Research

Regional economic forecast: 'It's going to get uglier before it gets better'

While businesses and consumers alike have been feeling economic doldrums all year, the National Bureau of Economic Research only recently made it official: the U.S. is in a recession, one that began in December 2007. And the pain — for the nation as a whole and for Arizona — will continue in 2009, said economists Lee McPheters and Elliott D. Pollack, speaking at the 45th Annual W. P. Carey School of Business/JPMorgan Chase Economic Forecast Luncheon.

2008-12-10

While businesses and consumers alike have been feeling economic doldrums all year, the National Bureau of Economic Research only recently made it official: the U.S. is in a recession, one that began in December 2007. And the pain — for the nation as a whole and for Arizona — will continue in 2009, said economists Lee McPheters and Elliott D. Pollack, speaking at the 45th Annual W. P. Carey School of Business/JPMorgan Chase Economic Forecast Luncheon.

Arizona labor market among worst in nation

"As of October, Arizona was one of 31 states losing jobs over-the-year," said Lee McPheters, director of the JPMorgan Chase Economic Outlook Center and editor of Economy@W. P. Carey. "The Grand Canyon State ranked 49th out of 50 states for labor market performance in October." The strongest states, McPheters said, are "found along a band extending from Texas to Montana."

Their strength lies in their energy resources and housing markets "that have held up while the residential building in the rest of the country was in free fall." In the one-year period ending in October, McPheters said, 70,900 jobs were lost in Arizona: 37,600 in construction, 17,600 in retail trade, 10,800 in employment services and 8,800 in food service. The health care, science/technical and government sectors actually added jobs during that period.

"Before the current contraction is reversed," McPheters said, "it is possible that Arizona's unemployment rate will be higher than recorded in the previous two recessions." An unemployment rate of 7 percent is not unlikely, he said. Arizona's current unemployment rate is 6.1 percent.

And while the economy, in the recent past, has been bolstered by consumer spending, the retail sales outlook is weak now, too. In 2008, retail sales are estimated to have fallen 5 percent and are forecast to fall remain flat in 2009 "as the consumer struggles with reduced confidence, weak income growth, and rising unemployment rates," McPheters said.

Greater Phoenix housing market remains in disarray

According to McPheters, much of the state's economic woes were precipitated by the bust of the real estate bubble, which was much more severe in Arizona than in most other states. "Since home prices had gone up so much here, they fell faster and farther, and had more profound effects," he said.

"The Greater Phoenix housing market, as in other major 'bubble' cities, remains in disarray," said Elliott D. Pollack, president of economic and real estate consulting firm Elliott D. Pollack & Co. "In Greater Phoenix, housing permits this year will be down approximately 75 percent from the peak in 2005. Next year, they could be down even more — roughly 85 percent from the peak," Pollack said.

There are homes selling, of course, but the market is extremely weak. "Over the past 12 months in Greater Phoenix, roughly half of all the homes sold were at a loss and of the homes purchased over the last 5 years, roughly 42 percent have negative equity. In other words, they are worth less than the debt."

That's an amazing figure, Pollack said, given the fact that 25-35 percent of buyers had high down payments; prices have fallen so much that the declines have erased even those high down payments. And borrowers who bought since 2005 without substantial down payments are even more seriously underwater (owing more than the home's value), Pollack said.

Foreclosures continue to weigh heavily on real estate market

Over the past 12 months, roughly 38 percent of homes sold were in foreclosure, but the situation is getting worse. In the last month, 50 percent of all resales in Greater Phoenix were foreclosures. Pollack said that while the high number of foreclosure sales is keeping the overall number of resales at roughly "normal" rates (about 70,000 sales per year), those foreclosure sales keep prices "under pressure."

"New home sales are down to about 25 percent of what is normal. Simply put, it is difficult for new housing, or non-distressed existing housing for that matter, to compete with foreclosures on the resale market," Pollack said. The number of homes in the foreclosure process in Greater Phoenix was 5,000 in 2006, 11,000 in 2007, and 27,000 today, according to Pollack.

Yet Pollack predicts that the number of homes in foreclosure will continue to rise in the near term. He said that "even if banks are successful in renegotiating with some of those in foreclosure, and the Obama administration does craft a package that keeps some of these people in their homes, it is doubtful that we have seen the peak in foreclosures. Until the foreclosure issue is resolved, housing will be under pressure."

Pollack said that lenders' loan modification programs as well as governmental policy changes could reduce the number of homes in foreclosure. But, he said, "The impact won't be significant." The only resolution to the housing situation, he said, is time. "The only way to come out of the real estate downturn is to absorb the excess supply," Pollack said.

Paying the piper for overbuilding

Pollack said that "We are, in essence, paying the piper for the overbuilding of single-family housing that occurred between 2003 and 2006." While there's no way to know for certain how many excess units there are in the Greater Phoenix real estate market, Pollack's "conservative" estimate is between 40,000 and 50,000.

Pollack thinks that 5,000 of those may be absorbed in 2008 and another 10,000 in 2009, still leaving 25,000-30,000 excess units at the end of 2009. "Even if half of those are rented," he said, "the housing market does not face a speedy recovery."

"While the bottom might be 2009 in terms of [new housing] permits, there simply is no quick fix," Pollack said. For the housing market to recover, he said, "the people who are bound to be foreclosed upon must be foreclosed upon and the foreclosed homes and excess inventory must be sold so the market clears. In the residential market it's really just wait-and-see until that happens."

