INDUSTRY NEWS

APARTMENT FINANCE TODAY • MARCH 2008

What Are Properties Worth?

Anthony Downs shares his views on the economy and the housing slump.

By Dana Enfinger

Anthony Downs, a senior fellow at the Brookings Institution in Washington, D.C., will give a big-picture outlook of where the economy is heading during the opening plenary session at the APARTMENT FINANCE TODAY Conference April 7-9 in Phoenix.

Dave Woodward, CEO of Colorado-based Laramar Group, will join Downs in the session, “Building A Better Business In An Unsettled Economy.” Woodward was named 2007 Executive of the Year by MULTIFAMILY EXECUTIVE magazine.

Downs has been a senior fellow at Brookings since 1977. Brookings is a private nonprofit research organization specializing in public policy studies. Downs has served as a consultant to many corporations, developers, and government agencies, including the Department of Housing and Urban Development and the White House.

Q: What are some of your observations about the housing slump?

A: In the four previous times since World War II when we’ve produced 2 million units in a year, the following three to four years, production of new homes fell between 37 percent and 40 percent. The peak of production was in 2005. 2008 would be the third year of the decline. So I expect that new starts will continue to fall in 2008. In fact, it rarely happens that past cycles repeat exactly, but I’ve been forecasting for some time that we would have another 40 percent drop in new starts. And that’s not too far from where we are. There were a little more than 2 million starts in 2005. If you take 40 percent of that, you’d drop to 1.2 million new units built. I wouldn’t be surprised if the number of new starts at the end of 2008 is somewhere around 1.2 million.

Q: What is the difference between the new home market and the existing home market in the current economic climate?

A: The situation with existing housing is quite different than the situation with new housing. The price of new housing units is falling because the builders are anxious to combat the problem of low production. They are cutting prices quite substantially. In 2004, and to some extent in 2005 and 2006, a lot of people thought that the price of their existing house had gone up so high that they were interested in cashing in. And so the great many existing homeowners put their houses on the market in 2005 and 2006. That tends to oversupply the market with units for sale. That slows the ability of the market to have continuing increases in prices.

As a result of this phenomenon, the price increase has dropped. The National Association of Realtors data shows that in December 2007, the median price of existing homes fell by 6 percent from 2006. That’s the first time since 1968 that the median price has been less than what it was in the previous year. That’s not exactly a collapse in prices because 6 percent in a year is nothing like a collapse.

Most people who put their houses on the market don’t have to move, and they are reluctant to accept prices that are lower than what they think the house is worth. They are holding out. If prices stay low (and I think they will), they will take their homes off the market. That puts a floor underneath the price in the market. A certain number of people have to move because they got a new job or are going to retire. I don’t think we are going to see a collapse in the price of existing houses. We have had a downturn. It’s been 40 years since prices have dropped. That’s significant, but it isn’t a collapse. I don’t think we have a bubble that’s bursting.

Q: What about seniors who need to sell their homes and transition into a form of rental housing? Is the housing slump delaying them from going over to the rental side?

A: The population that is 65 and over in 2008 is about 2.6 million. That’s higher than it’s been in some numbers of years. But it’s going to be even higher in the future. This is only the beginning of the number of people who are going to want to move. In the year 2027, the baby boom generation will peak.

I don’t think they are going to sell at a loss. Home prices have gone up tremendously since 2000. Between 1990 and 2000, median existing home prices went up by 50 percent. In between 2000 and 2006, prices went up 59 percent. In California, home prices during that six-year period went up 134 percent. The price has fallen 6 percent in the last year. That’s nothing compared to how much they went up. In the next 10 years, the need for housing for people 65 and older will be increasingly important.

Q: What do you think about the Federal Reserve’s cuts on interest rates?

A: The Fed was responding not so much to the drop-off in the new construction of homes, but the freeze in lending. The people who have capital and want to put it in real estate aren’t certain about what the values of properties are.

In commercial real estate, more than in single-family homes, the lending community—since about 2000— was not taking proper account of the risks that were involved, and they were not charging enough to loan money. They were not demanding high enough prices or demanding a high enough interest rate on the money they were lending to offset the risk involved.

The defaults in the subprime market and the resulting foreclosures have awakened people—not just in the subprime market, but in all real estate markets—to the fact that they were not doing proper underwriting. They were not charging enough for the risks they were taking. And the reason for that is that there was such a huge flood of money into real estate starting in about 1997, and then a flood of money after the stock market crashed in 2000. The people who had the money were competing with each other to buy properties, and in any market where you have a whole lot of people on one side of the market and a much smaller number of people on the other side of the market, the people competing with each other tend to lower their standards of quality. The overflow of money created an imbalance in real estate markets.

Now it’s “be harder on the borrower,” which means they are going to have to raise interest rates and also provide for more due diligence. The Fed is trying to offset this to some extent by cutting interest rates, but the Fed is in a box because first of all, inflation is starting to pick up. Secondly, the international value of the dollar is falling. If interest rates are cut further, it will reduce the flow of capital into the United States for investment purposes. The flow of capital reduces the dollar’s value even more.

The Fed probably went too far in cutting interest rates this last time. They shouldn’t cut it much more. [Federal Reserve Chairman Ben] Bernanke has gone about as far as he can go. He may not agree with me. He may want to take it further. Nevertheless, the people who have the money are going to have to charge more for the risks they have to take if they are going to want to put the money into investments or loans. That means that they are going to have to raise interest rates.

Q: What is going to have to change to improve the current condition of the economy?

A: The problem is people don’t know what properties are worth. The lending community needs to do a better analysis of properties, and when they do that, they’re going to charge higher interest rates, not lower ones. That’s going to lower the price of property to some degree, but many sellers of commercial property aren’t willing to do that yet. They don’t want to recognize the change in the market. The change in the market is that lenders are going to demand more return for the risks they were taking. This will mean higher interest rates and lower prices, particularly with commercial property like apartment buildings. I don’t see a collapse in prices, but it’s going to be a change in direction.

Sellers are going to have to lower their prices. If repairing the property, they are going to have to borrow money to do that, and they will have to pay higher prices. Higher cap rates have to be produced for the people who are putting up the money. For the past 10 years, lenders have been putting up the money for a song.