Real Estate and the Economy May 2013

William L. Pittenger

Risk Management AssociationFlorida Commercial Lending School

2013

Condition | Trends | Outlook

A Quick Look Back: The Great Recession

Recessions are generally thought of as short-term fluctuations of output around a path of long-term equilibrium. When recessions occur, the cause is usually some form of economic shock (oil, terrorism), inflation, monetary policy and a wide variety of other factors which lead to declining GDP, rising unemployment and more. Eventually, the adverse effects flow widely and broadly into other sectors of the economy including housing. Rarely do recessions begin with housing.

The Great Recession, as it has come to be known, began with housing and expanded like a virus from there.

It was also accompanied by a financial crisis which history has shown compounds the effects of recession and prolongs recovery.

The Great RecessionThe Great Recession was broader, deeper and more severe than any recession since the Great Depression of the 1930s. It left an indelible mark on the nation and its collective psyche.

Virtually nothing or no one was immune. It was especially severe due to being accompanied by a deep financial crisis. The economy came remarkably close to a collapse of the U.S. financial system.

The Great Recession left its mark on the entire economy but especially employment, real estate, credit and regulation.

Many of its effects are structural rather than cyclical. Some will be felt for years or alter the way we do business.

Where It All BeganSome Things Never Change

“In the ruin of all collapsed booms is to be found the work of men who bought property at prices they knew perfectly well were fictitious, but who were willing to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit.”

Chicago Tribune Editorial, April 13, 1890

Today’s Program

• Perspective: A quick look back at The Great Recession and some of its enduring effects.

• Current Conditions• Employment and the Broader Economy• Housing• Commercial Real Estate

• Forecast

Some Results of the Great Recession• Most severe U.S. recession since the Great Depression of the 1930’s. The

recession, though technically declared over in June 2009, continues to linger with painfully slow recovery, lost decade(s) in job creation and economic growth, low confidence, record unemployment, record foreclosures, declining house prices and more.

Some Impacts In Perspective

• Existing home sales volume declined roughly 50% from 2005 peak.• New home sales declined 80% from 2006 peak. • Median price down declined 33% nationally. • Median price declined 53% in Florida.• Construction employment declined 65% (20+% unemployment by 2010)• Mortgage banking employment declined.

Employment History | Current Conditions | Outlook

Recession Employment History• 8.8 million jobs lost during “The Great Recession.” Non-farm employment peaked in January

2008, one month after declared start of recession. Steadily fell until 2010.

• Losses were not confined to the typically cyclical industries such as manufacturing but rather reached into every sector, largely due to unprecedented growth in housing earlier in the decade.

• Construction, housing and allied industries, including banking and mortgage banking, saw employment levels fall precipitously. That was compounded by the financial meltdown in Q3 2008.

• Most losses during and after The Great Recession were structural rather than cyclical and probably won’t be replaced.

• Most losses today are more likely to be permanent thereby requiring retraining.

Recession Employment History

• Both recession AND impact of technology have constrained job growth. Technology induced productivity gains have been chipping away at employment since the 1970’s.

• Hardest hit sectors were those in the 18-43 age group which are perhaps the most productive and innovative years.

• There are currently two million persons unemployed in the 24-35 age group. Even newly minted college graduates are having difficulty finding “real” employment.

• Changed and changing employment dynamics could have significant social and economic consequences.

Current Employment Condition BLS Release for April 2013

• Employment has steadily improved since finding a bottom in 2010. That’s the good news.

• The bad news is gains have generally been slow, lower pay and fewer people are working today.

• Civilian labor force participation rate is 63.3% which is the lowest since 1979. The rate has declined by 0.3% this year.

• Employment to population ratio was 58.6%. That is virtually unchanged over the last 12 months.

• New Payroll Jobs in April: 165,000 NET. Private employers added 176,000 jobs while government lost 11,000.

• Economy has added an average of 162,000 jobs per month over the last three years (169,000 over the last 12 months and 208,000 over last six months). That is good but barely enough to cover rising population.

Current Employment Condition• Headline unemployment rate (U-3) declined to 7.5% which is the lowest in four years.

Headline unemployment rate does not include:

• Involuntary part time: 7.9 million and rising. Rose by 278,000 in April.• Marginally attached: 2.3 million. Unchanged in April. • Discouraged workers: 835,000. Down 133,000 year over year.

