Apartment Market Looks Downtown

[HenryTo]

Anywhere here lives in Kansas City? Houston is booming quite a bit as well in terms of new construction in outlying areas and now near downtown. Everyday I go to the office wondering if all these apartments/condos will be eventually occupied.
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Apartment Market Looks Downtown

By NANCY D. HOLT
Special to THE WALL STREET JOURNAL
April 13, 2005

Kansas City, MO., has added 1,400 new downtown apartments since 2000, and that's just the start. Mayor Kay Barnes wants developers to add thousands more rental units and condos over the next five years. The question is can they fill them all?

The city is no boomtown. Job growth is modest and apartment vacancies are still near their recent high of 10%. But $3.3 billion worth of development projects are completed or under way downtown, the biggest of which is the Power & Light District. The nine-block area is being developed by Cordish Co. of Baltimore, and includes apartments, a hotel and 450,000 square feet of entertainment and retail space. Nearby will be a new library, a performing arts center and a sports arena to be managed by Los Angeles-based Anschutz Entertainment Group.

There are reasons to be optimistic that Kansas City can pull off this downtown revitalization. Tax preparer H&R Block Inc. will consolidate operations into a new 525,000 square-foot headquarters in the new entertainment district. South of that area, the Internal Revenue Service and the Federal Reserve are building facilities for a total of 7,000 employees, most relocating from the suburbs.

Developers are turning Kansas City's office buildings into condos, but it's not clear if they will attract many residents.

With a population of 435,000, Kansas City is the nation's 36th largest city. Known for jazz and barbecue, it has never had the boom and bust cycles of other cities. Instead, its downtown began a slow decline in the 1960s.

Developers hope that will change. Over the next two years 38% of the new apartments completed in the metro area will go downtown, according to Property & Portfolio Research Inc. Most developers are relying on a medley of municipal, state and federal tax credits but say that demand for city living is gaining momentum.

Conversions of old office buildings into housing are helping stabilize the city's office vacancy rate at 18.9%, above the national rate of 17.6%. The 34-story former Fidelity National Bank & Trust building this fall will be reborn with 160 apartments. About $20 million in tax incentives will defray the $62 million cost of renovating the Art Deco building, says Glenn Solomon, principal of Simbol Commercial Inc. in Dallas.

Nearby, a local developer has sold all but 20 of the 144 condo units in the Wall Street Tower, the $35 million conversion of a 1975 office building. Townsend Inc. will deliver one-, two- and three-bedroom units this summer, with prices ranging from $170,000 to $595,000.

Kansas City's apartment market is affected by the graying of its population. Only about one-fifth of the city's population falls into the prime apartment-rental demographic between the ages of 20 and 34.

Also, single-family homes are affordable in the city, cutting into rental demand. The median price at the end of 2004 was $150,700, well below the national median of $189,100, and the homeownership rate was 77% compared with 69% nationally.

Growth is another concern. While employment growth is expected to pick up this year, it is likely to remain modest in the coming years. And the merger between Sprint Corp., which is based across the river in Overland Park, Kan., and Nextel Communications Inc. raises additional worries. The combined company will have its headquarters in Virginia, where Nextel is based. While Sprint will keep its operational headquarters in the Kansas City area, the worry is that there will be job cuts, or at best, no hiring.

[HenryTo]

Dave - here's a good article from IBD on the recent speculative trends in the housing market.
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Red-Hot Housing Market Spurs Buying Homes For Investment
Tuesday April 26, 7:00 pm ET
Laura Mandaro


Sherman L. Ragland II has ridden many of the big business waves of the past 15 years, from arranging sales of failed thrifts to starting a dot-com.
The 42-year-old father of three is now hoping the most recent wave, real estate investing, will carry him safely into retirement -- and more.

"The expectation is that my son or my grandson will be the one making the decision" about whether to sell or keep renting the apartment buildings he recently bought, said the Bowie, Md., resident.

Real estate has been this decade's siren song, especially for investors singed in the bear market.

Housing activity remains hot. New-home sales soared 12.2% in March to a record 1.43 million annual rate, the Commerce Department said Tuesday. Existing-home sales hit their third highest level ever last month, the National Association of Realtors said Monday.

Many Investing In Homes

Homes bought for investments made up 23% of all home buys to a record level last year, found the National Association of Realtors.

