Thursday, September 29, 2011

Real Estate Market Analysis

Current Economic Conditions
America is in the third year of a ‘Great Recession’ brought on by a financial crisis. Depressions and recessions induced by financial crises tend to be longer lasting than other recessions. It takes time for banks to de-leverage, write of bad debts, and attract enough deposits to restore their core capital ratios to sufficient levels to begin making additional loans, a process largely dependent on the population savings rate.  Until that occurs, the supply of private credit to business is limited. Given the current popularity and financial advantages to debt financing, ongoing sources of credit are no longer essential just to business expansion, but also integral to business operations and cash flow management.  After the collapse of Lehman Brothers, the climate of uncertainty slowed both the expansion of the money supply and the velocity of money, resulting in a ‘credit shock’ that rippled through out the economy, resulting in delayed payments and missed payments. While the Federal Reserve policy of QE (Quantitative Easing) has increased the volume of money available to overcome the lack of liquidity, political opposition to it is increasing, and it seems unlikely to continue.
The recession has also resulted in massive job losses and an increasing unemployment rate. While job creation is increasing, it is currently only keeping pace with the rate of population growth, and is thus insufficient to bring down the unemployment rate. Additionally, because unemployment only counts those seeking a job, official statistics fail to recognize the ‘shadow pool’ of previously employed workers.
Local economic conditions are rosier. The State of Utah has endured the recession far better than many states, with ongoing economic growth and an unemployment rate lower than the national average. Despite also having been victim of the ‘housing bubble’, its rate of house-hold creation exceeds the national average as a result of its higher population growth, and will be able to reduce the stock of unsold housing at a faster rate.  

18 Month Outlook
The eighteen-month outlook continues to look grim. Previous economic recoveries were ‘housing led’, an impossibility under current circumstances. As a result of both a growing population and a declining household size, new households were continuously being formed. New households represented an ongoing demand for additional housing units. That demand in turn fueled residential construction, and related household formation induced purchasing (furniture, home construction, appliances, etc.). The construction industry in turn provided employment with low skill, low income laborers with low education. Further, this led to a competitive shortage of labor for other low-skill positions, resulting in rising wages. Given the propensity of low-income workers to spend a high proportion of their income as consumption, this resulted in a ‘virtuous cycle’ of economic activity. That dynamic will not be pushing us out of this recession.
Previously able to resell mortgages to be repackaged into mortgage backed securities, banks are now stuck with any mortgages they originate, a trend pending regulation seems determined to reinforce. As a result, lending standards for mortgages are tightening. Combined with the need to rebuild core capital (as mentioned earlier), and declining income, the pool of qualified mortgage borrowers has shrunk substantially.
Further, the rapid appreciation in housing prices permitted many Americans to take home equity loans. These loans were then used to fuel consumer purchases, artificially elevating retail sales per square foot, and raising rents. Responding to these artificially high rents, additional retail space was constructed. Following the advent of the recession, sales tax records show consumer demand crashing, reducing the demand for retail space. Demand on retail space cannot be expected to return to the pre-recession ‘normal’.      
Again, the outlook for Utah remains rosier. Because of its larger than average family size, and high dependency ratio, a higher percentage of purchases are non-discretionary. While inferior complements (cheaper toys, off-brand food) can by substituted, they actual purchase cannot be avoided.
Utah is also riding a rising tide in the health care and education sectors. While the future seems likely to hold lower federal payments for medical care, the aging population of baby boomers will continue to demand (and pay for) quality medical care. Another consequence of the recession has been the return people (especially young adults) to school, and to keep them there longer as they wait out a bad economy. While this has future implications on  National financial stability, the present bounty in education is fueled by subsidized Federal loans, a dynamic which seems unlikely to change.

Real Estate Market Analysis Methods
The purpose of real estate market analysis is to reduce risk in real estate investment. The primary threat to profitability is competing supply. When supply exceeds demand, prices fall to compensate, and may result in a negative capitalization rate. To ensure that real estate development is profitable, it is necessary not only to estimate existing supply and demand, but to be able to forecast future supply and demand at the end of the real estate development process, so that new product can be absorbed into the market at an acceptable rate.
While there exists a large stock of real estate, demand for new real estate is driven by the small segment of businesses and households currently seeking new or additional space. Unlike many industrial products, one of the essential elements of real estate development is developable land. And, as the saying goes ‘They aren’t making any more of it’. While many parcels are interchangeable, parcel locations are (if not unique) then certainly limited. As a result, real estate demand takes place not at an aggregate level, but at a local level.
Critical to determining both demand and supply is the market area for which both totals are drawn. The market area varies by product type. The market area for a regional resort is different for that of a convenience store—the former may span several states, while the latter may only span a few blocks.
There is never exact comparability between product types—in order to avoid niche saturation and direct competition many developers attempt to bridge niches, establish cross-niche appeal, or provide a superior package of amenities. As a result, even with the same geographic area, two different analysts may produce different supply and demand numbers.
Additional supply of a product type are created primarily by competing developers, but may also originate as a result of conversion or rehabilitation of existing real estate. As mentioned earlier, not only the current stock must be assessed, but the ‘pipeline’ representing expected future supply of currently planned, permitted, or under construction.
            Demand for real estate is a more complex phenomenon, because it tends to be more elastic. Increasing the usage of existing space (through over-crowding or more intensive use) can be increasingly inefficient, but it faces no ‘hard’ limit. For each major product type (residential, retail, office, industrial, and service), there are different drivers of demand. For residential, it is a combination of household formation, financing, and socially conditioned tenure-style expectations. Demand for retail and service real estate results when the expected rents per square foot exceeds the construction cost per square foot of additional space. Demand for office space tends to be conditional on increase in employees in the types of businesses that demand for office space, with different types of office users demanding different ‘classes’ of office space. Industrial is similarly driven by sector growth, but is also contingent upon access to necessary inputs—proximity to raw materials, processing facilities, supplier clusters, or equivalent transportation access. Data for projecting employment growth by sector can usually be obtained at a state or metropolitan level from the relevant business/demographic/planning agency or body.

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