• Add them up and you get the U6 Measure of unemployment which was 13.9% in April. Probably the best indicator of unemployment and under employment but not widely reported.

• Still 11.7 million unemployed.

• Approximately 4.4 million long term (>27 weeks) or 37.4% of the total unemployed.

Employment Trends• The nation’s unemployment rate has averaged 5.7% since 1948; some 64 years. It is very likely

that the “new unemployment rate” will be 6.5% to 7.5%. (Note that Economist Edmund Phelps, who won a Nobel Price for his work on the natural rate of unemployment, advances that view).

• Not only have more people been unemployed during this recession, more have been unemployed longer. Long term employment has hovered around 40% (37.4 % in April) .

• Even during the relatively severe recession of the early 1980’s, job losses were cyclical and the unemployed quickly found jobs in the same or allied field. Today’s losses are systemic and more likely permanent.

• Technology has changed the unemployment dynamic in the last decade. During the mild recession of the early 2000s, it took four years to recover jobs during which time wages stagnated.

• Job losses have been most severe in several key sectors of the economy such as construction. No demonstrable change likely in short or mid term.

Looking Forward at Employment• All but the lowest skilled jobs will require specialized training. Jobs that were once mere

assembly are now or will soon be automated.

• Importantly, there is a growing mis-match between current worker skills and current employment needs. In a survey of employers, The Organization for Economic Cooperation and Development (OECD) found that a full 50% of employers had DIFFICULTY filling available positions due to skill mis-match.

• Specialized training will be less likely to be on the job or employer paid (although it needs to be to better align worker skills with job demand).

• IMPORTANT: As the economy recovers, global competition and skill based technological change will drive worker skill requirements even higher. If the level of educational achievement does not keep up (and it has not for nearly four decades) the median wage will continue to decline, long term unemployment will rise and wage inequality will widen further thus increasing the structural unemployment rate.

• Note that the median wage for men with only a high school education has declined 46% (inflation adjusted) since 1970.

Changing Employment Dynamics• These trends appear structural in the sense that they are systemic and there are no leading

indicators to suggest a reversal anytime soon.

• Does not bode well for the nation’s economy, innovation and competitiveness.

• Does not bode well for housing and, by extension, commercial real estate:

- Lingering higher than historic average unemployment rate.- Stagnating wages (since the 1970’s)- Longer term unemployment.- Declining work force participation rate.- Skill based technological change.- Wage based disparity.

• Many of these factors will profoundly affect housing (and by extension CRE) by constraining consumers ability to purchase housing or to move up.

Job Creation PatternLosses Have Been Larger Than Gains

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Red Line Current labor force participation rate

The labor force participation rate has dropped to 63.3%. That is the lowest rate since 1979. It remained higher throughout four previous recessions

Employment and the Broader EconomyWeakest Employment Recovery Since World War II

1990 Recession

2001 Recession

Current Recession

Employment Recovery • Federal Reserve Bank of Atlanta produces a jobs calculator which takes into account a variety

of factors such as average job growth, population change, etc. to mathematically project job creation necessary to achieve certain unemployment rates. For example:

• To reach Federal Reserve target of 6.5% to cut back QE: • In 12 months requires 224,805 net new jobs per month. • In 24 months: 164,917.

• To reach average historical rate of unemployment (5.7%) over 65 years:• In 12 months requires 322,959 net new jobs per month.• In 24 months: 214,444.

• To reach unemployment at peak level of employment (early 2008 - 5.0%):• In 12 months requires 408,845 net new jobs per month.• In 24 months: 257,779• In 60 Months 167,140

Employment Outlook

• BUT: New jobs have been generally lower level and lower pay. Wages have stagnated thus driving down loan opportunities and driving up repayment risk.

• Headwinds are against a surge in new job creation as a result of:• Changed and changing employment dynamics.• Shifting demographics.• Sequestration.• Affordable healthcare act.

• Likely result: • New average level of unemployment nearer 7.0%.• Positive but mediocre job creation for most of thje current decade.