Vacation homes made up an additional 13%.

A more conservative measure says 9% of mortgages taken out last year to buy homes were for investment, said market researcher LoanPerformance.

The cities with the most investor activity tend to be smaller metro areas not far from major cities but with enough rural life to attract second-home buyers and retirees.

About 19% of mortgages taken out to buy homes in Redding, Calif., north of San Francisco, and southern Oregon's Medford were for investment, said LoanPerformance.

Home buying is now a hot investment class. Individual investors in November ranked real estate as the best place to invest, ahead of drug firms and technology, said the National Association of Investors.

Buying homes for investment has fed fears of a bubble. One worry is that wage growth hasn't kept pace with home appreciation in some areas. A shock like heavy local layoffs or an earthquake could force overextended buyers to sell.

The price and income gap is widest on the coasts. In California, only 19% of families can now afford to purchase a median-priced home vs. 37% in 1999, said the California Association of Realtors.

In greater Boston, prices have jumped 80% in the last five years as employment inched up just 2%.

Those factors gave the Boston area a 53% chance of experiencing a price drop in the next two years, according to PMI Mortgage Insurance. Six California metro areas held over a 32% risk of decline.

"It's 1990 all over again. The market is sitting at the top," said Phyllis Rockower, president of the Real Estate Investors Club of Los Angeles.

Nationally, the situation doesn't look so bad. Over half of families can afford to buy a median price home, said the California Realtors.

As hiring improved, the national risk for a price drop actually fell to 16% last year, said PMI.

Yet national averages mean little to the owner watching home prices on his cul-de-sac fall.

"In specific metropolitan statistical areas, the risk has gone up and is quite high," said PMI chief risk officer Mark Milner.

But interest in investing in real estate hasn't slacked.

A Los Angeles "real estate wealth expo" featuring Donald Trump is expected to draw 25,000 to the two-day event this weekend, said organizer the Learning Annex.

Real estate clubs have blossomed. The National Association of Real Estate Investors' club members neared 150 at the end of 2004, triple their level at the end of 2001.

In contrast, membership in stock investing clubs at the end of 2004 was down 40% from three years earlier, said the National Association of Investors Corp.

For investors like Ragland, real estate looked like an oasis of stability after stocks peaked in 2000.

First, gross income at his firm, which made most of its money from running a private airfield at Reagan Washington National Airport, fell to $2 million from $24 million after the 9-11 attack spurred the U.S. to ban private planes flying near the White House.

Meanwhile, the graduate of the Wharton School of the University of Pennsylvania wrote off a $250,000 stake in an online real estate startup after he and his partners had trouble raising venture capital during the bear market.

And Ragland's IRA, mostly in mutual funds, fell from about $500,000 to $200,000 by 2001.

Luring buyers like Ragland are home price gains like 25% in Los Angeles and even 18% in Baltimore.

For his first purchase, Ragland in 2001 shifted $27,000 from his mutual fund IRA to a "self-directed IRA" that allows real estate investments. With that, he bought a two-bedroom home in Maryland's Capitol Heights area. After investing $7,000 to rehabilitate it and renting it for a year, he sold it in 2003 for $78,000.

The second purchase he "flipped," assigning the contract on the same house to another investor before he closed it, making a $7,500 profit.

Ragland says flipping gets a bad name because some disguise real problems in a home when they sell.

Still, rapid turnarounds have made builders and owners nervous.

Las Vegas home prices shot up 36% in 2004. But last fall, a flood of homes for sale caused Pulte Homes (NYSE:PHM - News) to slash prices, sinking some investors who'd bought high-end models.

Bubble fears have prompted builders to tighten the sales process.

Last week, MDC Holdings (NYSE:MDC - News) said it raised deposit requirements to weed out speculative investors in Las Vegas and Phoenix.

Four years after his first buy, Ragland has moved from flipping to rehabilitating higher priced homes. He sells three rehabbed homes a month for about a $100,000 profit each.

Profit goes into buying apartment buildings, whose value should rise as higher mortgage rates slow demand for homes. He envisions having enough in real estate to turn to other investments.

"I expect to be back in the stock market sometime down the road," he said.

