Research

Cleaning up after a tornado: Real estate in 2010

Once the envy of most of the nation, Arizona's real estate industry has become a cautionary tale, and the new story of recovery is one of fits and starts. Knowledge@W. P. Carey consulted experts at the W. P. Carey School and elsewhere to take a long look at the 2010 market in Arizona and the nation. Like the rest of the country, Arizona is experiencing another period of declining prices, and the state is still a front runner for foreclosures. And similar to other states, Arizona is burdened with excess supply in both residential and commercial properties. The last months of 2010 showed signs of slow job growth, but not yet enough to generate the energy needed to pivot the real estate industry for a fast rebound.

2011-01-05

Once the envy of most of the nation, Arizona's real estate industry has become a cautionary tale, and the new story of recovery in the real estate market is one of fits and starts. In the past, the Valley and state's real estate industry had been able to grow its way out of economic downturns thanks to a steady stream — and at times flood — of new residents from around the country.

Over the past decade, in the belief that the good times would, at worst, merely slow, thousands of new homes rose up in the farthest reaches of the Valley and new commercial real estate ventures boomed. A typical down cycle was predicted. But few could have guessed at the devastation the Great Recession would wreak all across the nation. The state is finally starting to create jobs again, but the pace won't be strong enough or fast enough to translate into a quick and powerful rebound for Arizona's residential and commercial real estate sectors.

"Conditions are improving, but slowly," said Lee McPheters, director of the JPMorgan Chase Economic Outlook Center and a W. P. Carey research professor of economics. "It's like cleaning up your yard after a tornado compared to a rainstorm. This recession was a job-loss tornado. Every state in the nation lost jobs in 2009; we didn't see that in the recessions of 1991 or 2001."

Residential market

The latest figures from the ASU-Repeat Sales Index (ASU-RSI) show that housing prices in the Valley have resumed falling. According to preliminary November data, housing prices fell for another month and the year-over-year rate of decline accelerated slightly to -7 percent.

"We started 2010 with prices falling on an annual basis at single-digit rates, which was an improvement from prior years," said Karl Guntermann, a professor of real estate finance and author of the ASU-RSI reports.

"By March, prices turned slightly positive for several months, but then began a gradual downturn in August. The first-time homebuyer credit undoubtedly helped support prices earlier in the year, as did demand from investors who remain strong buyers in the market. Buyers were attracted by prices that reached levels not seen since the late 1990s. Investors are confident that Phoenix will return to its long-time high rate of growth but also realize that the market will take several more years to fully recover."

In the November ASU-RSI report, Guntermann points to a trend of continued price declines over the next several months. "Markets don't move smoothly in one direction so perhaps it should not be surprising that another period of price declines has begun," Guntermann said in his report.

"To put things in perspective, in November 2008, prices had declined by 32 percent from the prior year, and by November 2009, they had declined another 17 percent. Those declines reflected the depressed condition of the Phoenix housing market and the Great Recession."

According to the November data, the overall median price for sales was $122,300 compared to $125,000 in October and $124,900 in September. Since June 2009, the index has recorded a price fluctuation between $122,000 and $135,000, which Guntermann said in his report reflected "the instability that characterizes the current market and recent median prices are still within that range in spite of indications that the market is softening."

A resumption of falling home prices is not limited to the Valley. In fact, the October S&P/Case-Shiller Home Price Indices indicate a nationwide decline. "The double-dip is almost here, as six cities (Atlanta, Charlotte, Miami, Portland, Ore., Seattle and Tampa) set new lows for the period since the 2006 peaks.

There is no good news in October's report. Home prices across the country continue to fall," stated David M. Blitzer, chairman of the Index Committee at Standard & Poor's, in the report. "The trends we have seen over the past few months have not changed. The tax incentives are over and the national economy remained lackluster in October, the month covered by these data.

