Published by the CIPS Network of the National Association of REALTORS®
Second Quarter 2005
An Economic Conundrum
By Mark Lee Levine, CIPS and Libbi Levine Segev
Note: Part of this article was based on another article by Levine: "A Potpourri of Economic Issues Impacting Real Estate and the rest of the World,” scheduled to be published in an upcoming issue of Real Estate Issues, a publication of the Counselors of Real Estate.
In the U.S., we are constantly flooded with a myriad of interacting economic, cultural, political, and social issues. Many of them are "parry-and-thrust," arguing contrary positions in support of diametrically opposed viewpoints. In this article, you'll find a roundup of contrasting positions. It might cause you to review your thinking on these important issues. It might also provide some philosophical background on which to reexamine some issues that previously appeared to be on solid ground.
The Importance of Culture
In many of our classes, such as International Real Estate, we emphasize the importance of cultural aspects in making investment decisions. Investments decisions are not normally made solely by examining financial issues. This is especially true when doing business internationally, as opposed to simply within the U.S.
How important are cultural issues in our decision-making, and in life in general? Professor Dick Lamm, Executive Director at the Center for Public Policy and Contemporary Issues at the University of Denver, examined this question in an article, "The Elephant In the Room: How Culture Matters.1" Lamm, a three-term Governor of Colorado, emphasized the importance of cultural issues in the focus on what's important in educating our children.
Contrary to what some believe, Internal Rates of Return (IRR) and return on investment (ROI) are not the only areas of focus for real estate investors. Many investment decisions are strongly influenced by nonfinancial considerations, such as the desire to own property, the desire to live in a given location, ethical issues, the safety of individuals (as opposed to simply safety of capital), and many other non-financial issues. As the saying goes: “A starving man is not looking for gold.”
Economic Position
In September 2004, the Meyers Group Housing Market Key Indicator Alert2 showed that many factors indicated that the U.S. economy was very strong. On the other hand, many other factors indicated that the economy was having a difficult time. Depending on the focus of the study, determining which of these factors is correct is sometimes difficult. In recent months, the sales price of some commercial property has increased while the Net Operating Income (NOI) has decreased. The argument used here is that it is not inconsistent to think that pricing would increase, with capitalization rates thus decreasing, in a setting where the NOI is also decreasing. So, financial indicators can be confused, and so can those who use such indicators.
There is confusion as to whether unemployment has decreased or increased, given questions as to the types of jobs, seasonally adjusted issues, outsourcing of jobs (including to other countries), what is included in job levels and job descriptions, and so forth. In the Meyers Study noted above, in grading what was performing well, the indication was that the real Gross Domestic Product (GDP) growth would be rated, in their view, as a C+. That same Study showed that employment growth is at B-, indicating a not-so-favorable position. Of course, many politicians would disagree.
Very few would argue that mortgage rates are at level other than A or A+, given the low rates of interest for residential property today when compared with the last 45 years, despite a recent slight raise in interest rates. The Meyers Study indicates some concern with affordability, giving it a rating of B-, despite many contrary conclusions from an economic standpoint, such as employment numbers.
Interest Rates
What are the implications of higher interest rates? Some might argue that higher interest rates portent for good news in that it keeps the economy from overheating and creating a larger bubble. The practical point is that interest rates have been increasing, slightly, in recent months.
In a recent article, “Six Ramifications of Higher Interest Rates,3" Anthony Downs asserted six key impacts from the increase in interest rates.
- Commercial property prices will probably not continue to increase, and in fact will begin to decline.
- Some capital will shift or be moved elsewhere, given changes in interest rates.
- Homeownership will decline or slow; certainly sales of existing homes will also decline or slow. Appreciation will be slower; it may stop, or even drop in pricing of homes.
- The amount of residential mortgage activity will certainly be reduced, as will refinancing. Thus, the era of refinancing and "pulling" money from refinancing for tax-free, tax-deferred use may have seen its days, at least for now.
- There will be some decline in residential pricing, especially in condominium markets that were overheated, specifically in certain condominium markets, such as those in South Florida and Las Vegas, where the condo bubble may burst.