Housing: History | Current Condition | Outlook

40 Years of U.S. Home Prices

Departure from long term trend

Florida Statewide Housing Performance

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Current U.S. Housing Conditions• Housing free fall has ended both locally and nationally. The bottom (perhaps arguably)

occurred in July 2012. On average, roughly 56% of value loss has been recovered although that varies widely by location.

• After six long years, housing markets are recovering. Having been fooled by the “green shoots” in 2009, the obvious concern is whether recovery is real and sustainable as well as how robust it will be.

• April 2013 Existing Housing:• Volume: 4.92 million (SAAR). Sales have been above year ago levels for 21 consecutive

months. • SFR Only: 4.32 million• Median Price (all SFR types): $184,300.• Median Price (SFR detached only) $185,100. • Distress Sales: 1.03 million. (13% foreclosures, 8% short sales.• Distress gap: Foreclosure 15%, Short sale 13%• Months of Inventory: 4.7 • Median time on market: 62 days.

Current ConditionNew Home Sales & Construction

• Builders built somewhere between 25% and 40% more homes in the U.S. than there were people to occupy them either by purchase or rental. The problem was widespread with 40% overbuilding occurring in sunbelt states. The result was a steeper slide, more defaults and huge remaining overhang.

• New home sales peaked at 1.389 million units (SAAR) in late 2006.• Fell to a low of 280,000 (-80%) in May 2010.

• Current Condition (March 2013):• Sales: 417,000 SAAR (fastest pace since tax credit induced surge in early 2010).• 17.5% increase over year.• Median Price: $247,000 • Months of Supply: 4.4• Permits: 902,000 (17.3% increase over the year)• Total housing completions: 800,000 (Single family 593,000)

New Home Sales and ConstructionRed line depicts March 2013 sales level.

Peak 1.389 Million Units | Late 2006

Trough 280,000 | May 2010

Potential Threats to Robust and Sustainable Housing Recovery

• Barring a fall over the fiscal cliff early next year, or some other currently unforeseen economic shock, we expect recovery to continue albeit at an agonizingly slow pace and in an inconsistent and sometimes painful fashion.

• HOWEVER, there are still well defined weaknesses and potential pot holes along the road to robust and full housing recovery. Housing remains fragile.

Potential Threats to Robust and Sustainable Housing Recovery

• Tax Payer Relief Act of 2012 (fiscal cliff mitigation). • Affordable Care Act• Impact in 2013 approximately $264 billion.• Fiscal Crisis. Debt and debt ceiling.

• Employment: Aggregate losses have been broader and deeper than any of the 11 recessions since World War II. Recovery is the slowest. New jobs tend to be lower pay. Wages have been stagnating and job losers tend to be unemployed longer.

• Shrinking work force.

• Foreclosures: Temporarily slowed but new wave (perhaps the last) is coming.• Shadow Inventory: Down but still over 1.8 million.

Potential Threats to Robust and Sustainable Housing Recovery

• Delinquencies 6.3% of all mortgages nationally but 15% in Florida (Q2 OCC Mortgage Metrics) .

• Underwater Mortgages: 20% nationally but 37% in Florida.

• Household Wealth.

• Financing Availability. Improved but not good.

• All indicators have improved over the last 12 months.

• IMPORTANT NOTE: Existing home inventories are currently at historically low levels thus putting upward pressure on prices. This will change as equilibrium is achieved.

Demographics Affecting Housing In the New Economy

• Marriages down and being deferred.

• Household formation down. • Adult children have moved back home for economic reasons.

• Also: Less urgency about buying.

• Finally: House will again be for shelter – not pure investment, nor for flipping.

Macro Housing Outlook• Prices will re-gain equilibrium at a lower level than we saw at the peak.

• Prices will increase much more slowly consistent with the natural rate of growth.

• Can’t have housing prices advancing at a rate far faster than people can afford. • Alternative financing instruments will be fewer than we had last decade.

• Factors combine to mean fewer sales at lower prices as well as lower home ownership.

• OUTLOOK: Continued improvement leading to equilibrium barring currently unforeseen economic shock.

Commercial Real Estate

Commercial Real Estate: History | Current Condition | Outlook | Sector Analysis

• Economically, commercial real estate is secondary to residential which is primary. Everyone needs a place to live but not everyone needs office, retail or industrial space.

• In a balanced market, commercial development follows residential.

• That pattern failed during the run up when some commercial developers sought to get ahead of residential. Be there when it arrives.

• Rents increased, capitalization rates plunged and prices SOARED.

• The “field of dreams “ was built but they didn’t come.

• Like residential, markets predictably crashed.

Commercial Real Estate

• Commercial real estate prices peaked in December 2007 and began to slide precipitously in Q1 2008. The decline was steeper and faster than the residential sector. The commercial sector reached a trough in December 2009. The trough was roughly 50% lower than the peak.

• Prices have bounced along the bottom since with the only gains occurring in select markets and among “trophy” properties.

Commercial vs. Residential Price Performance

Commercial Real Estate Current Conditions & Outlook

• It is difficult to see meaningful recovery in most CRE product sectors. That is largely the product of the broader economy where recession recovery has been the worst of any of the 11 recessions since World War II.

• The exception is multifamily rental apartments which has been “on fire” for 12 quarters. This has largely been the result of the impaired purchase housing market.

• Caution is even warranted in the apartment as cracks in the fundamentals are now emerging.

• Keep in mind that no sector nor geography can outperform the broader economy on a sustained basis.

• Under the CRE radar: Small business, middle market, commercial-industrial with real estate are performing better than true CRE. The following is a product by product overview:

Office Real Estate Current Condition • With the economy struggling to recover (GDP roughly half of the long

term rate), the office market continues to languish.

• Demand for office space remains positive but at a very low level. Reis reports that only 4.096 million square feet were absorbed in Q1 and only 1.697 million square feet of new space came on line. Both are down from previous recent quarters.

• National office vacancy in Q1 was 17.0%. That is equal to the 1993 level making the office sector the slowest recovering sector. The outlook for 2013 is modest at best. If current pace of construction continues, sector will sety a new historic low.

• Average capitalization rates are hovering around 8%. (CBD 7.8% and Suburban 8.4%)

Office Real Estate Current Condition • Historically, post recession, suburban office markets have

tended to recover first and more quickly as the recession created new entrepreneurs who tended to migrate to less expensive space in the suburbs.

• Not so this recovery as entrepreneurs have less financial capacity to start businesses or expand. Historically, many did so with home equity which is now almost non-existent.

• CBD tends to be dominated by larger established companies with more capacity.

Office Outlook

Outlook: The office sector is facing significant structural and demographic changes that are creating some strong headwinds. Evidence currently suggests there may be a demand for less space as a result of more modest space requirements associated with telecommuting and shifting preferences.

Lease expirations are also a growing concern as are maturing loans.

Economic feasibility (absence of) will keep a lid on value increases and hence new construction until the market works its way through the current foreclosure cycle.

Retail Current Condition• The retail sector has been plagued by slow or no growth in consumer and retail spending plus

low consumer confidence.

• The brief retail real estate market recovery seen in 2010 and into 2011 has clearly stalled with no leading indicators to suggest another short term rebound. Retail sales contracted every month in Q2 but grew slightly in Q3 due only to rising gasoline prices.

• New retail construction has declined to near record lows nationally (1.04 million square feet delivered in Q1.

• The national vacancy rate (Q2) is about 10.9% overall after peaking at 11%. Regional malls have performed modestly better (9% vacancy) due to the dominance of national tenants who usually, though certainly not always, have more financial capacity and staying power. Having said that, they are more likely to close underperforming stores more quickly.

• Capitalization rates are hovering in the low to mid 7% range.

Retail Outlook

• Outlook: The retail sector has clearly not yet recovered but there are some positive signs. Nevertheless fundamentals such as household income, employment, confidence and spending will need to recover before sector recovery is assured. New development will remain constrained as most projects are not economically feasible at this time.

Industrial Real Estate Current Condition• The “industrial sector” includes two broad sub sectors: flex / R&D and warehouse /

distribution.

• Sector vacancy rate was 12.2% overall. The flex sector experienced a 14.1% vacancy rate in Q1 while the warehouse/distribution sub sector registered 11.9%.

• Capitalization rates according to PWC registered 8.65% for flex and 7.33% for warehouse / distribution.

• Historically, flex space has been the first in the broader industrial to recover as it has been dominated by technology and entrepreneurial ventures. Once again, the current recovery is different. Warehouse / Distribution is recovering quicker due to pent up demand.