Existing homes sales and housing starts have been reported for both October and November, and neither is giving any sense of optimism. On a year-over-year basis, sales are down more than 25 percent and the months' supply of unsold homes is about 50 percent above where it was during the same months of last year. Housing starts are still hovering near 30-year lows.

While delinquency rates might have seen some recent improvement, it is only on a relative basis. They are still well above their historic averages, in both the prime and subprime markets." In recording home sales for the third quarter, Ken Fears, manager of regional economics for the National Association of Realtors (NAR), stated that the foreclosure rate on prime loans remains highest in Florida, Arizona, California, and Nevada, which were hit hard by the subprime market collapse.

Not surprisingly, the most recent ASU-RSI shows that foreclosure prices declined again in November, dropping 11 percent compared to November 2009. "Last month, the decline had been only 3 percent, so this reflects serious deterioration in a segment of the market that had been doing better than all but lower-priced housing," Guntermann said in his report.

He added: "The supply of foreclosures coming on the market continues at a fast pace, greater than investors and other buyers can absorb, so prices are falling. Foreclosures are expected to slow in 2011, but they will still be a major factor in the market. The biggest challenge for the Phoenix housing market is creating new jobs. When we create jobs, people move here and that increases the demand for houses and apartments. With the recession, demand associated with growth has been the missing element in the housing market."

"As the Phoenix economy improves throughout 2011 that should have a positive impact on the housing market and eventually the construction industry. Our foreclosure problem has been among the worst in the country, making recovery in the Phoenix housing market a very slow process." Another factor bringing down home prices in the Valley is the continued high level of excess supply."

Elliott D. Pollack, CEO of Elliott D. Pollack and Company and co-editor of the W. P. Carey School's Greater Phoenix Blue Chip Economic Forecast, estimates there are about 75,000 vacant single-family homes in the Valley. In the NAR's third quarter sales report, Fears echoes Pollack's warning about excess inventory continuing to pull home prices lower.

"Markets in states where sales were resilient, but face high shadow inventories such as Phoenix, Miami-Fort Lauderdale, Las Vegas, Sarasota, Orlando, Tucson, and other markets in Arizona, Florida, Nevada tended to experience a shift in the year-over-year price trend from positive to negative or extended their negative trend, while markets in California mostly saw a softening in their recent positive gains," Fears said in the NAR report.

"With the economy gradually recovering and the foreclosure problem past its peak, the odds are good that the housing market will end 2011 a lot better than it will be beginning," Guntermann concluded in his report.

Commercial real estate

There's no doubt that the Valley and state's commercial real estate sector is in bad shape. But just how bad is it? "No one really knows," said Jay Butler, associate professor of real estate finance. "You read the national news on commercial real estate and one article says we're at the bottom and the recovery will be next year, and next one will say the bottom is well beyond where we are now — nobody really knows."

According to the ASU-Commercial Repeat Sales Index (CSRI), the commercial real estate market began a dramatic decline at the end of 2008 that accelerated throughout 2009. The ASU-CSRI concludes that the commercial real estate market bottomed out in the fourth quarter of 2009 and prices have stabilized to pre-expansion levels.

"By the end of 2009, the annual decline reached 40 percent, far more rapid than the 25 percent decline in 1990 during the Resolution Trust Corporation (RTC) era," Guntermann wrote in the latest ASU-CSRI report. "As of 2010, [third quarter] prices have rebounded to essentially no change from 2009, [third quarter]. The decline was dramatic, but lasted a relatively short five quarters in contrast to the residential market, where the decline lasted almost 40 months."

Pollack explained how the Valley's commercial real estate market hit such a low: "What happened was that the expectations of 2007 were never met. In fact, you had negative absorption in office for two years in a row. If you have fewer jobs, and basically we lost 200,000 jobs, you need less office space, you need less industrial space, you need less retail space.

So, you had declining absorption at the same time you had new projects coming on stream, so vacancy rates shot through the roof. Because the reality was so different from the expectation, vacancy rates got very high. "Now, we're in a situation where there will be no new spec office space built for the next three, four years, but it will take that long to absorb the excess supply, because, although we're growing again, we will be growing slowly," he continued.

