From a small northwestern observatory…

Finance and economics generally focused on real estate

Archive for December 2010

Housing equilibrium — part 1

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This is going to be a bit convoluted, so bear with me.

This week, I’ve been at Renaissance Weekend, an annual gathering of top minds in a variety of fields (Nobel laureates, authors, actors, CEOs, etc) and I’ve been asked to make several presentations on real estate finance and economics. It’s a pretty heady experience, but more on that later.

One of the principle questions thrown my directions is, ‘When will real estate bottom?’ One might argue that commercial real estate has already bottomed, and there’s a fair amount of data to support that. (A weak “bottom”, I’ll grant you, but a bottom, none-the-less.) Apartments are coming back particularly strong, but even hotels and industrial are showing positive gains this year.

Owner-occupied residential is a completely different story. We’ve really never had a phenomenon like this, and according to both the Federal Housing Finance Authority and Case-Shiller, housing prices continue to collapse all across the country. Indeed, C-S just released a report two days ago indicating that new lows were hit in 6 out of 20 top markets. Overall, housing prices have been downtrending every quarter since mid-2007.

When will this bottom? I’m toying with a set of models which suggest that the pricing market won’t bottom until the ownership rate reaches an equilibrium. Heuristically, that optimal rate appears to be around 64%. Why? I’m looking at the last time ownership rates ballooned, which was at the end of the hyper-inflation period of the late 1970’s. Pricing markets stabilized after the ownership rates stabilized.

This posting is a deviation from my normal routine — My thinking on this topic is evolving, and I’m hoping to trace that evolution here on the blog until I reach something that I can actually flesh out into a paper. I’d appreciate any comments you have, either added as a comment here on the blog or, if you’d like privacy, e-mail them directly to me (john@greenfieldadvisors.com)

Written by johnkilpatrick

December 30, 2010 at 7:38 pm

Conway-Pedersen

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If you’re in business in Western Washington (as we are), then the quarterly Puget Sound Economic Forecaster by Dick Conway and Doug Pedersen is must-reading. The latest issue just hit my desk, and given the current state of flux, it’s worth reviewing.

You have to get to the back page to find what I consider to be the most interesting graphic — a chart of Puget Sound Leading Economic Indicators dating back to the early 1970’s. The era is marked with 5 recessionary periods — 1974, the “hic-cup” recessions of 1979-1982 and 1990-1992, the “9/11” recession (which really started in late 2000) and the current mess, which dates to 2007. Intriguingly, in each of these periods, the index turns downward well before the beginning of the recession. Of more interest, the index turns upward well before the end of the recession (as it has now) and turns into a sustained multi-year period of growth which carries it to a new peak. If you’re a chartist (as I am) this is interesting stuff.

C & P note that the Puget Sound region — despite its famed economic health — actually had a somewhat worse time than the nation as a whole during this recession. We lost 7.4% of our jobs during this period, compared with 6% for the U.S. They suggest this means that the region will trail the nation as a whole coming out of the recession. I concur with them that the region lost disproportionately in construction and finance.

Written by johnkilpatrick

December 22, 2010 at 1:01 pm

Fa.. la… la… la.. la…

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Having a good holiday season yet?

About 20 years ago (darn, time flies…) I wrote a paper using Monte Carlo simulation to model the potential failure rate in shopping centers. Ended up presenting it (of all places) at a major Economic Geography conference, and it got published in the proceedings of that conference.

Now fast forward to today. As regular readers know, we do a LOT of environmental valuation work. I don’t use M/C simulation, even though it has been used in the valuation literature. Well, this year, the 5th Circuit Court of Appeals was faced with an environmental case in which the testifying expert used M/C simulation to aid in allocating damages between two responsible parties, Lyondell Chemical Co. v. Occidental Chemical Corp., 608 F.3d 284 (5th Cir. 2010).

“The other side” opposed M/C, arguing that it hadn’t been applied in these cases, and that the error rate could not be determined. The Appeals Court rejected those arguments, and ruled in favor of M/C.

Neat. I need to work up a working paper on this, but I can already see some significant applications to what we do.

Written by johnkilpatrick

December 20, 2010 at 4:12 pm

Tis the season….

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Intriguing mixed messages from the economy. Employment continues to lag, but holiday shopping was up. Go figure?

Two or three things may be in store. First, I’m sure that some of the more profitable businesses, fearing future tax increases, were holding off spending tax-deductable money until 2011 rather than 2010. The key lesson for lawmakers — get some stability and predictability into the tax system.

Second, while “on-line” shopping went up, the unmeasured impact of on-line was the ability to target shopping. Lots of holiday shopping went at bargain prices, and I’m interested to see how much sustainability there will be in the increases. It’s very difficult to imagine, with the underlying instability in economic fundamentals, just how long the shopping bubble can be sustained.

But, on to real estate. What looks good right about now? What looks bad? We continue to be doom-sayers on housing construction into 2011. Normally, in a recession, there’s a build-up of excess supply (construction in the pipeline pre-recession get unsold DURING the recession). However, past recessions rarely have a contemporaneous melt-down in homeownership rates (see the following).

Note that since we began keeping records in 1960, ownership rates have inexorably trended upward but for two instances — this one and the 1980-84 period. After 1984, it took until the mid-1990’s for rates to start trending upward again, and many would suggest that this up-trend was only the result of Greenspan’s “easy money” policies. In a more cautious lending environment, it’s hard to say where the true equilibrium might lie. However, it’s intriguing that the run-up in the 1970’s is often blamed on the high levels of inflation (making home ownership the favored “inflation hedge” for families) and that in the post-recession, low-inflation period of the late 80’s and early 90’s, rates seemed to hover around 64%.

If in fact that’s where the equilibrium lies, then the U.S. has about three more percentage points in owner-occupied homes to absorb. This absorption occurs in one of three ways — growth in the population, conversion of homes to other uses (usually rental in lower-end or transitional neighborhoods), or demolition. Whatever the reason, with the current slope of the trend-line (which, intriguingly, matches the slope of the 1980-84 period), we see that it took about 5 years (2004 through 2009) to get from about 69% to about 67%. At this rate, getting to 64% will take another 7 – 8 years, suggesting a best case scenario of stability in the 2016 range.

This scenario, interestingly enough, matches some of the employment-growth scenarios I’ve seen, which suggest we’re looking at the mid-to-late teens for unemployment to get back down to pre-recession levels.

So, if owner-occupied housing stinks, what looks good on the menu? Apartments. In very rough numbers, we WERE building about 1.5 million homes per year prior to the recession (year-in, year-out, with a HUGE amount of variance from year to year). Now-a-days, we’re building about a third of that or less, suggesting an un-met demand for housing of about a million units per year, more or less. Apartment construction also flat-lined during the recession, primarily because banks simply didn’t have the money to lend for construction financing. (Permanent money comes from other sources, and it’s available, but the construction financing problem is still with us.)

As credit continues to ease — particularly with the recent announcements by the FED in that regard — we can see some strong lights at the end of that tunnel. Good news for construction workers — their unemployment rates have been huge lately, but the same folks who drive nails for owner-occupied homes can also drive nails in apartment complexes. Easing credit in this area will thus fuel job growth, which also fuels consumption, home purchases, etc. Thus, addressing the housing demand/supply problem may be the most important single thing policy makers can do to restore the economy to good health.

Written by johnkilpatrick

December 16, 2010 at 9:57 am