[dmichels]

As you said - I am pretty busy. On the other hand, I have some new research specifically regarding the recent housing starts data that may be of interest to your readers. I will e-mail it to you off-line.

If I do have the chance to update that research, I will. I think it would be very interesting to see how it the data has changed over the past year.

I was afraid you would say there are some other factors that could couple with the housing bust. A storm may be gathering here...

[HenryTo]

Dave - I did go back and read your article, thanks. Care to provide an update for me and for our subscribers?

I know you're really busy but I think it'll make a great guest commentary!

It is timely that you mention that "Coupled with other issues, though, perhaps it could." I'm sitting here Saturday morning reading Doug Noland's Credit Bubble Bulletin and here is takling about GM bonds widening 200 basis points only yesterday. The stock market hasn't been this bad in two years. The DJIA declined 191 points yesterday and yet the ARMS Index still only closed at 1.67. A 191 point decline two years ago this time would have given us an ARMS reading of nearly 3 - suggesting a hugely oversold situation. That means we are now still not close to oversold per the ARMS Index and that a huge decline in the coming weeks is now very likely (perhaps as early as Monday).

Given that GM's pension fund is invested in high yield, emerging market, and the stock market as well as hedge funds, I believe that GM's bonds will be downgraded to junk within the next four to six months.

[dmichels]

You make a good point that the housing market & the possible bubble (esp. in particular markets) is nothing to sneeze at.

On the other hand, I do not think that real estate prices are as out-of-whack with reality as many stocks were during the tech bubble. Do you have the article I wrote last May? If so, you can see that the last extreme run-up in real estate prices was as bad or even worse in many markets across the country as the current run-up. After that "bubble" popped, the resulting value loss was significant, but nothing too damaging (10% value loss total in most markets).

Now, that is only the LAST 'bubble' - perhaps there are earlier examples that indicate real estate could lose even more value, or perhaps we are in an environment that could prompt even heavier losses. I am not sure. But, looking at the data I have available, I tend to think there is not too much to worry about. 10% real estate losses in isolated markets spread throughout the country will not damage the overall economy beyond repair. Coupled with other issues, though, perhaps it could.

[HenryTo]

Dave,

Was just reading your research again - I agree in the sense that despite the record level of real estate ownership and prices relative to household net worth here in the U.S., you can't really say that there is a national housing bubble. The disparity between housing prices and incomes, etc., is most pronounced in places such as Manhattan, San Francisco, San Diego, etc. Here in Texas, things are a bit more sane.

That being said, I think things in general have gotten crazier this time around. A lot more marginal buyers are pulled into the market this time believing that prices will always go up and that having an adjustable rate mortgage is generally okay. The "good thing" (if you can call it that) about the whole deal this time around is that banks in general are much less exposed to real estate prices - given the continuing securitization trade in the mortgage market. So the risks are being transferred to investors such as pension funds, insurance companies, and even hedge funds. A housing bubble in places such as NY, SF, LA, Boston, Seattle, etc., is nothing to sneeze at. This is precisely like the tech bubble in early 2000. Stuff such as QCOM, YHOO, INTC, ORCL, DELL, EBAY, etc., were all trading at nose-bleed levels. At the same time, value stocks (especially small cap value stocks) were being dumped en masse (basically from early 1998 to early 2000). Even legendary hedge fund investor Julian Robertson got caught off-guard. We probably do not have a housing bubble here in Texas and in most of the country, but having sky-high real estate prices in major cities like the ones that were mentioned is probably "bubbly" enough.

So no major bank will fail - which will be good for confidence. The interesting thing would be what would happened if there are defaults in these cities. Fannie and Freddie, presumably, will back these loans - but what if they don't have the resources to do that? Will the government step in? Will pension funds and insurance companies take a hit from this? What would happen to GM's pension plan - the last I heard they were invested in things such as private equity, hedge funds, emerging market debt, etc.

Let me know what you think. I think this will be a very important theme going forward!

Henry

[dmichels]

By the way, business week ran the following article two weeks ago. HT - do you remember the article I wrote over 9 months ago on the housing market "bubble"? It was exactly parallel to this article in terms of calling for rising interest rates, ARM holders being especially at risk, and the fact that there will not be widespread value loss, rather only specific markets that have grown beyond reason are at risk. Most markets' growth will simply slow down, not actually lose value. I do like the article's take on the financing shift, though.