• Containerized storage is also changing the warehousing dynamic. Port cities are scrambling to deepen channels. Many can currently accommodate most Panamax container ships which need a 35 foot channel depth. New ships, however, (especially those from Asia) require 42 to 52 feet of channel depth.

Industrial Sector Outlook

Outlook. There is clearly improved investor sentiment around warehouse and flex R&D space. In our view, the warehouse sector will recover first followed closely but not immediately by flex R&D. Cities with deep water ports will do best followed by other port cities and those located near rail or trucking hubs. Users will be more selective.

Rental Apartment Current Condition• The apartment sector has been “on fire” for over 12 quarters. That begs the question “how

long can it continue?” The answer is “not long” and weakness is emerging.

• According to research firm Reis, the Q3 vacancy rate is down to 4.3%. This is the lowest since 2001. Improvement in occupancy is slowing. The Q4 2012 occupancy gain was half the last few quarters. The vacancy rate is not likely to decline much further for the next five years or so.

• Instead of trying to raise occupancy, owners are now trying to raise rents but that comes with

some strong headwinds. The risk is how much more can rents rise in the face of stagnating incomes, tax increases, sequestration and more. Class A has the most room, Class B&C the least.

• At this moment, absorption is still faster than inventory growth however the risk of

overbuilding by mid 2013 is high as between 100,000 and 200,000 new units are expected to come on line in early 2013 and forward.

Rental Apartment Condition• Capitalization rates remain in the mid six percent range (back to 2006 levels). There

are anecdotes of lower but those are few and far between and exceptionally risky. Absurdly low cap rates are being “justified” by exceptionally low treasuries.

• Geographically, tech areas like northern California and a few others are doing best.

• By product type Class A is doing best due largely to higher income tenants with more flexibility.

• The apartment market will slow naturally when housing recovers.

• CMBS market is limping along.

Rental Apartment OutlookOutlook. The apartment sector has clearly the shining star in the broader CRE marketplace. Nevertheless, the jury is still out on whether the current level of performance is sustainable. Our view is growth is not sustainable at the recent pace.

With broader economic recovery clearly softening and wages stagnating while the apartment sector is still heating up, our opinion is that the growth is not sustainable at least mid or long term. Growing stock could easily damage apartment sector fundamentals and lay at least a luke-warm blanket on the once hot sector.

Gross Domestic Product• The first estimate (advance) of GDP for Q3 showed the economy expanded at

2.0%. That is the same as the first quarter but higher than the dismal 1.3% growth recorded in the second quarter.

• Virtually all of the increase was government spending which, in the third quarter, was the highest in decades. The government share advanced at 3.7%. Without government spending, the GDP would have held steady at 1.3%.

• Growth in “non-residential structures” (commercial buildings, etc.) continued to be a drag on GDP while “residential structures” contributed positively at 14.4%.

• Imports fell slightly thereby recording an increase to GDP.

• Consumer spending rose 2%.

Gross Domestic Product

• Over 12 months, the GDP has averaged about 2% which suggests the economy is still limping along and under-performing its potential.

• Q1 2013 advance estimate was 2.5% which is much better than Q4 2012 when it was 0.4%.

• The gain was led by a 4.3% in crease in consumer spending which came at the expense of savings which has retrenched.

• Government spending also declined in Q1 and will likely to continue to do so. Government defense spending declined 11.5%.

• Especially troubling in the first Q1 report was a 5.3% drop in real disposable income.

• Recession probability has declined even in the face of sequestration cuts.

Rate Outlook• The Federal Open Market Committee (FOMC) recently renewed its pledge to keep

interest rates at “rock bottom” until at least 2015. The Fed Funds rate target remains 0% to 0.25%.

• The Fed will keep purchasing mortgage backed securities at the rate of $40 billion per month.

• The Fed will continue to reinvest principal payments from repayment of agency debt thus boosting the Fed’s holdings to $85 billion per month.

• The Fed is openly trying to keep mortgage interest rates low to stimulate real estate markets. Stimulus success thus far is questionable.

Regulation

• History is replete with evidence of Congress creating new laws to solve the crisis just passed.

• Without dwelling on history and focusing solely on recent banking, finance and appraisal issues, we saw CEBA (The Competitive Equality Banking Act in 1988 and FIRREA, The Financial Institutions Reform Recovery and Enforcement Act of 1989.

• At the time, both were the most sweeping pieces of federal legislation to be enacted in the previous 50 years.

• Moreover, both were created to solve problems just passed and to help ensure they did not happen again.

• Then came Dodd-Frank.

Regulation• Congress left a lot to the imagination when it finalized The Dodd-Frank Wall Street Reform

and Consumer Protection Act in December 2009. It was the most sweeping piece of financial legislation to be enacted since the Great Depression of the 1930s, some seventy or more years earlier. The holes in the law have led to extraordinary uncertainty, fear of retroactive enforcement and countless unintended consequences.

• Despite its length, at around 2,000 pages and inclusion of 16 titles, the Act left gaping holes and created enormous uncertainty throughout the financial services industry. Nevertheless, it was signed into law by the President -- gaping holes and all -- on July 21, 2010.

• The holes in the legislation meant 22 affected agencies were required to create some 243 rules and conduct as many as 67 studies to interpret the will of Congress and determine how to proceed. Those numbers, however, are just the tip of the iceberg.

• Because many of the rules affect more than one agency, the requirement for new rules suddenly grew to around 400 when the impact on all of the affected agencies is considered. Additionally, the 67 required studies grew to 87.

Regulation• The Act also includes numerous statutory deadlines which agencies have been scrambling to

meet ever since. The initial deadlines were as early as October 2010 and proposed deadlines reach into 2013.

• Since many deadlines have already been missed it is likely that the rule-making process and the accompanying industry uncertainty will extend past mid-decade.

• Cost of implementation is extraordinary. The Government Accountability Office (GAO) recently estimated that Dodd-Frank implementation could cost the federal government as much as $2.9 billion over the next five years. First year implementation funding was estimated at around $974 million.

• Not all funding expense will come from taxpayers as at least six agencies receive funding from assessments on institutions they regulate. Those institutions are predominately banks however the timing is clearly poor for banks to bear additional costs of regulation when the industry as a whole still remains recession weary.

Regulation

• The newly created Consumer Financial Protection Bureau (CFPB), gets 100% of its funding from the Federal Reserve. The GAO estimates that the bureau will need to hire another 1,225 full time equivalent employees and all of the affected agencies combined will need to hire another 2,600 new employees just to implement Dodd-Frank rules.

• In addition, the Federal Reserve reported that it reassigned 69 of its existing employees to Dodd-Frank implementation and that it planned to hire 290 more and spend $77.5 million on implementation.

• The Office of Financial Research, another newly created agency, with broad powers to force financial institutions to provide data on their financial condition, has $74.5 million to work with and expects to hire another 135 full time staff.

Short & Mid Term Forecast • The nation’s GDP is currently at 2.5%. We expect it to remain at or near that level

for the next two years or so. The current level of job creation is unlikely to drive GDP much higher. A 2.0% GDP is at or near economic stall speed.

• The FOMC is walking a tight rope with its QE3 that could ignite inflation. At the moment inflation is under control and within the Fed’s zone of tolerance. As the Fed appears acutely aware of the risks, it seems reasonable that they will act decisively if too much inflation becomes apparent.

• Business confidence will remain low and investmentdollars will remain on the sidelines. Business loan demand will remain low until uncertainty around taxes, U.S. debt, health care, European crisis and more are resolved.

Short & Mid Term Forecast• Employment nationally and throughout Florida will continue to struggle for the next three to

four years. A return to recent peak employment (about 5.0%) anytime soon is not likely.

• Unemployment rate will likely be higher going forward than it has been historically. Unemployment in the “new economy” probably low 7% range.

• Housing is recovering nicely but remains in a very deep hole with no quick way out. Strong headwinds remain.

• Commercial real estate is recovering but it too will be a long slow grind. Many risks and impediments to recovery remain.

• The risk trajectory for community banks is up. Uncertainty, economic malaise, low rate environment, Basel III capital standards, regulation (Dodd-Frank), too little loan demand, increasing repayment risk due to employment, stagnating wages, diminished household wealth, economic feasibility constraints in development and general uncertainty.

Questions, Comments & ObservationsRequest Publications

William “Bill” Pittenger, MAI, SRA

William_pittenger@comcast.net