On Friday, October 18, The Norris Group proudly presents its 6th annual black tie event I Survived Real Estate. An incredible line-up of industry experts joins Bruce Norris to discuss perplexing industry trends, head-scratching legislation, and opportunities emerging for real estate professionals. Proceeds for the event benefit Make a Wish and St. Jude’s Children’s Research Hospital. This event would not be possible without the generous help of the following platinum partners: PropertyRadar and Sean O’Toole, HousingWire, the Apartment Owners Association, the San Diego Creative Real Estate Investors Association and President Bill Tan, Investors Workshops, InvestClub for Women and Iris Veneracion and Bobi Alexander, San Jose Real Estate Investors Association and Geraldine Barry, MVT Productions, Wilson Investment Properties, RODA Construction , and White House Catering. For event information and tickets, visit www.isurvivedrealestate.com.
Bruce Norris is joined this week by Christopher Thornberg. Christopher is the founding partner of Beacon Economics, LLC and widely recognized to be one of California’s leading economists. He is also an expert in economic forecasting, regional economics, employment and labor markets, economic policy, and industry and real estate analysis. He was one of the earliest and most accurate predictors of the sub-prime mortgage crash that began in 2007. He was also a predictor of the global economic recession that followed. Since 2006, Dr. Thornberg has served on the advisory board of Wall Street hedge fund Paulson and Company. Between 2008 and 2012, he was a chief economic advisor to the California State Controllers Office and served as the chair of State Controller Don Chang’s Council of Economic Advisors.
Christopher will be speaking on October 29th, letting everyone know what is going on in the Inland Empire. Bruce wondered where we were last year and if we have made progress. Christopher said last year we saw solid signs of recovery, and the Inland Empire economy has definitely been bouncing forward. There was a little bit of a slowing over the course of last year since globally there has been another worldwide slowdown in growth. China is having issues, and Europe is in the midst of a recession. This has really slowed down the logistics industry and trade in general. This is definitely taking a bit of a toll on the Inland Empire from a job perspective. However, there are a lot of other signs of the areas doing much better. The real estate market is really on fire at this point in time, construction is starting to return, population growth is back, and consumer spending is up. All you have to do is get on one of the highways to know that there is plenty of economic activity occurring. Bruce said he knows the road construction industry seems to be doing well.
Christopher said he has been doing the event with UC Riverside for the past couple years, and it has always been a great time to get out there and meet folks. When they do these events, part of it is to bring people the latest and greatest, both from a news and outlook perspective. At the same time, it gives them the ability to interact with the audience and see what people are discussing. What concerns them is just as valuable. You have to look at things from 30,000 feet, but it is also good to hear what is occurring at the ground level. People also react on anticipation of what is next. This has to do with hiring and aggressiveness. It is good to get a check on where we are going since a lot of people make decisions based on that. Christopher will be speaking on October 29 at the Riverside/San Bernardino Auditorium Event Center. If you go to his website beaconecon.com, you can get the information there.
Bruce asked how our economy is in general as far as the United States. Based on that answer, Bruce also wondered what he thinks the policies of the Fed will end up being. Christopher said our economy is getting better, but it has been getting a little bit better for the last few years. When you take a step back and look at our economy over the last four years, we are in the midst of what you would call a mediocre expansion. It does not really feel like that with the double dips and all the complaints about how terrible things are. However, if you look at the numbers you see that over the last four years we have grown a little over 2% per year. Unemployment continues to fall a little less than a percentage point a year, and we are adding a couple million jobs a year, most of which are full-time. We may not be moving forward as fast as we would like, but on average people are better off. Ultimately, this is what it is about.
Obviously, we would like to see more growth; but under the circumstances, where we are today is about the best we could expect given the crazy political climate in Washington D.C. today, overall problems, and the residual of what happened back in 2008 and 2009 still having an influence on things. Ben Bernanke has been making noise about the end of quantitative easing. What is funny is that this has gotten lot of people up in arms, and a lot are nervous wondering what it all means. There are two things to keep in mind. One, we knew quantitative easing was going to come to an end since it could not possibly go on forever. Second, everybody needs to take a step back and recognize that the low-interest rate environment we are in today is not just a function of quantitative easing. It is a mistake to think this, yet people continue to believe that the Fed has this huge influence on these long-term rates, and this is just not the case.
When you think about quantitative easing 1, 2, and 3, all together they pump about $2 trillion into the economy. Of this, $1.8 trillion is sitting in the banks in the form of excess reserves. 83% of all that cash has gone nowhere; it is just an accounting transaction between bank reserves and the Federal Reserve balance sheet. This is all it is. It is not real money. If you look at where money is now, what it has done is pushed the monetary base from a long-term 6% annual growth rate to an 8% growth rate. This is about what you will need in this current environment. From that perspective, Chris thinks the people are over estimating the impact on long-term rates on the way down. They are probably overestimating the impact when they get rid of quantitative easing in terms of how much up it is going to go as well. We know rates have been rising since they have been doing this since the end of last year. It was not since Ben Bernanke started making comments in June, but rather it has been going on for a while now.
