Market Report: March 2006

Dear Friends:

The residential market remains a bit dull. There are signs of life around but overall it is still an uninspiring picture. Our overseas projects are moving along and there is still plenty of commercial activity to make things interesting. I am still looking at apartment projects in Phoenix but more on that later.

--Jim

The Canary in the Mineshaft

The residential market remains problematic and can best described as sloth-like. To say we are heading into a recession, however, would be to overstate the issue. Activity is modest and prices appear to be stable even though buyers are burdened with way too much economic self-doubt for their own good. While it is smart to be prudent in these uncertain times it is also foolish to overlook the good deals languishing on the market. This  mini-consolidation will not last forever.

I think two interrelated questions need to be answered. First, what are the real odds that a buyer’s nightmare will occur? Second, will changes in investment real estate impact home prices? The investment world is useful to residential buyers and sellers. Judging from past recessions, commercial and residential renters are our canaries. More often that not, their actions presage changes in home values and market conditions. A look at renters will help answer both questions.

The Rent is Due

Residential renters are generally more adversely impacted by negative economic changes than the propertied classes. Renters tend to live closer to the economic edge and when prices in a particular sector of the economy surge there can be future difficulties in paying the rent. This problem is exacerbated when wages fail to match increases in the cost of living.

Every economic unit, be it a family or an individual, has its own inflation index. I call this the PRI, the Personal Rate of Inflation. This can best be illustrated by this simple example; a homeowner with a fixed rate mortgage who does not own a car will be less impacted by high credit and oil costs than a tenant who drives his Camaro 20 miles to work each day and has credit card debt. The reality is that last year’s 3.7% inflation rate for San Diego sheds little light. 

Put another way, oil and money can create havoc in residential rental markets unless real wages at least keep even with higher commodity prices. In 1991-1994 tenants temporarily set aside the laws of supply and demand. They simply doubled up, moved back to Topeka or became boomerang children. If this scenario reoccurs, landlords will experience high vacancy rates along with increasing interest expense.

Vacancy rates, while up slightly, are still within a normal range and are not cause for alarm. Demand for rentals is still historically robust even though rent increases are not. Tenants, squeezed by declining wages and higher prices, simply cannot shoulder the type of rental increases that this market should command. As it is still economically difficult, if not impossible, to build any new market rate apartments the long future looks rosy for owners. In the short term, flat rents and rising money costs mean less income and more risk for owners. Those owners are also consumers of houses—profits from investment real estate always find their way into the housing sector.

This is not to suggest we are heading for another 1991. Banks are quick to remove the dessert tray if they see us binging at the buffet. By requiring higher down payments as well as imposing tougher underwriting standards, fewer weak players have been able to buy rental property over the past few years. Banks learned their lessons well and none want to be the next Home Federal. The FDIC is watching.

The picture brightens even more when you examine the commercial arena. Demand for retail, office and industrial space is strong enough to suggest we have nothing to fear in the short term. These sectors are all performing well and are positive indicators of the health of the local economy.  Some businesses do fail but others immediately pop up to take their place. San Diego’s entrepreneurial culture, spawned by corporate exoduses of the past, is a real job engine. While wages may stagnate or decrease, at least the jobs are there and the rent can get paid.

So Why Worry?

Of course there are national and local economic issues to be concerned with. My short list would include gasoline pump prices, the unknown and growing cost of the war in Iraq and stagnating wages of the bottom half of the job force. But my personal worry-favorite involves my own trade. About 12.5% of our local economy is produced by people in the shelter business---title company reps, escrow workers, handymen, and real estate agents. This segment has blossomed over the past few years and is now the gorilla in the room. If the general level of activity in our local sport declines we could suffer a localized recession. So keep buying!

Click here to see Jim's past Market Reports. You can also download Jim's 26 page research paper on San Diego County apartments.

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