; as much as 50 percent of the inventory ended up unoccupied or investor-owned. More importantly, Seay adds, with so many people moving into the Valley of the Sun, this "will burn off very quickly." "Is an inventory of 45,000 homes too many? Sure, but consider that you have 65,000 homes being built every year in Phoenix and 128,600 people moved into the metro area last year.

That extra 25,000 will burn off," Seay says. "Phoenix has gotten a lot of bad press about the overhang, but Phoenix is a strong market." In regard to commercial (office, industrial, retail and multifamily) markets, Liu expects the Valley of the Sun "to experience greater growth." In addition, he adds, investors will be very active in the market this year and the next.

A new look at the commercial market

To discern the health of Phoenix's commercial market, Liu employed an unusual matrix combining corporate earnings and property returns, which begs the question, how does the change in corporate profits relate to property returns? As Liu explains, since land represents one of the four factors of production (which in turn generates the rents that comprise cash flow to property and the demand for more space which leads to price appreciation) and corporate profits are the residual after all production costs are paid, expect increasing profits to increase property returns.

"If you take a look at all the major corporate players, i.e. General Dynamics, Motorola, Intel, etc., in the Phoenix metro area as defined by the Greater Phoenix Economic Council, take the number of local employees for each of these different companies, and then take a look at forecasted earnings for the next 12 months, what this would give you is some sort of predictive measure of how real estate is growing," explains Liu.

There is a catch, however. There's another corporate index — from Bloomberg — that tracks the local economy. The difference between the two is that Bloomberg solely tracks companies with a headquarters in Phoenix, such as P.F. Chang's China Bistro Inc. The Bloomberg index includes a large number of high-tech and start-ups so it would show more volatility. Indeed, using the GPEC index as a base, the average forward looking EPS is $3.34 and has been on a moderately upward trajectory, while the Bloomberg index trajectory looks more like a hockey stick with a large inclining handle and the forward looking EPS closer to $14.

Showing both indexes, Liu overlaid the price per square foot for office and retail space, and the resulting graph showed similar upward trajectories for both price per square foot and earnings per share. "You can see there is a relationship between what happens with our local corporations, the kinds of profit they are generating, and to our local real estate markets," he stresses. "The same is true for industrial and apartment."

After looking at earnings per share data, Liu concludes Phoenix should experience a growth rate of 1.4 percent for 2007 and an even greater expansion in 2008. Liu also parsed existing data to discern the local investment market. What he saw, for example, was a capitalization rate (estimates value of real estate investment; net operating income divided by sales price) for the Phoenix office market that has been running correspondingly to the national average, from about 9 percent and above in 2001 to under 7 percent at the end of 2006.

In the same vein, the trend line for price per square foot for the Phoenix and the national markets both head upwards at about the same pace. However, the national price per square foot average is consistently ahead of Phoenix. A similar pattern takes place in regard to the apartment market. Cap rates have declined from about 8 percent in 2001 to below 6.5 percent in 2006.

The only difference is that Phoenix cap rates have declined more precipitously and the cap rate is actually below 6 percent. On a price per unit basis, the Phoenix and national average moved upwards over the same period of time. Again there was slight difference, with the Phoenix market trending north moderately, while the national price per unit average trend line showed volatility and was steeper. The result is that the national price per unit for apartments has remained higher than Phoenix.

Price pop?

That is actually good news for Phoenix, notes Liu. "My suspicion is, investors will probably be coming into the Phoenix marketplace if conditions persist for office properties. Prices will pop!" But in the industrial and retail markets, Liu concludes, investors will have to look hard to find bargains. Liu looked at annual acquisitions in the Phoenix area by market sector.

First off, he says, about a third of the investors in the Phoenix market are institutional players, another 15-25 percent are private out-of-state buyers, which means some 50 percent of the acquirers are regional or national players, Liu says. In the industrial sector, institutional investors are the biggest players, while in the office sector the big investors include opportunity and hedge funds, although institutional players are also major participants. As for retail, the big investors are real estate investment trusts (REITs) and private out-of-state players.

Finally, for multifamily, in the past five years, the action has been with condo-converters, with some institutional and private out-of-state investors. As noted, in the single-family residential market, things look a lot uglier than in the commercial sector, but again, as Seay observes, one really has to look deeper to see that this market is healthier than it first appears. From the beginning of 2002 through the first three quarters of 2004, the median list price of a Valley of the Sun home basically plateaued, hanging about the $200,000 range with no significant appreciation.

Then the bubble came to town and by May 2005, prices shot up like a rocket to a peak of over $350,000. Since then, the median list price has drifted back down to just above $300,000. This was a significant price decrease, says Seay. Prices dropped, he adds, even in the Multiple Listing Service "and you usually don't see the price of resale houses come down a lot." Added to this was the overhang of new homes on the market.

In fact, Seay says, there was an "inventory correction," with high contract cancellations, sales and backlogs declining, spec inventories on the rise, adjustments to house and land prices and finally to inventory write-offs. But don't despair, Seay cautions, because the Phoenix market is one of the most attractive in the nation based on:

• Population — The greater Phoenix metro area boasts 3.8 million people, with a growth of 128,600 last year. Arizona was the fastest growing state in 2006.
• In-Migration — Over a 10-year period, from 1993 to 2003, in-migration was up 60.9 percent.
• Employment — The metro area employs 1.9 million people. In 2006, the market added 90,700 jobs. Unemployment as of the beginning of the second quarter 2007 stood at 4 percent
• Job Growth — In 2006, Phoenix ranked second in terms of job growth right behind number one, Nevada, and ahead of number three, Idaho, two states with a much smaller population base. From 2005 to 2015, the Phoenix job market is expected to expand by 24.3 percent. In comparison, Dallas/Fort Worth will expand 19.4 percent, but Las Vegas should grow by 35.5 percent.
• Household income — The median household income stands at $50,651, which is above the national average. Says Seay, "Phoenix gets a bad rap for not having good jobs, but the median is higher than the national average."
• Lifestages — Again, says Seay, people talk about Phoenix being a retirement areas, but the percentage of the local population that is in the "mature years" is just slightly ahead of the national average.

Concludes Seay, for the period 2005 to 2010, expect Phoenix population growth, household growth and household income to run ahead of the national average. Meritage ranks as the fifth largest homebuilder in the Phoenix area, so in regard to the outlook for homebuilders in the area, Seay sums it all up this way: the market will be difficult in 2007 as the inventory overhang must be reduced; price competition will pressure margins, but eventually cancellation rates will slow; and then favorable economic conditions will bring underlying support to the market. Adds Seay, "long-term demographic factors are still in place."

Bottom Line:

• After looking at earnings per share data, Liu concludes Phoenix should experience a growth rate of 1.4 percent for 2007 and an even greater expansion in 2008. "My suspicion is, investors will probably be coming into the Phoenix marketplace if conditions persist for office properties. Prices will pop!" But in the industrial and retail markets, Liu concludes, investors will have to look hard to find bargains.
• Seay sums it all up this way: the market will be difficult in 2007 as the inventory overhang must be reduced; price competition will pressure margins, but eventually cancellation rates will slow; and then favorable economic conditions will bring underlying support to the market.

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