2007 Economic Outlook: On the Road to Recovery

January 1, 2007

If the second half of 2006 proved to be a tough period for residential real estate practitioners, “the good news is, the bad news is mostly behind us,” says NATIONAL ASSOCIATION OF REALTORS® Chief Economist David Lereah.

Lereah predicts that sales in many markets throughout the country are poised to pick up in 2007 and get on track for a full turnaround in 2008. He points to steadying mortgage interest rates, the top-out of home inventories, and declining new-home production as indicators that many markets are reaching a sustainable sales pace.

Look for good prospects in commercial real estate, too. “The U.S. economy is proving very resilient, and that favors commercial real estate,” says Kenneth Riggs, CRE, president and CEO of Real Estate Research Corp. in Chicago.

Sales and leasing were on a growth curve in the office, industrial, and multifamily sectors throughout 2006 and will stay that way in 2007 and into 2008, economists say.

For retail properties, though, the going will be a little tougher. Hit by still-soft consumer confidence and a megamerger between the Federated Department Stores and the May Department Stores that prompted the announcement of store closings, retail was the only commercial sector in which vacancies rose and rent growth decreased in 2006.

But while both residential and commercial have a few dark spots, 2007 promises to be a brighter year for real estate than 2006.

Residential market upswing

No doubt about it: “There was a lot of pain out there last year,” Lereah says.

On a national basis, home sales contracted by about 9 percent in 2006, to 6.5 million units from about 7.1 million units in 2005. And inventories rose about 36 percent to 3.8 million units available for sale nationally in mid-2006 from about 2.8 million units at the end of 2005.

But the slowdown looked very different depending on which market you were in. In 2006 it was a case of the higher you go the harder you fall.

Markets that experienced the hottest sales during the boom years—think fast-growth metro areas in California and Florida along with Washington, D.C.—are now facing the largest corrections. They’ll also be the last to turn around and may not see real improvement for a year or two.

“The large coastal markets are driving things down,” says Celia Chen, director of housing economics at Moody’s Economy.com. “Interior markets won’t see much of a correction if the economy keeps growing.”

Compare that performance with a market like Austin, Texas, which saw only 2 percent average price growth in 2004 and 2005. In 2006 it saw a healthy 8 percent price gain. What’s more, inventories are going down, not up. Ironically, the same is true of many markets from Atlanta to Charlotte, N.C. Lereah calculates that formerly hot markets such as Miami comprise only about a quarter of all residential markets, but their size is such that they’re skewing national numbers downward, making the slowdown look worse than it is for the bulk of the country.

On a nationwide basis, NAR is predicting existing-home sales will dip slightly to 6.4 million units in 2007 from an estimated 6.5 million in 2006. New-home sales should ease to 1 million units from an estimated 1.1 million units in 2006. Price growth will stay relatively flat, inching down to 1.7 percent in 2007 from an estimated 1.9 percent for all of 2006.

Why low is good

Although no one likes to see low average price gains, a moderate slowing is essential for restoring vitality to the market, says Lereah. That’s because affordability is at the core of the current downturn.

Unlike past housing downturns, which were precipitated by slowing local economies, U.S. economic fundamentals remained solid, with 3.3 percent growth in the gross domestic product, job gains averaging about 150,000 a month, and interest rates remaining historically low during 2006.

Instead, home sales suffered because rapid price appreciation, fueled in part by an influx of speculators in hot markets, and higher interest rates pushed people out of the market. “Homes were no longer a bargain,” says Chen.

Negative media coverage about a housing bubble didn’t help either. “It became a self-fulfilling prophecy,” says James Gaines, a research economist at the Texas A&M University Real Estate Center in College Station, Texas.

A slight decline in prices will make it possible for more potential buyers to transact. Lereah estimates that for every 1 percent reduction in price gains, some 50,000 more buyers will return to the market.

Already, the pieces for a market recovery are falling into place. In addition to low national appreciation of 1.5 percent for 2007 and plenty of inventory in markets around the country, the Fed has stopped raising interest rates and appears to be holding to a neutral policy for the near future. Wages are also on the rise, up about 4 percent annually in 2006.

These factors are helping to improve housing affordability. After dropping to a low of about 100 in mid-2006, NAR’s Housing Affordability Index started ticking back up, and at the end of November was projected to stand at 106 at the end of 2006. At this level, a household earning the national median income would have 106 percent of the income needed to by a house at the national median price.

No quick recovery

Even so, it will take all of 2007 before sales start to grow again on a national basis.