Like the ASU-CSRI, the National Association of Realtors is seeing indications that the commercial real estate market is stabilizing nationwide. "The basic fundamental of rising commercial leasing demand, resulting from a steadily improving economy, means overall vacancy rates have already peaked or will soon top out," stated Lawrence Yun, NAR chief economist, in a press release.

"The outlook for the office and industrial markets has moderated with modestly declining vacancy rates expected as 2011 progresses, while the retail sector should hold fairly steady. Still, high vacancy rates imply falling rents." The National Association of Realtors forecasts the following commercial real estate vacancy rates for the fourth quarter of 2010:

Yun said the national vacancy rate in the office sector is expected to drop from 16.7 percent in the fourth quarter of 2010 to 16.4 percent in the fourth quarter of 2011. However, there will be little change to vacancy rates during the first half of the year. "Is 2011 going to be a good year in commercial real estate? No," Pollack said.

"Will it be better? Yes. The economy is improving, we're creating jobs, you'll have more absorption that will start to eat into the vacancy rate, and that's important. But it's going to be a long process of eating into the vacancy rate to where we have to be." Pollack added that there is a bright spot.

"This is not like the RTC days when the government was forcing the dumping of property when there was little capital to spend. This time the government is not forcing the liquidations it did 20 years ago and there is a lot of capital out there," he said. "That capital will be buying good properties in Phoenix when the market's down — that's what smart money does."

Another bright spot, according to the ASU-CSRI, is the total forecasted earnings per share (TFEPS) estimated for all companies in the Bloomberg Arizona Index (BAZX) that are headquartered in Phoenix. In the ASU-CSRI, Guntermann found that TFEPS peaked toward by the end of 2006, signaling the downturn in the Valley's economic boom. Conversely, TFEPS began to increase in early 2009 and remained essentially positive in 2010.

"If the historical pattern is followed, which appears to be the case, 2011 should see a significant improvement in commercial prices, basically a recovery from the distressed levels of 2009 and 2010," Guntermann concluded.

Job growth and other challenges

A strong resurgence in job growth in the Valley and state is needed to pull the residential and commercial real estate sectors out of their craters. A year ago, Arizona laid claim to one of the weakest job markets in the nation. "Arizona ranked 48th out of 50 states in year-over-year job growth, and employment in the state was down by over 120,000 jobs from the year before," McPheters said.

"Then, by the end of last summer and into the fall months, employment actually increased compared to the prior year." Of course, McPheters pointed out, anything was better than 2009, but by August of 2010, the state's economy was seeing year-over-year growth of 7,000 jobs, the first gain in 30 months.

"Arizona finished out 2010 with employment increased in each of the final five months of the year," McPheters continued. "The best monthly ranking during this period was October, when Arizona ranked seventh among all states. The growth rate of around 1 percent, and the number of jobs, about 25,000, are not spectacular, but the Arizona comeback compared to other states, a gain of more than 40 places in the rankings, shows that the employment recession in Arizona definitely ended last year."

However, a full jobs recovery will not take place in the near future. "There are two dimensions to the situation. Employment in the average state fell by about 5 percent due to the recession, but Arizona lost 10 percent of its jobs. So, Arizona has a lot more ground to make up than the average state. The second thing that's important is that the pace of recovery is held back not only in Arizona, but also in most other states; credit is still tight, consumers are still cautious, businesses are postponing hiring," McPheters said.

Full recovery for Arizona will probably take up to three more years, even under the best possible assumptions.

— Lee McPheters, director of the JPMorgan Chase Economic Outlook Center and a W. P. Carey research professor of economics

Still, McPheters stressed, the jobs recovery, particularly in the last few months of 2010, began gaining some traction. "Arizona is growing faster than the average state now," he said. "Furthermore, many people don't realize that the Phoenix economy is growing faster than every large metropolitan area, except Washington, D.C. As of November, Phoenix was growing 1.5 percent over-the-year, faster than Dallas, Houston or Boston.

