From a small northwestern observatory…

I got some strange looks last week when I was speaking at a real estate investment group. The “theme” of my talk was on the structural shifts in the economy, which I’ve talked about here as well as in our monthly newsletter. However, when asked about the “bottom” of the recession, I told everyone I thought we were looking at a rolling bottom. The equities market would bottom out first (and we’re probably there right now). The real estate market would bottom second, sometime later this year. The employment/GDP picture would bottom third.

Now, I think I’m on pretty safe ground with the first and the third. The dire predictions of a 5000 DJIA seem to be behind us, and some recent analyses of options market pricing suggests that the market puts less than a 10% probability on a “depression era” type crash. As for the third prediction, I’m relying primarily on the Livingston Forecast, produced by the Philadelphia FED. This semi-annual survey of leading economists gives us both the central tendency of their opinions as well as the degree of consensus around those opinions (more or less a measure of dispersion). Generally, they’re looking at GDP growth and employment bottoming this year, with GDP growth turning positive again by the last quarter and employment turning positive in the first quarter of 2010. (Note: I’m a huge fan of this survey — while they don’t always get it “right” , they get it “less wrong” than other forecasts.)

The audience of real estate professionals and investors was a bit skeptical of the middle component of my forecast. Some skeptics even suggested that real estate should lag the rest of the economy, and won’t rebound until after employment and the GDP bottom out.

Economy.Com, in their recent report Housing in Crisis projection that the Case-Shiller index will continue to decline into the 4th quarter of 2009, bottoming out some 36% lower than the recent peak. While even that would suggest that real estate prices (at least housing) will bottom out before the employment sector, it still seems somewhat on the pessimistic side.

Current evidence suggests the bottom may be nearer than these projections imply. For one, a report this week from CNBC provides three important clues to the near-term. First, the National Association of Realtors reports that 45% of all residential transactions in 2008 were distress sales. That’s a pretty large number of sales, and wringing the distressed market dry is a necessary precursor to a recovery. Anecdotally, this would suggest that the bottom feeders have pretty much found their bottom. Second, much of the U.S. has not been hit as hard as reports indicate — particularly “middle America” which were never truly overbuilt or badly overpriced, and where price-declines have been moderate. Finally, some of the hardest-hit areas — Florida and the Phoenix/Scottsdale area — are receiving significant interest, even in the hard-hit second home market.

This all portends good things for the residential market, but what about commercial? Construction lending is nearly dead today, and permanent financing for all but “sure bets” (or low income housing) is a tough sell. Nonetheless, pricing seems to be accomodating both the increased cap/discount rates as well as forward-looking fundamentals. Some markets will continue to suffer (residential development, big-box retail) while others are already getting some upward pricing pressure (apartments). However, the market seems to have a pretty good consensus pricing on this, we’re not seeing nearly the “distress sale” pricing in commercial assets that seem to have plagued residential, and in general the damage may pretty much have already been realized.

Does this imply buying opportunities? Probably, but only for the most patient investors. If we are seeing a bottom, that doesn’t imply a return to a steep upward slope on prices just yet. Both investment demand and occupancy demand are going to stay low for a while, the former as funds and investors lick their wounds and the latter as corporate America comes to terms with what the post-recession economy will look like.