APRIL 11, 2005
COVER STORY

After The Housing Boom
What the coming slowdown means for the economy -- and you

Admit it -- you've done it. You've surfed Web sites such as GetMyHomesValue.com and Domania.com to get a sense of the real estate values in your city. On weekends you skim local real estate ads to check asking prices. And at neighborhood dinner parties you steer the conversation to find out what price that four-bedroom colonial down the block fetched when it sold last month.

In today's ownership society, few investments have been so lucrative for so many as homeownership. Since 2001 extremely cheap mortgage rates have fueled a record-setting level of home sales. Frenzied demand caused home prices to jump at rates not seen since the 1980s and generated 10% gains each year in housing wealth for many Americans, who quickly used refinancings or home-equity loans to convert some of the windfall into cash.

With millions of Americans still eager to get into the housing bonanza, it's no wonder signs of overheating are popping up. At building sites from Florida to California, househunters stand in line just for the chance to buy a home. Investors are flipping properties almost overnight. For some lucky folks, home values have doubled in five years. And in early 2005 the boom was in full swing. New-home sales surprised many economists by jumping 9.4% in February, to an annual rate of 1.2 million. And starts rose to a yearly pace of 2.2 million in the month, a level not seen consistently since housing's go-go 1970s.

But hold on. Despite February's strong numbers, 2005 looks to be the year that housing finally cools off. Thanks to tighter monetary policy and a stronger-than-expected economy, mortgage rates are on the rise. In just six weeks, rates have jumped by almost half a percentage point, to over 6%, by Mar. 25. By 2006 they will likely hit 7%. As a result, economists surveyed by Blue Chip Economic Indicators see housing starts slipping by about 5% this year and more in 2006. Sales are likely to fall by the same amount. On a national level, home prices aren't going to plunge -- they just won't rise very much. "Home prices will rust, not bust, for the next few years," says Richard Berner, chief U.S. economist for Morgan Stanley (MWD ).

Housing's slowdown will be relatively mild compared with past downturns, though there are pockets of froth. Why? It's taking place at a time when the economy is expected to grow by over 3.5%. In the past 40 years, national new-home prices have fallen only twice, and both times were during a recession.

Besides the good job and income growth associated with a healthy economy, there are other compelling reasons that the market won't soften too much. Baby boomers continue to fuel demand -- especially for second homes -- and immigrants are increasingly becoming first-time home buyers.

Even so, the new reality will have a big impact on homeowners who have begun to look at 10% annual gains in home values as a birthright. Consumers who made a habit of tapping into their home equity will find that their home is no longer a personal ATM. Anyone counting on continued home appreciation to fund their retirement or pay for their children's education may face a big shortfall when the bills come due. The new ways that housing is financed also shift the risk of rate changes from banks to homeowners. That could squeeze some families who have adjustable-rate mortgages.

Rising Rates
For the economy, a slowdown in home demand and prices could crimp consumer spending. In just three years, from 2002 to 2004, homeowners who refinanced their mortgages took out a phenomenal $400 billion in extra cash, most of which was pumped back into the economy. That source is going to dry up. The loss will come on top of the eventual softening in construction activity and mortgage lending, both big sources of employment in this expansion.

A cooler housing market could even have an impact on the ability of the U.S. to finance its enormous current account deficit. Since 2000 foreign investors have poured $400 billion to $500 billion into mortgage-backed securities, which seemed safe and attractive. But that money could go elsewhere if the U.S. housing market turns sluggish and fewer mortgages are written.

Of course, predictions that housing is about to peak have been made repeatedly over the past few years. So why does the turn look certain now? "The slowdown is all because of higher rates," says David A. Lereah, chief economist at the National Association of Realtors. True, mortgage rates have bounced up before -- most recently in the summer of 2004 -- but this time economists expect them to keep rising, in part because of the stronger economy. Plus, inflation has picked up, and not just from higher oil prices. In its last survey of regional business activity, the Federal Reserve found that "a number of districts indicated greater ease in passing along price increases."

