Research

Housing continues to fall; will non-residential real estate be next?

The U.S. real estate market, which was central to the global financial crisis, remains deeply troubled, and a full recovery could be years away, according to industry experts and analysts at the W. P. Carey School of Business. The problems of real estate and the economy are especially severe in Arizona and other Sunbelt states, where construction is a cornerstone of the local economies. As the housing market continues to fall, non-residential real estate — which includes offices, retail, warehouses, and other structures — has remained a bright spot in the national economy, but now there are signs it too is headed for a slowdown.

2008-11-13

The U.S. real estate market, which was central to the global financial crisis, remains deeply troubled, and a full recovery could be years away, according to industry experts and analysts at the W. P. Carey School of Business. "The underlying problems are that there are too many homes, and the average person has too much debt and not enough savings," said Elliott D. Pollack, head of the real estate and economic consulting firm Elliott D. Pollack & Co. in Scottsdale.

"That means that 2009 is either a bad year or a terrible year — that is the range of possibilities. Good is not in the equation." The problems of real estate and the economy are especially severe in Arizona and other Sunbelt states, where construction is a cornerstone of the local economies, according to analysts.

During the boom years, one out of every four new jobs in Arizona was in construction. "When construction began losing jobs, the general economy began contracting soon after," said Lee McPheters, director of the JPMorgan Chase Economic Outlook Center and a research professor of economics at W. P. Carey.

Looking for the bottom

Arizona has gone from being consistently in the top three states in the nation in employment growth to almost last. Housing has been especially troubled. In Greater Phoenix, there are approximately 53,000 homes for sale — 20,000 more than normal. In Maricopa County alone, there have been 27,000 foreclosures, which could send the oversupply even higher. The glut in the market, combined with the slump in jobs, has produced a sharp slowdown in home construction.

"Basically construction follows job growth," said Crocker Liu, professor of real estate finance at W. P. Carey. "If there's no job growth, they don't build houses." The real estate market in Arizona and nationally will not fully recover until the excess supply is absorbed, according to Pollack. This could take two to three years if conditions are favorable or four to five, if things go badly, he predicts.

"It's not going to be a quick recovery," said Pollack. Liu agrees that real estate is in a downturn, but he sees signs of improvement ahead. He notes that futures indices for real estate show prices falling but at a decreasing rate. "It's not like prices are in a free fall," he said. To Liu, this means that real estate may be close to bottoming out.

"For the housing market, things have started to turn. It's just that most people only see the doom and gloom," he said. Liu also notes that falling home prices can be a good thing for people who have been priced out of the market. "For those who have kept their gunpowder dry and have a lot of cash on hand there is a lot of buying opportunity. One man's loss is another man's opportunity," he said.

Non-residential real estate in danger

McPheters suspects that the troubles of housing could be repeated soon in non-residential real estate, which until now has been a bulwark of the national economy. A recent preliminary GDP report indicated that amidst the general economic slowdown, three big components of the U.S. economy have so far continued to grow: exports, the federal government, and non-residential building.

Non-residential construction has been growing strongly, and since early 2006 has recorded several quarters of double-digit growth. Now, McPheters believes, the troubles of the broader economy will spread to non-residential real estate. When homeowners lose their jobs, they can't pay their mortgages, McPheters notes. "The parallel on the non-residential side is that developers and owners need cash flow in order to pay off loans. As vacancy rates go up, their ability to repay is going to be affected," he said.

According to McPheters, a good way to understand the direction of the overall economy in the coming months is to examine the performance of non-residential real estate, which includes offices, warehouses, retail, manufacturing facilities, health care centers and mining-related structures. "It's the next indicator to watch because the credit crisis and slower real growth will eventually take a toll on non-residential building in a weak economy," McPheters said.

Liu sees troubling signals for non-residential real estate as evidenced by the recent rise in capitalization rates for commercial properties. Capitalization rates, or "cap rates," are the ratio between net operating income and market value. "Vacancies have increased and cap rates have risen. Rising cap rates mean property values have been falling," he said.

Fewer shoppers, fewer malls

The slowdown in the economy is already affecting commercial real estate, according David Larcher, vice president of Phoenix-based Vestar Development Co., a leader in the management and development of commercial real estate. "The commercial real estate industry operates using leverage," Larcher said. "As long as capital is constrained in that regard, we are not going to have a normal market."

Frozen credit markets are only part of the problem for commercial real estate developers, according to Larcher, whose firm is a large manager and developer of shopping malls in Phoenix, Los Angeles, and San Diego. The broad economic slowdown means falling retail sales, which means less demand for space in shopping centers.

Commercial real estate is especially vulnerable now in Arizona and other Sunbelt states because of the extreme problems in the residential market, according to Larcher. "The old adage that retail follows rooftops is certainly true, but I think it goes beyond that here," he said. "So much of our economy in Arizona is directly or indirectly tied to homebuilding and all of the spin-off businesses and industries that go along with it."

Fundamentals still strong

While Pollack is pessimistic about the short-term prospects for Arizona's economy, he believes the long-term outlook is positive. The state has a climate and quality of life that will continue to draw people, according to Pollack, and he sees the social and political climate also as favorable to business growth. With its pool of skilled labor and base of industries — including manufacturing, tourism, and export services — Arizona appears poised for recovery once the problems of real estate are resolved.

"The long term fundamentals haven't changed," said Pollack. "We are basically paying the piper for the overbuilding that occurred between 2003 and 2006." McPheters agrees. "Population growth is kind of the ace in the hole for Arizona," he said. "There's really no reason to believe people will stop wanting to move to the Southwest. They've been doing that for a hundred years."

Arizona's fortunes now are largely tied to the ups and downs in the national economy, according to McPheters. The state does not possess an industry that is strong enough to run counter to the national economic cycle, he said. "I don't think there will be any recovery by Arizona independent of the national economy," McPheters said.

Bottom Line:

• Arizona and other Sunbelt states have been especially hard hit by the sharp downturn in real estate. Construction, which is a big employer, has slowed dramatically.
• The housing market nationally and in Arizona suffers from oversupply, and credit markets remain very tight. Nevertheless, some analysts believe the bottom of the housing market may be in sight.
• Non-residential real estate — which includes offices, retail, warehouses, and other structures — has been a bright spot in the national economy until now, but there are signs it too is headed for a slowdown.
• Despite its current woes, the fundamentals of the Arizona economy remain strong, and the state is poised for recovery when the national economy improves.

Real Estate Economics Faculty