- In most cases, aside from the bubble bursting, as noted, many of these changes will occur gradually.
What does this mean, relative to future planning? Many would differ with Downs and argue that many bubbles will burst, and that there should be concern about refinancing and defaults because of sudden changes in interest rates.
Will Real Estate Values Decline?
On the commercial side, in the REALTORS® Commercial Alliance Report (Summer 2004)4, Torto Wheaton Research is cited as saying that office values will probably decline by 7.4 percent, and retail will decline by 6.5 percent in 2005, "even if interest rates only increase moderately." Whether most real estate professionals would agree on this statement is open to question.
One could ask, however, what the implications of such decline would be in the marketplace, not only on specific buildings, but also the commercial market and the general economic market in the U.S., and in markets outside the U.S. that follow the U.S. position.
Will the Economy Recover? Has it Recovered?
At what rate would the economy recover? In the last few months, there have been many questions as to whether the economy is in a stage of recovery, and whether this will be sustained. There is also the question raised as to the force of that recovery.
In “A Modest Economic Recovery Will Be Sustainable, But Disappointing,5” Craig Thomas argues that the economy is recovering, slowly. He argues that, although we are gaining some jobs and are seeing some improvement in the overall market, there are also unfavorable areas. He notes the pressure for more inflation, rising of interest rates and other negatives that are now apparent in the marketplace, which he believes will cause the recovery to be somewhat disappointing. He notes, "Moreover, expect higher borrowing costs to create a few new troubles of their own in the quarters ahead."
What the implications are to either view should be seriously examined. The Economist, (July 24, 2004)6, in summarizing its data, noted that Alan Greenspan, Chairman of the Federal Reserve, was very positive and upbeat in his assessment of the American economy during his testimony before Congress. Contrary to what Mr. Thomas seems to be saying, Mr. Greenspan said that the recovery was "broad based" and even with some offsets in consumer spending, the recovery would be forthcoming, and "broad" in its nature.
Exuberence: Irrational and Rational
The term "irrational exuberance" entered the lexicon when Alan Greenspan asserted he saw a level of overconfidence among investors resulting from the market doing so well. One could argue, however, that there is such a thing as "rational exuberance." In his book, The Lexus and the Olive Tree: Understanding Globalization, Thomas Friedman used this term to describe a number of factors in the economy and the global interaction of various countries.
An argument could be made that there is a little bit of both rational and irrational exuberance related to the U.S. economy. This same point was made by James DeLisle in his article "Real Estate and the Economy: The Train Has Left the Station7." He concluded, "After struggling through 15-19 months of cyclical bottoming out, the commercial real estate market is finally showing signs of improvement. However, this improvement will not be a near-term phenomenon. It will be a lagged event that will depend on a continuation of the fledgling economic recovery."
Forecasts: but What if…?
Economists and experts in financial markets have made many forecasts. The question might be: What will happen if some of the forecasts are substantially impacted by negative events, such as the terrorist events referred to earlier; negative trade balances; oil considerations; occupation positions by the U.S. and others; wars; medical crises like SARS; consumer confidence (or the lack thereof); inability to refinance because of prior refinancing; financial scandals; increased energy costs; and other unforeseen events?
It is not a matter of if, but rather when the economy will change. Many forecasters of the economy agree that the economy is changing, mostly to the positive. How long it will take for these changes to take place, however, and the timing within various markets remains uncertain. In his article "More Challenges Ahead8," Brian Miller noted that the jobless recovery; the India factor; and the growing presence of high net worth investors are just a few of the issues addressed that will be impacted by the timing of the recovery.
Tax Rates and Budget Deficits
If the U.S. economy is doing better, an argument could be made that there will be more monies available for the Treasury, and there is no need to increase tax revenue through increased taxed rates. It is no secret that most conservatives in government will attempt to hold Federal income tax rates to the current tax position and that liberals generally believe tax rates should be increased. The broad economic question may be to ask what implications are inherent in Federal, state, and local tax increases in the coming months and years.