A lot of this simply has to do with the diminishment of fear. For a while rates were very low, but that was because everybody was afraid to put money in anything but treasuries. Now that they economy has a little bit of life and some decent things are happening, you are starting to see a little more investment activity. From a long-term standpoint, you could argue that the housing market is still quite pressed and overall business spending is still pretty light relative to the cash flow. However, it is getting better. What this means is people are walking away from these low return but safe bonds and putting their money inside other places in the economy. This is causing rates to drift up, although he would argue these rates are drifting up for a good reason. There are options, and people are making choices to put their money into something other than funding our massive budget deficit.
The U.S. unemployment rate has gradually gotten lower, but the participation rate has also gotten lower as well. Bruce wondered if this is where most of the improvement is. Christopher said absolutely not and that it has mostly improved because of people getting jobs. If you look at the decline in participation rates, there is no doubt about it that it is low and has dropped to levels we have not seen since the early ‘80s. The group of people who left the labor force can be divided into four groups. The first group are people who have gone back to school. Ultimately this is a good thing since we know that having an education is a good investment for your future.
There is another group of folks who would not be in the labor force regardless. Boomers are getting into that 60-65 year old range and are starting to line up for retirement. The leading edge is past retirement age. The participation rates automatically drop for people over 55, and as a result there is a long-term demographic impact for those moving into those years. This means the participation is going to drop. The other half of the participation group are discouraged workers who can be divided themselves into two camps. The first camp is people who are discouraged but will eventually be re-trained and get back into the workforce.
The other part are the people who cannot be back in the workforce. These are folks who have been left behind. You live in a new kind of world now, and having skills is incredibly important. The creative fields are booming where the low-skilled jobs that used to give a decent wage do not exist anymore. This is reflected in our economy in parr by the huge increase in the number of people on social security disability. They are not really disabled, but they are just really incapable of finding reasonable employment in the context of what our economy did given their skill set. People are barely making ends meet, and Christopher calls this a social crisis and not an economic crisis. These are people we have to worry about socially; but from an economic perspective, whether or not they go back to work is probably not all that important for where the economy heads over the next decade.
Last year real estate was up year-over-year by about 30%. Bruce asked Christopher what he attributes this to and if he thinks this will affect the direction of the future as well. Christophe said for one it mostly refers to California since in the nation prices are only up about 10-12%. Christopher, who is big with lists in this segment, said this is a function of three things. Part of the 30% is imaginary. When we say prices are up 30%, this does not mean the value of your house is up 30%. Rather, it looks like prices are up 30% because of a change in the mix. A year ago and two years ago there were many more distressed transactions in the state of California. Christopher said by their estimates, at one point in time a foreclosure sale would be at about 25% below the market value if it was not a distressed transaction.
Why the low price? Probably the quality of the property was severely diminished, various issues with titles, or other sorts of reasons. The share of distressed transactions in that market mix has gone down massively from half a couple years ago to 15% today. This is pushing the market average price up since there are few of these discounted units. Then there are two other considerations, which are very real. California has one of the tightest housing markets out there. The US overall right now has about five months of supply according to the National Association of Realtors. We talk about supply being the pace of sales divided by the number of units being listed. When we say 4 ½ months, this means there is four months’ worth of sales currently listed in the market. Here in California, it is about 2 ½ months and very tight. Part of this is because there are still a lot of people who are underwater and cannot transact. Even more significantly, it is the fact that the state has not built enough housing for the last two decades, even in the midst of the crisis with prices plummeting. Back in 2009 and 2010, we still had the lowest housing vacancy rate in the nation, which is astonishing when you think about it. This kind of tightness will drive prices up.
Bruce said he was sure a builder would have built something if he could sell it for a profit. Christopher actually disagreed and said if they can build it, they will make a profit. The problem here is not that they will not make a profit, but rather that they are not allowed to build it. Look how long it takes to get anything permitted in the state. You have any kinds of designs on building, whether it is a new development out in the High Desert or some kind of condo/apartment complex. It can take years and years of fighting off frivolous lawsuits all under the name of sequa. If you look at what is happening with the millennium project in Hollywood, all these people are fighting tooth and nail against it and coming up with any kind of excuses to shrink it or prevent it from being built.
