Skip navigation

How the End of the Residential Boom Affects Commercial

Is it finally happening? After years of warnings by economists and industry watchers, the housing boom of the 2000s is winding down. The news this week is chock-full of ominous reports about slowing existing home sales, rising inventories, longer selling cycles and lower asking prices.

So if the $2 trillion housing market finally appears to be cooling down, commercial real estate investors should take heed. Here’s why: There is a strong connection between the residential boom and the health of four key commercial sectors — retail, multifamily, office and industrial. Soaring home prices and low interest rates have enabled millions of homeowners to take out home equity loans and cash-out refinancing and that wealth effect has rippled through the economy.

The most obvious beneficiary was retail real estate, where owners of malls and shopping centers have seen valuations soar, along with retail receipts. But the boom also has helped drive growth in industrial construction, particularly on the West Coast, to handle incoming goods from China. And it has bolstered office occupancies in hot residential markets as the mortgage business expanded. Finally, the housing boom has whipsawed multifamily, first depressing occupancy rates as renters became owners and more recently boosting occupancy rates as the condo craze culled units from the rental inventory.

Get ready for some changes. Sales of existing homes plummeted 2.7% last month — more than double the 1.1% that analysts predicted in September — and a solid 2.87 million unsold homes are now on the market (which represents the largest unsold inventory since 1986, reports the National Association of Realtors). What’s more, even David Lereah, the chief economist at the National Association of Realtors, stated on Monday that the housing sector “has passed its peak.”

With the home-equity cash cow running dry, homeowners will curtail their shopping binges next year, predicts Hans Nordby, research strategist at Boston-based Property & Portfolio Research. Nordby estimates that cash-out refinancings generated 6% of all retail sales in 2005, and he expects that percentage to fall to 3% in 2006. “The effects of a slowdown will be most acute in the priciest markets where owners are already strapped trying to pay off their mortgages,” adds Nordby.

This could materially impact retail REITs, particularly those with vast holdings in pricey markets such as Southern California and the Northeastern cities. According to PricewaterhouseCoopers’ most recent Emerging Trends In Real Estate 2006 report, the only factor that will keep consumer spending afloat are wage increases. “But don’t count on it. Energy costs and rising mortgage rates could zip pocketbooks. Retail has all the risk,” reads an excerpt from the bellwether study.

After retail, multifamily is the most directly affected sector in the housing slowdown. And, in this case, the news could be good. With apartments dropping out of the rental pool and more renters priced out of the purchase market, national apartment vacancies dropped from 6.4% to 5.8% between midyear and the end of September, the largest quarterly drop that Manhattan-based Reis Inc. has measured since it began tracking the apartment market in 1999.

“The peaking of the home-ownership market will mean increased demand in rental markets — not so much because of people leaving homeownership to become renters, but rather fewer renters and potential renters being drawn into homeownership,” says Jamie Woodwell, senior director of research at Washington, D.C.-based Mortgage Bankers Association.

There is one caveat, however: Overhanging the rental market is a potential glut of condos. If converters fail to sell recently converted condominium units and throw them back into the rental market, occupancy rates could fall again.

“We definitely believe that the condo converters will take a breather in 2006,” says Michael Cohen, a senior real estate economist at Property & Portfolio Research. Cohen believes that this could slow down the removal of units from the rental market.

A housing slowdown could also ripple through pockets of the office market, especially those where residential mortgage firms have aggressively staffed up in recent years. No market exemplifies this trend better than Orange County, Calif., where heated demand to buy homes and refinance existing loans has fueled a leasing binge on behalf of these firms.

“There are just so many of these expanded companies in Orange County, and some buildings are full of mortgage firms,” says Gene Page, senior managing director at Charles Dunn Company, a California-based real estate services firm.

This won’t help, either. Roughly 37% of all recent homebuyers in Orange County are using interest-only mortgages (whereby the first few years of the mortgage require just interest payments). Orange County is the third most expensive housing market in the country after Los Angeles and San Diego, so it’s obvious why so many new owners are resorting to esoteric financing methods.

Much like the office market, the industrial market is also exposed to ripple effects from a housing slowdown. The difference here is that any negative effects will be delayed for several months because the industrial market tends to move at a much slower pace than its peers. To Bob Bach, national director of research at Grubb & Ellis, the industrial market is possibly the least exposed property class for one simple reason — imports.

“So much of the goods that are shipped throughout the country are coming from abroad, but a housing slowdown that affects retail spending does eventually impact industrial demand,” says Bach.

Of course, the biggest threat to commercial real estate would be a national recession, sparked by a slowdown in retail sales (consumer spending now accounts for roughly 72% of GDP). The gloom scenario is a downward spiral. Consumer spending falters because the cash-out boom ends and the situation is exacerbated by rising fuel prices and higher interest rates on all consumer debt. That triggers falling profits, layoffs, deeper cutbacks in consumer spending…

That suggests parallels to the dot.com bust — an economic watershed that the real estate industry misjudged. “The consensus among real estate analysts was that the dot-com bust would allow other tenants to step into the market,” says Bach of Grubb & Ellis.

“But it took the entire economy down with it, and we saw 25% of all office space in this country brought back to the market. It didn’t seem so healthy after that.”

On the other hand, the housing market is not the same as the equities market—for all the paper gains and stories of speculation, residential housing is illiquid and most homeowners are invested in keeping a roof over their heads. Indeed, the other news this week has been a surging stock market, strong durable goods orders and a rebound in consumer confidence. The plot will thicken next Tuesday, December 6, when the National Association of Realtors (NAR) releases its November index of pending home sales.

Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish