Navigating the treacherous real estate markets of the first half of the 1990s required an intense concentration on immediate pitfalls and hazards. Short-range vision had to be acute: for many, the survival of entire enterprises was at stake. As we enter 1996, though, the real estate industry finds its point of view shifted further down the road. Alert to improved conditions, investors, builders and lenders are accelerating growth plans, rather than practicing the tactics of defensive driving. Strategy is rotating to the fore, and the longer perspective is now the essential framework for analysis.
It is a fortunate time for the national economy to go on cruise control. After nearly stalling in the spring, with real Gross Domestic Product gaining only 1.3%, U.S. business activity stepped up nicely to 4.2% last summer. Once again, we see evidence of comparatively long business cycles, with moderate peaks and valleys. The Federal Reserve Bank has to be feeling good about its "preemptive strike" strategy of 1994 in engineering a slowdown, ostensibly to dampen the potential for inflation.
As long ago as 1989, Landauer predicted that the Fed would shift its inflation target (then about 5%) to 3% by the mid-'90s, while giving lip service to a "zero inflation" baseline. We now perceive that the Fed's realistic target will be 2% CPI growth at the turn of the century, as policymakers use the occasion of a recession later in this decade to shift inflation into even lower gear. This should be causing all segments of the real estate industry to rethink assumptions about operating cash flow projections and capital values.
Interest rates should decline in 1996, although we perceive the Fed's easing move last July as a cautious admission that it had overshot the mark in 1994, rather than a commitment to an extended round of rate cuts. If GDP expansion settles between 2% and 2.5%, with a gain of less than 1.5 million jobs and unemployment touching 6% - all highly plausible estimates, in our judgment - we expect short term interest rates to fall about 50 basis points.
The real estate community is naturally skittish about the fragility of the economy. A September 1995 report of the National Association of Business Economists attributed the slowdown in the first half of the year to four factors: a pullback in the housing sector in reaction to relatively high mortgage rates; the Mexican peso crisis; a slump in auto sales; and an inevitable inventory correction from the unsustainably high level of stock rebuilding in 1994. While all four factors had been mitigated somewhat by autumn, the sensitivity of the economy at this point in the business cycle has been amply demonstrated. Hence, our belief that the Fed will be in an accommodating mood in 1996.
Besides a lower cost of funds, what will drive growth, and what are the implications for real estate? First and foremost, real corporate profits are at unprecedentedly high levels. At midyear 1995, after-tax profits were $355.8 billion, up 10.7% for the year. About $220 billion was distributed in the form of dividends, with the remainder retained to finance future needs. In such an environment, corporate competitiveness is tied to increasing market share. This has mixed results forneeds. The amount of cash being retained suggests that the big firms will continue to pursue the aggressive merger and acquisition route, and that "downsizing" has not yet run its course. Demand, in the office sector, will be compromised.
Certainly the banking sector is now the most dramatic example of this. Landauer counted no fewer than 32 bank mergers in the first nine months of 1995, with the giantbetween New York's Chemical and Chase Manhattan banks by far the blockbuster, eclipsing agreements in the Midwest (First Chicago/NBD), Southeast (Nationsbank/Bank South) and Northwest (U.S. Bankcorp/West One). But while the mega-mergers have captured the headlines, virtually every part of the country has seen its small and medium-sized financial institutions in play.
In NewYork City, the Chemical/ Chase Manhattan combination will trigger a 4,000 person reduction in payroll in the near future. Nationwide, FIRE sector employment grew by only 6,000 jobs in the 12 months endingAugust 1995. Coupled with a 27,000 Federal Government job reduction last year, white collar employment is under tremendous pressure, keeping the gains in office absorption modest, though still in the plus column.
Year-over-year gains in U.S. nonagricultural employment were 1.7 million, or 1.4%, as of last August. Where was the hiring occurring? The leading sectors were entertainment (268,000 jobs), health services (257,000),(191,000) and computer services (104,000). Such sectors were not completely exempt from the merger urge (e.g., Disney/Capital Cities and IBM/ Lotus), but overall the trend seems to be upward.
In fact, the blurring between the entertainment, communications and consumer services sectors is already sprouting significant numbers of new firms requiring business facilities. Service firms supporting the explosion of the Internet (up to 3.2 million host computers now, a 45% increase between January and September 1995) are generating space demand from a technology once presumed to drastically erode the need for offices. As one measure, consider the Commerce Department's Index of Business Formations, 128 in August 1995 compared with 115.2 in 1992 and 125.5 in mid1994. Importantly, too, Dun & Bradstreet reports business failures at a five year low through mid-1995.
Real disposable personal income rose 3.3%, or $ 128 billion in 1995. Wage and salary income failed to keep pace, but total income was boosted by the high level of corporate dividends. Add to this the gains realized in bond and stock portfolios and it is apparent that consumers had cash to spend. As in 1994, however, buying was concentrated in durable goods and in services.
Soft goods sales, the mainstay of mall merchants, are disappointing. Some of the problem, in truth, can be laid at the feet of the IRS, which was very late in getting tax refunds out. At the end of March, the IRS was behind $9 billion on the amount of refunds it had processed, compared with the prior year. Spending jumped 1.1% in May, and the figures for September were up a surprisingly strong 1%. Still, 1995 is shaping up as a disappointing year for nondurable goods, especially in the apparel sector.
More ominously for retailing in 1996, consumer indebtedness is reaching record levels, approximately $968 billion at midyear. At 16.1% of pre-tax personal income, household balance sheets are stretched. Credit card delinquencies are a near-record high of 3.3%, even as the economy is expanding rather than dipping into recession. A good deal of economic zip has been provided by borrowed money during the past two years, a period in which installment debt climbed 30%. It is probable that this trend will be drastically curtailed in the coming year.
Landauer's 1992 Forecast predicted that the manufacturing sector would be the engine pulling the U.S. economy out of recession and into a period of sustainable expansion. With the conventional wisdom at the time claiming that America was destined to be a "post-industrial economy," this was a bold assertion on our part. Since then, we have seen sustained double-digit percentage increases each year in plant and equipment spending, a rise in the Industrial Production Index from 104 to 123, and a manufacturing capacity utilization rate of 83% maintained, up from the recessionary level of 78%.The hard goods sector is driving the improvement, and year-to-date employment figures for the durable manufacturing firms show a rise of 120,000 jobs.
Obviously, this has been goodfor industrial property and has contributed to a bullish outlook on the part of the manufacturers themselves. At the September meeting of the National Association of Manufacturers, half of the employers indicated that they will be adding to payrolls again in 1996, and only 13% indicated that they expect to cut their workforce.
Partly in consequence, construction activity in the industrial category (which is mostly factory and assembly facilities) and"other" commercial (including warehouses and retail) has now returned to the 1988-1990 level. Office and hotel development, by contrast, is still only 60% of the levels of the late '80s.The building industry is inching its way back.
Commercial construction Clending grew by 2.7% in 1993 and 4% in 1994, according to Federal Reserve Bank figures.The upward curve is likely to steepen in the next three years, as the office market recovery matures.The spread on construction loans has reportedly narrowed from 250 basis points over LIBOR to 125 basis points. Such real estate lending appears more lucrative to banks than standard business loans, where spreads are even narrower. But Landauer is concerned, for the sake of the long-term health of our industry, that sound underwriting standards remam in place even as the property markets return to balance. Our uneasiness is heightened by the Barron's/Levy Mortgage Survey report that loan volume is at its highest level since 1986.
Looking at longer-range trends, we are encouraged that substantive progress on the Federal budget deficit is being made, and that a commitment to more prudent fiscal policy has bipartisan support. The fiscal deficit has been reduced from 4.9% of GDP to 2.5% in the past three years.While we are skeptical of the balanced budget claims issuing both from the Republican Congress and the Democratic White House, it is truthful to acknowledge that a sea change in fiscal policy is underway. The hyper-stimulus of the ,80s is being withdrawn, and the American economy will be much stronger for the reform.
In sad contrast, we hit new lows in our external trade balance in 1995, giving back all the ground gained between 1987 and 1992.A great deal of the difficulty can be attributed to the peso crisis, which roiled the international currency markets, derailed any short-term NAFTA benefits by drying up Mexican markets for U.S. goods, and put the expansion plans of many exporters into limbo. But the more persistent problems are with our Asian trading partners. Japan has the most sizable surplus with the U.S., and its progress in opening markets, while genuine, is only occurring very gradually. This is, admittedly, understandable given Japan's debilitating problems in its domestic economy. China, as well, has achieved a substantial surplus with the U.S., and trade relations with the world's most populous country are sure to become a nettlesome issue in the last years of the 20th century.
On a technical note, the Government will be re-benchmarking its economic statistics in 1996 to reflect"chain-weighted" GDP calculations. The rationale for the new measure is to more accurately reflect factors such as changes in relative pricing of products, and the effect of technology on the economy. All our comments in this Forecast, however, use the current economic definitions. The Government is also looking at alternative measures of consumer inflation, and we expect definitional changes in this important concept soon, too. But the new vocabulary and statistics, helpful though they may be, do not constitute actual change in the economy. We have oriented our remarks to the key trends as we see them and will, of course, adopt the new Government definitions as they become the common coin of economic discussion.
Our bottom line on the U.S. economy and the real estate industry in 1996? The year shapes up as one close to the long-term trendline for GDP and employment growth, although one in which the Fed will be attentive to the fragility of the expansion. For real estate, user demand will be adequate in most property types - as we will detail in the remaining chapters of this Forecast- and the commercial real estate price recovery will be stepping up at a faster pace than the year's macroeconomic indicators.