Housing Drag Inhibits a True Recovery

The United States will not feel that its economy has recovered until the housing market is strong once again. Even if there is stronger GDP and employment growth this year and the stock market remains strong, a lagging housing market will weigh on consumers and therefore the economy. This is because two-thirds of the wealth of the typical middle-class family has historically been in their home, creating a psychological tie with confidence and spending. Residential fixed investment comprised 6.1% of the GDP in 2005. In 2009 and 2010, it was under 3%. Cuts in spending in residential fixed investments accounted for more than 30% of the decline in the GDP during the downturn.

During the past 18 months, the economy has posted growth despite a weak housing market. However, the overall improvement should be characterized as ‘the economy regaining its footing’ rather than a true expansion. Consumers are unlikely to propel the economy to the next phase of growth, largely due to the drag from housing. Nearly 30 percent of home sales are still distressed, 23 percent of mortgages are under water and additional waves of foreclosures are expected through at least 2012.  This puts unusually high pressure on Corporate America to lead a fundamentals-based expansion by increasing investment and hiring.

The ripple effects of the housing downturn have been many, including a sharp drop in development fees to municipalities, property taxes, job losses and lower income among some of the nation’s highest-paying professions. In the commercial real estate sector, large blocks of office space that were once occupied by these professions are still empty, and demand for home-related stores and warehouses has shrunk sharply.  Housing directly impacts CRE financing as well. Commercial banks will remain reluctant to increase overall lending until their current inventory of troubled home mortgages is largely cleared. Unlike most commercial real estate assets, foreclosed or troubled homes do not generate cash flow and must be dealt with much faster. The re-foreclosure rate of modified home loans has also been disappointing, which supports the notion of further foreclosure waves. Despite recent improvements in CRE lending by banks, additional losses on home mortgages will keep lending volume below normal for some time.  A major risk to bank earnings is the unknown quantity of likely foreclosures yet to hit the market in many metros.  This creates a unique opportunity for commercial banks that are not highly encumbered, for the CMBS market, for life insurance companies and other lenders. 

Beyond the short-term pain in the housing market lie some promising trends. The United States is projected to add 1.4 million households per year in the next five years. Current building-permit activity indicates starts of just 500,000 units in 2011.   This supply/demand balance should result in excess inventory burned off by the second half of 2012, assuming the economic recovery stays on track. Until then, housing will not be a contributor to the expansion.  Although the housing crisis remains a macro headwind, the pain is highly localized. While the median price nationally should be close to bottom, harder hit areas continue to see price volatility due to the severity of their local housing crisis including parts of Florida, Phoenix, Las Vegas, parts of Texas, California’s Central Valley and Inland Empire. 

Until the housing market enters a ground-up recovery resulting from the realignment of supply and demand, the greater economy and commercial property lending will continue to under-perform against true potential.

Hessam Nadji is managing director, research and advisory services, for Marcus & Millichap Real Estate Investment Services. Contact him at hessam.nadji@marcusmillichap.com or (925) 953-1700.