WHEN IS THE HOUSING MARKET LIKE OFFSHORING?

Craig Thomas, SVP, Director of Research & Research Systems

When is the housing market like offshoring? The housing market is like offshoring when it becomes the topic of enough newspaper articles and conference speeches that it prompts people who should really know better to, a) start worrying about it for the first time at this very late date, and b) do their best Chicken Little imitations and expect us all to follow suit. We here do try to avoid such rash behavior, in that we have been considering a slowing housing market for a long while now, and we do try to avoid the Chicken Little approach to forecasting. Nevertheless, I do acknowledge that it can be a challenge to not be overly reactionary.

Do you remember when worrying about offshoring at the expense of all other considerations was in vogue? I do. What started as a very prudent consideration of our evolving competitive advantages relative to emerging countries, devolved into a sad spiral of protectionist rants and doomsday prophecy. It became all the rage to outdo one another with ever larger downward revisions in job growth and office demand projections. I even recall some serious discussion of there not being any future whatsoever for U.S. suburban office space.

And yet, suburban office parks live on to this very day?! Imagine that.

So now we have the great housing market slowdown to contend with. In this case, the concerns are much more real and based to a greater degree in intellectual rigor than was the great spasm caused by fear of call centers in India and the rise of cheap foreign medical radiologists. Home prices do touch the majority of households in the country, the reason being that most households own at least one residential property. Offshoring, on the other hand, only really scared the pants off of those office workers who knew deep-down that they were overpaid.

Moreover, the housing market has played an unusually large role in financing household spending in recent years and the result is that there is now more sensitivity to the ups and downs of home prices and transactions than there has been in previous similar circumstances. In the past, outside of those extreme instances where concentrated local economic problems coupled with a falling housing market prompted folks to have to either stay in their homes and wait out a poor local job market or even return the keys to the bank, house price trends have been more of a secondary concern - jobs and wages are always number one. It was nice when homeowners were able to sell at a good price and the opposite case was unfortunate, but the economy certainly didn't hinge on it. It held weight, but perhaps no more than the ups and downs in, say, one's retirement account. The reason is that refinancing and home equity lending were far less expansive than they currently are, and that people tend not to sell their primary residences into down markets if they can help it. Everyone needs some place to live no matter what the market is doing.

This time, however, U.S. households and lenders got a bit more creative, took on a bit more risk and stretched their assumptions with regard to future house price appreciation. In effect, it appears that we have likely overinvested in residential real estate and have perhaps underpriced the risks of owning a home, particularly investment properties, which, incidentally, are more easily sold-off at the end of a cycle.

But enough about all that -- let's get down to brass tacks. How much are we going to lop off of our demand forecasts now that home sales seem to be slowing? Well, let's see: divide by two, carry the three, estimate the average credit card balance, subtract the propensity to watch HGTV, and we come up with zero. Nothing. We're not going to subtract one solitary job from what we have been projecting all along.

The reason is that a housing slowdown is an explicit assumption in our baseline outlook, and has been for a while. Historical relationships between household income and housing prices have made it clear that this could not last forever. We expect layoffs in construction, mortgage finance and residential brokerage. We expect house prices to flatten; we expect that households will have to spend essentially what they earn (Home Depot isn't going to like that!); and as a result, we expect that the economy is nearing its peak velocity for this expansion.

Heck, if it wasn't for the fact that we have so much spent-up demand in the housing market, we would likely be projecting an expansion more similar to that of the booming-1990s. But that's just not in the cards. The only twist to any of this has been that we did expect it to take higher lending rates to set this all into motion, and we continue to expect higher long-term rates in the outlook. It is simply a surprise that it didn't take more of a nudge in the 30-year fixed rate to dampen expectations. Regardless, the rest of the economy is in good shape; so the housing slowdown tempers the baseline outlook, but doesn't halt its progress.

Now, we're not entirely naïve to a downside. It could be the case that oil prices spike anew and bond markets finally turn dour, and rates really do spike to the extent that we have a full-fledged housing bust. That would be a different story. However, here again, we have had our Outlook XL clients covered with access to this very scenario, run right through each of the property types we cover (office, industrial, multi-housing, retail and hotel) in all local markets for several quarters.

In the case of the full-fledged "housing bust", we essentially assume that the housing industry shrinks back to the size it was before the housing market really started to boom, which was in 1995. This loss of jobs - taking industries back to their size ten years ago - is phased over several quarters. Jobs are subtracted from construction, manufacturing, real estate services and mortgage finance. The result is roughly 3.5 million fewer jobs in the nation's economy by the beginning of 2008 than what we have projected in our baseline outlook. Keep in mind though that this isn't an end-of-the-world scenario - it's more like a shallow recession - so we allow folks like restaurant workers and stockbrokers to keep their jobs.

Just to give you a taste of it, I will let you in on which markets take the biggest haircut in a "housing bust" scenario.

Who's At Risk From a Housing Bust?

For all of our clients out there, I'm not telling you anything that you don't already know. In fact, you can go check out the ramifications on the market fundamentals in each local market for each Outlook XL to which you have access. We've got you covered. And for those who are not clients of TWR, but simply members, you at least have the peace of mind of knowing that someone out there has been thinking about this and informing commercial real estate investors for a while now--which I imagine is a warm, comforting feeling. Without a level head about such things, someone might do something rash and we wouldn't want that. Heck, I'd like to think if we hadn't been the voice of reason when it came to offshoring, someone might have gone and sold-off one of their nice suburban office buildings and later regretted it, and that would have been a real shame.

Craig Thomas is a Senior Vice President and Director of Research & Research Systems at Torto Wheaton Research. Craig can be reached at cthomas@tortowheatonresearch.com.

For more information regarding TWR's products and services contact Matt McDaniel, Assistant Director of Client Services at mmcdaniel@tortowheatonresearch.com.