Investment Matters: Non- Residential Structures. Introduction. Volume 1 Number 5 May Thanks again for subscribing! By CR

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1 Volume 1 Number 5 May 2008 Introduction Thanks again for subscribing! This month CR is going to shift gears and start with non-residential investment and commercial real estate (CRE). It appears the CRE slump has started (see Investment Matters) and this has negative implications for GDP and employment. For the residential market, the numbers released in April were simply ugly see Quick Hits for a summary. Our intention with this newsletter is to follow the national housing market closely, write about housing economics and mortgage issues, and hopefully provide readers with some tool to analyze their local markets. CR also hopes to provide examples of possible investments or home purchases. Most importantly, we will try to write about the housing and real estate issues that interest you - and your feedback is greatly appreciated. Thanks for subscribing and Best Wishes, CR and Tanta Investment Matters: Non- Residential Structures By CR Recently many companies have announced plans to cut capital spending in This probably means non-residential fixed investments will decline in 2008, as compared to This decline in investment is an important indicator for the economy, since changes in fixed investment correlate very well with GDP. The graph on the following page shows the change in real GDP and Private Fixed Investment over the preceding four quarters through Q The red line is the year-over-year change in fixed investment, and the blue line (scale on left axis) is the year-over-year change in GDP. Correlation is 79%. A decline in residential investment is one of the best indicators of a future recession, and that has been flashing a recession warning for some time. Now some of the focus is on non-residential investment, especially on commercial real estate, to determine if a recession has started. Note: This is a pay newsletter. Please feel free to forward it to friends and business associates, but please only one issue per person. Please include a link to the sign up site: and hopefully recommend they buy a subscription too! Please do not post the newsletter online or a post a link to the newsletter online. Thanks!

2 The second graph on the following page shows two components of private fixed investment: residential (shifted 5 quarters into the future) and nonresidential structures. This graph shows something very interesting: in general, residential investment leads nonresidential structure investment. There are periods when this observation doesn't hold - like '95 when residential investment fell and the growth of nonresidential structure investment remained strong. Another interesting period was in 2001 when nonresidential structure investment fell significantly more than residential investment. Obviously the fall in nonresidential structure investment was related to the bursting of the stock market bubble. However, the typical pattern is that residential investment leads non-residential structure investment. The normal pattern would be for investment in non-residential structures to have turned negative now. There is plenty of evidence of an imminent slump in non-residential structure investment. Research firm Reis recently reported that the strip mall vacancy rate has risen to 7.7%, the highest level since For offices, the vacancy rate has risen to 13.6% nationally according to Grub & Ellis, and they expect the vacancy rate to rise sharply: With demand turning negative at the same time that the construction pipeline will deliver the 94 million square feet still underway, [office] vacancy Page 2 of 14

3 is expected to peak at 18% by the end of Grubb & Ellis economist Robert Bach, April 2008 The Fed survey in April of Senior Loan officers provides further evidence of an imminent slump. The April survey showed an increase in tighter lending standards for Commercial Real Estate (CRE) loans. The following graph compares investment in non-residential structure with the Fed's loan survey results for lending standards (inverted) and CRE loan demand. This suggests investment in non-residential structures should decline soon since lending has tightened considerably. Page 3 of 14

4 Another indicator is the architectural billing index from the American Institute of Architects. From the AIA (emphasis added): [T]he Architecture Billings Index (ABI) dropped two points in March and fell to its lowest level since the survey s inception in As a leading economic indicator of construction activity, the ABI shows an approximate nine to twelve month lag time between architecture billings and construction spending. Page 4 of 14

5 Clearly the CRE slump is here. Now the question is how deep and how fast CRE investment will decline. One way to think about this is to look at previous declines in non-residential investment. The following graph shows non-residential investment in structures as a percent of GDP since Over time there has been a decline in spending (as a percent of GDP), probably related to globalization (more factories were being built overseas). The non-residential investment boom related to the S&L crisis is obvious on the graph, and we should probably ignore that period when looking at a typical CRE bust. The two light red circles show the investment busts during the '90/'91 and '01 recessions. The decline in non-residential investment was fairly rapid during the previous two recessions (a decline in non-residential investment is usually more rapid than a decline in residential investment). In fact most of the decline in investment happened within four quarters. During the '90/'91 investment slowdown, non-residential investment declined 17% in total, and about 14% in the first year. For the '01 investment slowdown, non-residential investment declined almost 20%, and 19% in the first four quarters. It is very possible - based on tighter lending standards that the decline in non-residential investment will be greater (on a percentage basis) than the previous two busts. However, based on commercial vacancy rates, it doesn't appear that some segments of Page 5 of 14