Because tax rates go hand-in-hand with budget deficits, this will continue to be a great concern for the U. S. economy, one that will have global implications. The U. S. budget deficit is huge. Many states are also facing growing deficits. There are concerns as to how these deficits can be serviced and reduced.
The implication of the tax cuts in the existing U.S. deficit is a question that has been raised by many economists. In his article, "The Trillion-Dollar Question9," NAR Chief Economist David Lereah raises the question of what price the U.S. economy will pay for the position taken by the U.S. government on tax cuts. He says if the economy picks up speed and jobs continue to be generated, the U.S. might work its way out of some of these economic concerns. If the deficit remains high, however, and the U.S. is not able to adequately meet all the needs of the deficit, along with the other obligations of government, it means, " . . . prolonged joblessness; flattening profits and capital spending; and curtailed consumer spending."
Debt:The Joy of Spending
Many studies on the U.S. economy over the last year indicate that consumers have been keeping the economy moving. In fact, consumer confidence has buoyed the economy. Much of this has come from a refinancing spree in which homeowners, without paying income tax, have been able to withdraw their equity from their principal residence at very favorable interest rates.
Also, consumer spending from credit card activity has resulted in trillions of dollars of debt. This increased credit card debt, increased mortgage debt, and increasing debt in other areas, such as college tuition, lead to concern over the ability of consumers to service the debt, especially considering an increase in interest rates that also increases the amount of debt service in any of these areas.
Even if there is no bubble in the marketplace, but the housing market declines, say, by only 5 percent, this could be a sufficient decline to encourage homeowners who have no equity in their property to consider simply leaving their property and going elsewhere, especially in a marketplace where jobs are disappearing and new opportunities exist elsewhere.
When home prices increase, equity is created. In the recent past, this has been the case. But, this may not continue for the near future. In the item, "Cracks In the Brickwork?10," it was observed that, although pricing of housing has increased dramatically in many countries over the last few years, such increases are unlikely in the next few years, not only in the U.S., but also in other countries, such as in Ireland, Britain, and Spain.
Whether there will be continued increases in housing prices in the next few years is the subject of great speculation. In his article, "Boom vs. Bust,11" Jim Carlton states there are conflicting expert positions. One argument is that the housing prices will not continue to rise. John Talbott supports this position in his book The Coming Crash of the Housing Market12.
What is clear on this issue is that we are not clear. No one is quite certain of the eventual trend in the housing market, and yet, the implications one way or another are enormous for the U.S. economy.
Conclusion
What's certain is that many factors in this very complicated economic picture will influence the economy, and that the view remains shrouded. The economy, being bearish-and bullish-is much akin to the warning that has been given to patients by doctors: Don't take a sleeping pill at the same time you take a stimulant! Sometimes the systems fight each other.
© Copyright by Dr. Mark Lee Levine, Denver, Colorado, 2005. All rights reserved.
1 Head-First Colorado (Fall 2003) www.headfirstcolorado.org
2 www.MeyersGroup.com
3 National Real Estate Investor (August 2004) www.nreionline.com
4 www.realtor.org/commercial
5 Real Estate Forum (August 2004) www.reforum.com
6 www.economist.com
7 The Appraisal Journal (Winter 2004) www.appraisalinstitute.org
8 Real Estate Forum (December 2003)
9 REALTOR® Magazine (April 2004) www.realtor.org
10 The Economist (January 3 2004)
11 The Wall Street Journal (June 14 2004) www.wallstreetjournal.com
12 www.mcgrawhill.ca
Mark Lee Levine, Ph.D., JD, is Director and full Professor of the Burns School of Real Estate and Construction Management, Daniels College of Business, at the University of Denver. He is President and Chairman of Levine and Pitler, P.C., and Chairman of the Board of Directors of Levine, Ltd., REALTORS®, a real estate management and brokerage firm in Denver. Reach him at +1.303.871.2142.
Libbi Levine Segev, J.D., LLM, is an associate at the law firm of Isaacson Rosenbaum, P.C. in Denver, CO and is a licensed real estate broker. Reach her at +1.303.256.3961.
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