In addition to the Miamis of the world that have big inventories to work through, there are a few markets, such as Detroit, where the slowdown isn’t a product of affordability but of a local economy in contraction.

The multiplier effect from weakness in a major sector, such as the auto industry in Detroit, is great because of all the other industries it touches. “There’s a ripple effect throughout the industry down to the local car salesman,” says Gaines.

“These were the areas with the weakest price growth already,” says David Berson, vice president and chief economist at Fannie Mae.

Lereah calls these markets “non-boom stallers” and estimates that they make up about 10 percent of the country. Price growth in these markets is expected to be zero in 2006. Plus they’ll have to work through increased inventories that on average will be about 25 percent higher than in 2005.

How quickly home sales turn around in these markets depends on a host of broader economic factors like oil prices (which are heading down after reaching record highs in early 2006) and the continuing gains in jobs and wages that support consumer spending.

“Consumers account for two-thirds of all spending,” says Berson. “If they hang in there, there’ll be no further downturn in these markets. If they don’t, these cities could swing into recession.”

With continued economic resiliency, the long-term outlooks for both residential and commercial real estate remain positive. Says Riggs, “We crossed 300 million people this year, and we’re getting 3 million people a year. Many of these people are getting jobs, they have the money to buy, and they have to live somewhere, so the trends are favorable for real estate across the board.”

ECONOMIC INDICATORS
  Inflation
rate
Gross
domestic
product
Unemployment
rate
30-year
fixed
rates***
Existing-
home price
increases
Existing-home
sales
New home
sales
2005 3.4% 3.2% 5.1% 5.9% 12.4% 7.1 million 1.3 million
2006* 3.4% 3.3% 4.6% 6.5% 1.9% 6.5 million 1.1 million
2007** 2.3% 2.7% 4.7% 6.6% 1.7% 6.4 million 1.0 million
*Estimated **Projected ***Average for year

Commercial stays strong

The expanding U.S. economy and an influx of institutional investment capital are keeping the volume of sales transactions high in the commercial sectors. “Institutional investors have returned in a big way,” say NAR economic analysts.

For all the sectors, lending volume is up and delinquencies are down. High construction costs are holding speculative activity in check. Imports and exports remain at high levels, sustaining demand in warehouse and distribution facilities. Strong corporate profits are giving businesses the wherewithal to expand both their factories and their offices. From an investor perspective, though, the robust price gains generated from commercial sales in recent years will be harder to get going forward. “Investors will have to look for ways to enhance value,” says Riggs.

  • Offices: A slight upswing in new office buildings at the end of 2006 kept the vacancy rate relatively flat, but with healthy job growth, continuing healthy absorption levels, and only moderate speculative development, the vacancy rate is expected to drop by the end of 2007.
  • Industrial: A shortage of properties suitable for traditional and inland ports is fueling an uptick in build-to-suit facilities for warehouse and distribution. The conversion of some older industrial properties to mixed-use and residential purposes is also keeping inventories down and rents up. Vacancy rates are forecast to maintain the steady down trend they’ve seen since early 2004. Rents are expected to increase slightly.
  • Retail: Only a few years ago retail was an investor favorite, but these days regional shopping centers and neighborhood centers alike are suffering from store closures and softening consumer confidence. On the upside, personal income is rising, and retail sales have been solid. Retail vacancy rates are likely to rise slightly in 2007. Average retail rent is forecast to increase marginally.
  • Multifamily: The apartment market is strengthening as potential home buyers remain in rental housing and echo boomers enter the rental market. New supply is matching absorption, keeping vacancy rates flat.
  Vacancy
rate
Rental
rate
change
Net absorption
Industrial
2005 9.9% 2.9% 295.8 million (sq. ft)
2006* 9.7% 1.5% 201.2 million (sq. ft)
2007** 9.0% 3.6% 233.1 million (sq. ft)
 
Multifamily
2005 6.2% 2.9% 350,975 (units)
2006* 5.2% 4.8% 262,762 (units)
2007** 5.3% 5.0% 203,050 (units)
 
Office
2005 13.6% 5.2% 90.3 million
2006* 13.0% 5.5% 74.5 million
2007** 12.2% 8.3% 70.0 million
 
Retail
2005 7.2% 2.9% 30.5 million
2006* 8.2% –1.4% 3.9 million
2007** 8.2% 2.6% 16.0 million

Source: NAR Research

Robert Freedman

Robert Freedman is the former director of multimedia communications at NAR.

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