Will an Improving Economy Help Real Estate?

The fortunes of the US real estate market are inextricably tied to the overall performance of the US economy. With this in mind, a recent business economic update we produced with Macroeconomic Advisers LLC provides some significant intelligence for our industry.

Among the key points in the update:

1) After growing at a 4% rate in the third quarter of 2004, that economic growth is expected to achieve an above-trend pace of 4% this year, before again dropping slightly to 3.8% in 2006. Continued increases in consumer and business-capital spending will provide a solid foundation for overall growth. At the same time, a projected upturn in net exports will offset an expected decline in residential construction and the absence of previous positive contributions from inventory building.

2) Above-trend economic growth should continue to absorb the slack in both labor and product markets, resulting in a gradual decline in the unemployment rate to 5.1% by the end of 2005 and to 5% by the end of 2006. The capacity-utilization rate in manufacturing is expected to rise to 80.1% by the end of 2005, and it should reach 81.4% by late 2006.

3) With labor and product markets tightening, core inflation measures will be subject to modest upward pressure. The core CPI, which rose only 1.2% in 2003, is projected to increase 2.3% in both 2005 and 2006. Aided by an expected decline in energy prices, overall CPI inflation should trend lower this year, declining to near 2.25% from the 3.4% of 2004.

4) The Federal Reserve, as expected, increased the target federal funds rate to 2.25% in mid-December. Further increases in the rate--to 4.5% by the end of 2006--can be expected. Long-term interest rates are expected to rise slightly less than short-term rates through 2006.

5) Rising interest rates create a challenging environment for equity valuations. Nevertheless, we expect modest further increases in equity values during the next couple of years. The dollar exchange rate has been volatile, but it is likely to trend lower over the next several years.

Despite some obvious downside risks to this outlook--notably rising oil prices, further declines in the US dollar and the possibility of another major terrorist event on US soil--it's a generally positive outlook for the US economy. This, of course, bodes well for the commercial real estate sector. Although the pace of growth in the US may be slowing, there is still growth, and this means that expansion of the US commercial real estate sector is likely. In fact, nonresidential construction showed its strongest gains in more than two years in January, although overall construction levels in the office and hospitality sectors were down, according to the Commerce Department. However, a steadily expanding economy is good news for real estate investors looking to place capital in the market.

On the residential side, single-family housing starts are expected to decline steadily over the next two years, marking the first time in recent memory that residential construction has made a negative contribution to GDP. In January, residential construction grew by just 0.4%, following a 1.5 % gain in December 2004 and a 1.3% gain the month prior. Despite low mortgage rates, homebuilders also seem to be expecting demand to slow. How slow that demand for new homes becomes may hinge on how quickly the Fed moves interest rates up.

Dale Anne Reiss is global and Americas director of Real Estate, Hospitality & Construction at Ernst & Young LLP. She is based in New York City.