"The strength of the Phoenix rebound is remarkable, when you consider that those cities and states most affected by the housing boom also were hardest hit when that bubble broke," McPheters continued. "Some states, such as Texas, never got into boom conditions, and they have not seen the wild swings in employment and incomes that have hurt Arizona, Nevada, Florida and California."

For that trend to continue, economists caution that the state will have to take meaningful steps to make itself more attractive to relocating businesses. "Arizona has basically been asleep at the switch for the last decade-and-a-half and is now just finally getting around to doing things that are necessary to make us competitive again," Pollack said.

"We've lost the fire that got us here; we've lost the sight of what made us great. That unfortunately is something that you have to regain because you have a new generation of people who don't remember what happened in the '40s, '50s, '60s, and '70s to get us here."

Pollack added that while it's admirable that current economic development efforts are focusing on attracting the alternative energy industry, "you should be making yourself as competitive as possible, so you capture whatever shows up. You don't pick winners and losers. That's a sure recipe for disaster." Butler said the state needs to change its game plan for attracting businesses.

Gone are the days when companies looking for lower labor costs came to Arizona. "The United States is having this issue across the board. The manufacturing jobs have fled to lower-cost countries. It's an ongoing issue. It's a big fight on the economic development level," he said.

"The governor has created the new concept (the Arizona Commerce Authority) at the state level. But the problem is because of the Goldwater Institute lawsuit against CityNorth, the use of incentives is somewhat limited. How limited? People really don't know. For example, the [Phoenix] Coyote deal that was just finished [in Glendale], there's talk of a lawsuit there as being a violation of the constitution gift clause.

Other states like Texas and California and the Carolinas have enormous available funds to attract industry in their respective states." In 2007, the Goldwater Institute filed a lawsuit against the city of Phoenix for providing the developer of the mixed-used complex CityNorth with more than $97 million in subsidies.

The Goldwater Institute put to the test the state constitution's public gift clause. Under Arizona's constitution, a government entity cannot make a public gift of more than $350,000. In January 2010, the Arizona Supreme Court allowed the CityNorth agreement to stand, but also set the stage for a much more narrow reading of the public gift clause.

"A lot of people argue that the business tax structure does not favor businesses at the moment, and there is a lot of pressure to change that — the property taxes and certain business taxes, etc., don't make us competitive," Butler added. "But, of course, we can't really lower them in today's environment, when we're in a worse state budget situation."

Tax breaks aren't the only way the state can make itself more attractive to companies, McPheters said. Enhancing the state's current infrastructure and preparing it for future growth is another strategy. "People sometimes like to focus on taxes as a 'policy lever' that government can use to make a state more attractive for business or new residents," he said.

"But most businesses are smart enough to look at the tax structure and ask, 'What do we get for our money?' And if taxes are uniquely low compared to other states, most businesses will ask, 'What's the catch,' since they know there is no free lunch. A competitive tax structure that somehow provides higher-than-average quality of public services is the most attractive package for most businesses."

The type of planning becomes more crucial as population inflows become sluggish. According to preliminary 2010 U.S. Census figures, Arizona's population grew by 24 percent, from 5.1 million in 2000 to an estimated 6.4 million 2009. However, the number of people coming to Arizona dropped over the past year.

In July 2009, population figures projected that the number of residents in Arizona would hit 6.59 million in 2010. Despite that, McPheters believes Arizona will continue to be a magnet for individuals and businesses, boding well for the state's real estate industry. "The long-term outlook for Arizona is still strong. It is highly likely that Arizona again will rank among the top five states for job growth within two to three years," he said.

"There are many established metro areas that have declined as their industries have lost out to foreign competition or economic evolution. So far, that is not the case in Arizona. The challenge is to preserve the quality of life and competitive infrastructure that has made Arizona an attractive destination for both newcomers and businesses for the past 50 years."

Real Estate Faculty