Higher borrowing costs are already pricing potential home buyers out of the market. In housing, affordability is determined by monthly payments, including taxes and insurance. Take a home buyer with an income of $100,000 and a $40,000 downpayment. At a 30-year fixed-mortgage rate of 5%, the buyer can bid as much as $421,000 for a home. At a 6% mortgage, that falls to $390,000. At 7%, the upper limit is only $362,500. Spread across all income levels, that 13% drop in affordability whittles away at demand and cuts down on bidding wars, which helped drive big price leaps in some areas.

As higher rates dampen demand, the effects will spread to the rest of the economy. In the past three years homebuilding has made an oversize contribution to the growth of real gross domestic product and employment. Residential construction makes up less than 5% of the U.S. economy but accounted for over 12% of average yearly growth since 2002. Similarly, construction jobs tally just over 5% of all payrolls, but hiring at building sites has accounted for 16.6% of all new jobs in the past two years.

For 2005 homebuilders are still optimistic about demand. There's a backlog of unfilled orders for new homes, and Los Angeles-based KB Home (KBH ), for example, recently raised its fiscal 2005 profit forecast. Ryan Brown is one real-estate investor who remains upbeat. He and his business partner, Jeffrey Lewis, buy and remodel homes in the Los Angeles area. Their latest project is a three-bedroom, three-bath house in the Hollywood Hills that is listed for $1.49 million. "The whole bubble thing is really overrated," Brown says. Yet even he has reduced his price expectations, figuring appreciation may slow to about 3% or 5%. For the industry as a whole, higher mortgage rates will inevitably cut orders. By 2006 home construction will become a drag on the economy.

More important than housing's direct effect on the economy will be fallout from the slowdown in home-price appreciation. This is where the economy will be most vulnerable. Thanks to the easy availability of refinancings and home-equity loans, consumers have gotten used to tapping into the equity built up in their homes. In a 2002 study the Federal Reserve found that the average household extracted $26,700 in equity with each refinancing. One-third of that money was used to pay off old debts or add to savings; the other two-thirds was spent. The Fed estimated that the extra spending added a quarter- to a half-percent to consumer spending. That provided a welcome boost to demand as recession, terrorist attacks, and a sagging stock market were dragging down household purchases.

Now the refi windfall is going away. Freddie Mac (FRE ) forecasts that these cashouts will fall from $139.2 billion last year to $95.9 billion in 2005 and $61.2 billion in 2006. Luckily, stronger wage growth will take up some of the slack. But any brake on consumer spending at a time when households are already dealing with ever-higher energy costs will be a big deal given that household demand accounts for two-thirds of the total U.S. economy.

Financing Shift
Assessing the psychological impact on homeowners is more difficult. This time around, price weakness is happening when the economy is strong, and that's highly unusual. "The last time we had outright price declines, we were in recession," notes David W. Berson, chief economist at mortgage lender Fannie Mae (FNW ). So when it comes to gauging consumer confidence, "it's hard to disentangle the job-loss effect from the home-price effect." What does seem certain is that, if prices level off or rise only a bit, owners, especially on both coasts, may feel less wealthy, even though they will not have actually lost money. That could be another drag on consumer demand since studies show about 5.5% of new housing and stock wealth is spent.

Another danger to the household sector has been the proliferation of adjustable-rate or no-money-down loans. These new financing vehicles have enabled more people to buy homes. But the negative effects of rate changes will hit these consumers more than their lenders. Bert Ely, a bank consultant in Alexandria, Va., doesn't see a cause for concern as long as the economy keeps expanding. But he does worry about one thing: If interest rates rise much further, the combination of higher payments for adjustable-rate mortgages coupled with rising property taxes from past appreciation could make it difficult for some homeowners to meet their monthly obligations. "We're going to see some people get burned," Ely says.

Banks, though, should avoid most of the suffering. For all of the mortgage frenzy of the past few years, banks aren't carrying more exposure to housing than in past periods. About one-third of banking-industries' assets are in housing-related assets, such as mortgages and home-equity loans. That's the same ratio as in 1995, before the current housing boom. Barbara A. Ryan, associate director in the Federal Deposit Insurance Corp.'s research division, notes that many of the outstanding mortgages have been repackaged into mortgage-backed securities.