It's a process that will be hampered by slower population growth. "Population flows have clearly slowed," Pollack said. "Both APS and SRP report some of the weakest residential utility hookup numbers on record. This makes sense because if you can't sell your home in Phoenix, you probably can't sell it in California, Michigan, Pennsylvania or other places that people move from to come to Phoenix."

The weak housing market is further exacerbated by the recession and tight credit market. "Virtually all banks are reporting tighter lending standards on subprime loans and nearly three quarters report tougher loan standards on prime residential loans as well. Tougher lending standards and a weak economy will continue to act as a drag in the housing market," Pollack said.

Commercial real estate woes just beginning

While problems in the Greater Phoenix residential real estate market began several years ago, problems in the commercial real estate market are largely just beginning. The apartment market, Pollack said, should be doing well given the fact that more people are unable to buy single-family homes and more people are moving out of homes that have been foreclosed. Yet the apartment market is not doing well.

Vacancy rates — which should, in theory, be decreasing — will likely increase in 2009. The problem — in all commercial markets — is, in part, due to the number of projects currently under construction, despite weak demand. There are 9,800 apartment units, 3.5 million square feet of office space and 5.6 million square feet of retail space currently under construction.

"The problem is that there's such a long lag between a project's inception to opening that developers are just now building projects that they started during the boom. Of course, they now realize it's not a good time to be building, but they're stuck," Pollack said. While the residential real estate market could hit bottom in 2009, the bottom for the commercial market won't be until 2010 or 2011, Pollack predicts.

Just how bad is it?

When asked how today's Phoenix area real estate market compares to the real estate market during previous downturns, Pollack said, "This is by far the worst real estate downturn since the depression." "Overall, the outlook is just plain ugly," Pollack said of the residential and commercial real estate markets. McPheters said the recession, in terms of unemployment, could rival the recession of 1973-75.

"Arizona's largest job losses were in the recession of 1975, when percentage changes over-the-year dipped to more than 4.0 percent. Job losses in 1982 were in the 2.0 percent range. By comparison, the current downturn has already recorded consecutive months of Arizona job losses greater than 2.0 percent, and further weakness is projected in 2009."

Overall, McPheters forecasts a 1.0 percent decline in employment in 2009, following a 1.5 percent decline in 2008. In terms of duration, McPheters said that the 1973-75 and 1981-82 recessions were both 16 months long. He predicts the current recession — which began in December 2007 — will be at least that long, and probably much longer.

The silver lining

For those looking for a silver lining, McPheters said "in every previous downturn, the ultimate recovery has seen the Arizona economy rebound much stronger than the nation as a whole." That, McPheters said, is because of Arizona's faster-than-average rate of population growth (as much as 3 percent compared to 1 percent nationally).

"Growth in population leads to a demand for more housing and other types of construction, supports expansion of government services, and also leads to more overall economic activity in general. Factors causing people to move to Arizona — weather, lifestyle and a faster-than-average rate of job growth — are not likely to change in the next upturn."

In addition, the bursting of the real estate bubble in Arizona has brought housing prices down to affordable levels once again. According to McPheters, in 2006 only 27 percent of homes in the Phoenix area were "affordable" at the area's median income level (compared to 40 percent nationally). By 2008, 72 percent of Phoenix area homes were "affordable" (compared to 56 percent nationally).

And, Pollack said, "The good news is that the basic underlying dynamics have not really changed. We are paying the piper for overbuilding that occurred during the bubble. We also will be paying the piper for overbuilding currently occurring in the commercial market, which is exacerbated by the slow economy. We will get through this, but obviously it's not fun at the present time."

The bottom line, McPheters said, is that while Arizona's economy will be flat in 2009, "when the national economy recovers (expected in late 2009 or early 2010), Arizona will rebound more quickly and stronger than the average state, and within a couple of years will again be one of the leading growth states in the country."

Bottom Line:

• The Grand Canyon State ranked 49th out of 50 states for labor market performance in October. In the one-year period ending in October, 70,900 jobs were lost in Arizona. Overall, McPheters forecasts a 1.0 percent decline in employment in 2009, following a 1.5 percent decline in 2008.
• In 2008, retail sales are estimated to have fallen 5 percent and are forecast to be flat or fall in 2009.
• Over the past 12 months, roughly 38 percent of homes sold were in foreclosure, but the situation is getting worse. In the last month, 50 percent of all resales in Greater Phoenix were foreclosures. Pollack predicts that the number of homes in foreclosure will continue to rise in the near term.
• The only way to come out of the real estate downturn is to absorb the excess supply — estimated at between 40,000 and 50,000 homes. 5,000 of those may be absorbed in 2008 and another 10,000 in 2009, still leaving 25,000-30,000 excess units at the end of 2009. "The housing market does not face a speedy recovery."
• While problems in the Greater Phoenix residential real estate market began several years ago, problems in the commercial real estate market are largely just beginning. The problem — in all commercial markets — is, in part, due to the large number of projects currently under construction, despite weak demand.
• There is some bittersweet good news: first, the bursting of the real estate bubble in Arizona has brought housing prices down to affordable levels once again. Second, in every previous downturn, the ultimate recovery has seen the Arizona economy rebound much more strongly than the nation as a whole.
• When the national economy recovers (expected in late 2009 or early 2010), Arizona will rebound more quickly and stronger than the average state, and within a couple of years after that will again be one of the leading growth states in the country.

Economics Faculty