Recovery is Coming Says MIT Professor Bill Wheaton
But It May Not Be What Everyone Imagines
May 16, 2008
A recovery of the real estate market is "in the works" — that’s the good news from William Wheaton, Professor of Economics at the MIT Center for Real Estate. Wheaton shared this news as keynote speaker for the annual spring symposium hosted by the Alumni Association for the Center for Real Estate on May 16th. Drawing a large crowd of real estate professionals, alumni, and students to the MIT Faculty Club, Wheaton stressed — along with his upbeat forecast — that when and how the recovery will occur still remain to be seen.
While the downturn has been a significant setback for the real estate industry, Wheaton was optimistic that it would soon abate. "We are not in a recession," he said flatly, noting that the economy has not experienced three consecutive quarters of "negative growth."
"I dont think (the retraction) will go on for very long," he said, predicting that by the third and fourth quarters of 2008, growth will start to replace the current doldrums. But he added a caveat: the recovery may not turn out to be precisely what the real estate industry would hope for. He described the current housing glut as "a 50 year flood" and noted that he expects it to take another year or two for prices to stabilize.
Still, he thinks recovery of the debt market "for responsible loans" will happen sooner. And the global surplus of capital will help to keep down both rates and yields.
Sluggish Job Growth and a Large Housing Inventory
In explaining why he expects the coming recovery to be unlike past real estate cycles, Wheaton touched on several themes. First, there will be "secular job growth," he said, noting that — thanks to technology — in a number of economic sectors there will be fewer workers in the future, even as productivity rises. And from 2010 on, as baby boomers retire (or try to retire), the United States labor force will increase "at a crawl." That glacial labor growth rate may prevail, he said, for a quarter of a century.
Where employment of 250,000 workers per month was viewed as a sign of economic weakness only a few years ago, Wheaton said such numbers would be welcome now and may not be achieved again anytime soon. In the future, employment of "150,000 workers in a month will be good," he said. "60,000 to 70,000 will be more like the norm. Spain, Italy, and Germany will have negative job growth."
At the same time, the housing correction will continue, but full recovery is some distance in the future. "Excessive construction of housing in the past seven years — much of it speculative or second homes — has led to a vast inventory for sale. The huge flow of renters-becoming-owners (that dominated the market) from 1995 onward is reversing as the subprime market melts," he said. With foreclosures rampant, the rent-to-own tide is ebbing. That adds to the inventory glut.
For the foreseeable future, said Wheaton, slowing aggregate demand for housing, based on demographics, also makes it hard to reduce the huge inventory and allow sales to recover. "The current housing 'correction' has been caused by purely housing-related issues this time. So these factors have to be reversed for the market to start recovering," he said, observing that historically the key to housing prices has been "sales duration." As a rule, when duration exceeds five months, prices fall.
The current sales duration has set new benchmarks. That's bad news for housing construction, since new construction has to stay low in order to reduce inventory additions. "I don't expect any recovery for home builders for at least a year," Wheaton said.
He observed, as well, that rental vacancy rates were essentially constant from 1995 to 2005. "Positive demand in large buildings was accommodated with new construction," he said. "Negative demand in small properties was accommodated by unit conversions from rental to for-sale." That trend aided the rent-to-own transition.
Wheaton said a number of unknowns will define the impending impact of second homes on the market. Continued buying of second homes will, of course, help to reduce the inventory and stabilize prices. But it's unclear to what degree home owners will purchase second homes in this new climate, and that poses a number of intriguing questions.
Since second home development usually entails a long lead time, completions of properties currently under development will extend into 2009. Beyond that, it's hard to predict what will happen. "Demand has turned negative recently with buyers walking away from sales commitments," he said. "Will longer term investors head for the door at once and default, greatly increasing the for-sale inventory? Or will investors be patient, but with high 'reservations'?"
Wheaton also wonders if investors will buy into falling prices and rent to subprime foreclosures. And there is the issue of the global capital surplus. "Will the low dollar lead foreign investors to purchase U.S. condos?" he asks. That could be very good news for heavily overbuilt Sun Belt markets in Florida, California, and Arizona.
It's a complex picture and Wheaton says a host of factors will have to converge for prices to stabilize in the next two years. Construction will need to remain low. Subprime foreclosures have to be "at least partly ameliorated." Buyers will need to step in and buy in distressed second home markets. And buyers who are currently waiting need to take the plunge. It's especially important, Wheaton says, that at least some foreclosed REO properties get quickly converted to rental use.
"If these things do not happen," he warns, "the duration will remain high and prices will continue to fall." Eventually they will reach levels so low that all of those factors come into play.
No More Free Lunch
Wheaton questioned whether commercial mortgage-backed securities underwriting degenerated along with residential subprime loans. The answer, he said, is "No, but CMBX pricing over-reacts." At the peak, in 2005, trading spreads priced in more than 10 percent pool lifetime losses. Still, he noted, "Underwriting LTVs and DSCRs got worse in recent years, but not out of bounds."
On the flip side of the residential property glut, Wheaton acknowledged the high savings and growth rates in the developing world, which have created a global surplus of capital. That enormous liquidity leads to lower real interest rates. "Surplus capital has naturally impacted the yields on commercial real estate," he said.
Why have cap rates declined faster than T-bond rates? It's not due to net operating income growth, Wheaten said. "NOI actually declined over the past few years. The decline happened because risk premiums have also dropped with excess global capital." The capital surplus should lead to a partial return in premiums, he predicted.
"Greater global liquidity also reduces the traditional real estate illiquidity premium," he added. "Capital surplus should lead to a partial return in liquidity. Hence, yields will not rise that much, and income growth will resume its proper role in valuation."
As the market rebounds over the next few years, property rates will increase because of income growth. The recovery is coming, he reasserted, but "There's no free lunch anymore."
Wheaton's presentation was followed by two panel discussions featuring real estate industry leaders from the Greater Boston area. The first panel, moderated by Riaz Cassum, senior managing director of Holliday Fenoglio Fowler, L.P., featured a team of prominent capital providers, including Chris Tierney, vice president investment banking for Goldman Sachs; Susan Leff, senior vice president of Wells Fargo; Bill McPadden, senior managing director of the real estate finance group for John Hancock Financial Services; and Martin Zieff, managing partner of Alcion Ventures, L.P.
The second panel, a team of leading real estate developers and acquirers, was moderated by Brian Kavoogian, president of Charles River Realty Investors. Panelists included Jay Doherty, president of Cabot, Cabot & Forbes; Thomas N. O'Brien, executive vice president and managing partner for the northeast region of JPI; Eric Schlager, chief executive officer of The Bullfinch Companies, Inc.; and Young Park, president and principal of Berkeley Investment, Inc.