The dangers of speculation, too, have shifted from the building industry to individuals. In past housing booms overly optimistic builders flooded the markets with too many homes built on spec. The result was an oversupply that worsened a downturn, triggered bankruptcies, and caused layoffs among construction workers. Now builders typically wait for a downpayment before breaking ground, so the supply of housing is quite lean compared to sales. The speculation is popping up on the demand side. "In a way we've outsourced building speculation," says Michael Carliner, an economist at the National Association of Home Builders. That means the individuals who bought those properties, and not companies, will bear the pain if price gains or demand don't meet expectations.

Still, the pain won't be as bad as in previous slowdowns. In the last big housing recession, in the early 1990s, starts plunged 12.9% in 1990 and 16.2% more in 1991. That's not in today's forecast. And for all the media attention and party chatter about a bubble, there's little evidence that the national housing market is superinflated.


A Chance to Rebalance
Contrast today's home market with the economy's last bubble -- in tech stocks. In the late 1990s the NASDAQ surged 40% a year as people threw billions of dollars into companies that had no profits or coherent business plans. That's a far cry from 2005's housing picture. The supply of housing has not outstripped demand, and price increases have been supported by gains in jobs and incomes.

And the fundamentals of housing -- the health of the economy and demographics -- argue against a widespread drop in demand. Faster job and income growth should help to offset the drag of higher borrowing costs. Plus, even though a record 69.1% of Americans owned their homes at the end of 2004, demand will still be supported by baby boomers and immigrants.

Boomers, in particular, are driving the second-home market with an eye toward both investment and future retirement. Debbie Bockhold, a certified public accountant in Orange County, Calif., and her husband, Tim, a stockbroker, plunked down $450,000 for a new vacation home -- a two-bedroom condo just 15 minutes from the Strip in Las Vegas. Does she think she may be taking a gamble on housing in the city of big bets? Not at all. With other Vegas condos going for as high as $1,000 a square foot, "the price per square foot [$280] is just a great buy," Bockhold says.

Immigration is another trend that will help housing coast to a soft landing. Morgan Stanley's Berner points out that immigrants accounted for one-third of the new households formed in the 1990s, and these families are entering the housing market. Peter Gonzalez, a 32-year-old naturalized citizen from Mexico, is a prime example. In December, 2003, he purchased a three-unit building in Pilsen, a predominantly Mexican-American neighborhood on Chicago's West Side. He lives in one flat and rents out the other two. With demand for rentals strong, he's looking to raise rents. "I'm going to take the money and either build another rental building on property I already own in Pilsen or purchase and rehab another building," he says. But even he has turned cautious about the local market. "I think it's topped out for now," says Gonzalez.

There is a silver lining from the slowdown. Cooling in markets that benefited most from low rates will bring better balance to the national market as a whole. "People forget," says the Realtors' Lereah. "A housing boom does create haves and have-nots. Not everyone is a have. Detroit and Dallas have seen flat housing markets for several years." Slower price appreciation might make housing more affordable for young families. And builders might appreciate a breathing period that gives them a chance to whittle down their backlogs.

A slowdown in refis and home-equity loans might also address the growing problem of too little savings for baby boomers. Although housing wealth hit a record in the fourth quarter, the large amount of refis over the past half-decade means that equity as percent of real estate stood at just 56.1%. That's far less than the equity ratios of the 1980s and '90s. Boomers expecting to retire on the gains from their homes could face problems if they continue to refinance -- ending up with a substantial mortgage at age 65.

For now, homeowners still have faith that housing is a sure thing, even as they've begun to temper their expectations. Multi-homeowner Bockhold sums up the feelings of many: "Real estate's been good for us." And it has been good for the U.S. economy. But with so many families already owning their homes and mortgage rates rising, the party is winding down. Housing is entering a more sober period when it won't be a prime generator of growth. And the phrase "home, sweet home" won't have giant dollar signs attached to it.


By Kathleen Madigan with Christopher Palmieri in Los Angeles, Ann Therese Palmer in Chicago, and Dean Foust in Atlanta

[dmichels]

I read about 8 months ago that Houston's projected population growth was well below that needed to generate enough demand to occupy the new units for which builders had obtained permits. I read equally damning info re: office space. As a homeowner, oversupply is not appealing at all.

However, with interest rates as low as they have been over the past 1-2 years, can you blame the builders? Once rates rise to normal levels, this building frenzy will subside and market equilibrium will come back to within reach. Until then, enjoy those 2-4% appreciation rates (practically zero in real terms).