6 commercial are as overbuilt as in the '90/'91 and '01 periods. These two factors somewhat balance out, and my guess based on these two previous busts is that non-residential investment will decline about 15% to 20% over the next four quarters, from a $501 billion seasonally adjusted annual rate (SAAR) in Q4 2007, to about $400 billion to $425 billion in Q and that most of the bust will happen during Mortgage Market Update By Tanta In our January newsletter we observed that Fannie Mae and Freddie Mac were going to be the only game in town for mortgage financing in How well has that prediction held up? UBS reported at the end of April that the subprime and Alt-A mortgage markets remain virtually non-existent, and the Alt-A market is still under severe pressure. In the first quarter of 2008, Fannie, Freddie and Ginnie Mae issues accounted for a whopping 94% of all MBS issued, with Alt-A and subprime together accounting for less than 1% of the remainder. Jumbo A accounted for nearly 2% of security issues. The new jumbo conforming product has been a bust so far, so much so that Representative Barney Frank has threatened to hold hearings on March 21 to explain why we have not gotten more bang for the buck with the raised conforming loan limits. In an apparent pre-emptive response, Fannie Mae announced in its first quarter news release that it would price jumboconforming loans flat to conforming for the remainder of What that means for retail loan pricing isn t yet clear; industry sources tell me that while the liquidity premium for these loans will be eliminated, there will remain a likely loan size adjustment resulting in loan rates around higher for fixed rate product than for conforming conforming. Whether that s enough to kick-start the jumbo mortgage pipeline I rather doubt, but it will allow some happy talk to be talked. Fannie Mae also announced that it would begin purchasing refinances of Fannie Maeowned performing loans at LTVs up to 120%. I have yet to see any estimates of how many loans might be in the money for such a refinance. Freddie Mac issued its quarterly cash-out refinancing report on May 2, indicating that 56% of Freddie Mac refinances in the first quarter of 2008 were cash-outs, down from (revised) 77% in the Q The total equity cashed out dropped from $36 billion to $29 billion, the lowest quarterly figure since the first quarter of Finally, Housing Wire ( reports that what to do about subordinate liens was indeed the major topic of discussion at the May 5 meeting at the Treasury with a dozen or so major lenders. Whether it s workouts (short sales, deeds-in-lieu, and modifications) or straightforward refinances, efforts to put borrowers in more affordable loan terms are being stymied by the inability or unwillingness of second lien lenders to resubordinate or reduce the balance of their liens. Many of the mortgages in question had junior liens taken out after the original property purchase, of course, in order to liquidate equity. But very significant numbers of these loans were piggyback purchases, in which the second mortgage constituted 20% of the original purchase price. As Housing Wire reports: Page 6 of 14

7 Some of the proposals on the table at today s Treasury meeting, according to American Banker, included a discussion of the conditions that would be needed to induce second lien holders to resubordinate during a refinance of a troubled borrowers first mortgage, as well introducing token fees paid to second lienholders by first lienholders in the event of a short-sale. Solving for second liens is the single most critical issue on the table right now, said one source, a senior executive at a national bank that asked not to be named. If that doesn t get handled, it doesn t matter what the FDIC proposes, or what Barney Frank wants done. Until we see what specific proposals are on the table for dealing with second lienholders, I don t personally expect the short sale process to unclog in the coming weeks. Page 7 of 14

8 CR s Quick Hits New Home Sales The first graph shows New Home Sales vs. recessions for the last 45 years. New Home sales were falling prior to every recession, with the exception of the business investment led recession of It appears the U.S. economy is now in recession (not official) - possibly starting in December - as shown on graph. New home sales in March were the lowest since This is what we call Cliff Diving! Page 8 of 14

9 New Homes Month of Supply The second graphs show that the New Homes "Months of supply" is now at 11 months. This is the highest level since Note that this doesn't include cancellations, but that was true for the earlier periods too. The all time high for Months of Supply was 11.6 months in April Once again, the current recession is "probable" and hasn't been declared by NBER. Page 9 of 14

10 Builder Confidence The NAHB reports that builder confidence was at 20 in April, unchanged from 20 in March. Usually housing bottoms look like a "V"; this one will probably look more like an "L". (this refers to activity like starts and sales, but will probably also be apparent in the confidence survey). Starts and Completions On the following page is a long term graph of starts and completions. Completions follow starts by about 6 to 7 months. From the Census Bureau: Privately-owned housing starts in February were at a seasonally adjusted annual rate of 1,065,000. This is 0.6 percent below the revised January estimate of 1,071,000 and is 28.4 percent below the revised February 2007 rate of 1,487,000. Single-family housing starts in February were at a rate of 707,000; this is 6.7 percent below the January figure of 758,000. Page 10 of 14

11 Existing Home Sales The following graph shows existing home sales, on a Seasonally Adjusted Annual Rate (SAAR) basis since Sales in March 2008 (4.93 million SAAR) were the weakest March since 1998 (4.87 million SAAR). Page 11 of 14

12 Existing Home Months of Supply The next graph shows the existing homes 'months of supply' metric for the last six years. Months of supply increased to 9.9 months. This follows the highest year end months of supply since 1982 (the all time record of 11.5 months of supply). Even if inventory levels stabilize, the months of supply could continue to rise and possibly rise significantly if sales continue to decline. Page 12 of 14

13 Real Home Improvement Investment The BEA reports that real spending on home improvement fell 2% in Q (from Q4 2007), and has fallen about 4% in real terms from the peak. This is probably just the beginning of the home improvement slump; if this housing bust is similar to the early '80s or '90s, real home improvement investment will slump 15% to 20%. U.S. Homeownership Rate The homeownership rate has now returned to the levels of the summer of Note: graph starts at 60% to better show the change. The declining homeownership rate shows the huge drag on the housing market of the shift at the margin of households moving from ownership to renting. Page 13 of 14

14 Homeowner Vacancy Rate The final graph shows the homeowner vacancy rate since A normal rate for recent years appears to be about 1.7%. There is some noise in the series, quarter to quarter, so perhaps the vacancy rate has stabilized in the 2.7% to 2.9% range. Still this leaves the homeowner vacancy rate almost 1.2% above normal, and with approximately 75 million homeowner occupied homes; this gives about 900 thousand excess vacant homes. The excess supply is even higher when we consider new home inventory and the high rental vacancy rate too. The total excess housing units is probably close to 1.7 million units. Best Wishes to all, CR and Tanta Page 14 of 14