What you have here is the extreme form of nimbyism. You have these people complaining that they don’t want a property in their neighborhood since things are getting crowded. This is LA and the second-largest city in the nation. This is a densely populated area, and if you don’t want to live there then move. It is not your world, and we have to share. People are going to be in California, and they are going to come here one way or another. There are two ways of accommodating this. One way is to build on the periphery and keep putting sprawl out there to make these highways bigger, longer, and wider. We could also do the second more reasonable thing, which is to continue to build the transport system that work in the context of a dense economy. It will then grow up and become a modern city.
Construction is usually a bigger piece of the pie than it is right now. This is true in the nation overall, but particularly in California. If you look at housing starts, particularly for single-family, they are not even running 600,000 units annually right now. This is half of the long-term average rate. A lot of this has to do with the fact that we really haven’t seen homeownership. The tight housing markets you are seeing here in the state and in the nation overall is not due so much to a broad-based increase in demand for owner-occupied properties. Rather, it has to do with the fact that there is definitely some demand for it. At the same time, we are also seeing a very large increase in demand for properties by investors. There are about 4 million more single-family rental units in the market today than three years ago.
People are asking why prices are rising so much. A lot of it has to do with that over the last few years, prices have been ridiculously affordable. When you look at incomes and interest rates, housing has not been this cheap in decades in the U.S. overall. Even here in California, it has relatively cheap in comparison to the last few decades. With that in mind, much of price increases is really the housing market bouncing back towards something resembling normalcy. Even with interest rates at 4 ½%, national prices will have to go up another 20% before we go back to normal levels of affordability. This does not account for the fact that incomes are also starting to grow a little bit faster. With that in mind, these price increases are really in a market that is going back to a normal place.
However, there are many other levels that are not doing as well. For example, construction is still very depressed because homeownership rates continue to fall. The mortgage markets are not acting appropriately, and it is very hard to get mortgages in today’s economy. With Fannie and Freddie, for example, the average loan they are making today has a FICO score of about 750. This was at 710 a decade ago. FHA may even be worse as far as who they used to loan to and who they are loaning to now. They used to loan to under 660 with 60% of their business. Now it is something like 9%. Everything is much tighter out there. Refi activity, while it was doing pretty well for a while, has really slowed down quite a bit. There is almost zero equity extraction in today’s markets.
Christopher has heard people make comments that it is starting to smell like a bubble. However, nothing of the sort is happening. You could argue that as opposed to going into a new bubble, these prices are reflecting the leading edge of the housing recovery. If you look at the affordability numbers for California being 36 after the rate hike and price increase, as well as the highest we got in the 90s at 46%, we really have not used up too much of our affordability. That really gives you some sustainability going forward.
Bruce asked about California migration and if it from here that all our growth is coming. There is no doubt we are still seeing domestic migration, but there are really two ways of interpreting this. One way is the hysterics of the right way of looking at things, which is to say that all the millionaires in California are leaving because of our high tax rates. In reality, if you sit down and look at the numbers you see that it is not rich folks. People make a decision about where to live on a consumption basis, not an investment basis. People want to live in California because they want to live in California. If you are wealthy, then you are willing to pay for that, just like if you are wealthy you will end up paying for a fancy car. You are willing to pay for a fancy house in California despite the higher taxes because you want to be here.
The people who leave the state are actually the backbone of the modern economy. It is the mid-skill folks with a two-year technical degree. These are the people who, under normal circumstances, would make $50-$60,000 a year, which means pretty much anywhere else in the U.S. you can get a nice house. However, you cannot here with our system, our lack of housing, and our terribly high prices. They are the ones who are indeed leaving at this particular point in time. We have had this environment of ridiculously low interest rates, and this is great if you are a borrower. However, if you have money and are trying to chase yield, including retirement programs, then it has been a tough time.
Christopher said this is something to get used to for the time. These long-term rates are low not because of the Fed or government policy, but because of the fact that we live in a world that has a lot of capital available. The Asian economies are growing, they’re savers, and they are putting billions of dollars into the capital markets every single year. At the same time, if you take a slow-growing U.S. and recession in Europe with not a lot of demand for capital, and you throw information technology into the mix and a lot more investment bang for your buck, and you add it all up it shows that it is here to stay for a while. We have retirement programs that are projecting about 7 ½-8% returns in an environment that is very unlikely to occur. This is a big problem and we have to stop pretending that these funds are solid; and when they are not we have to start selling our pension funds. They need to be more honest about what their needs are from a financial standpoint. If you did that, the political price would be horrendous because it would mean that the contributions of all sorts of cities and states would just go through the roof in order to back fill all those losses.
Bruce wondered what the alternative would be. He asked if Detroit is going to set a precedent that backfills into some legal problems for other areas. The question really is whether it is legal problems or legal solutions. Christopher said the other way of dealing with this is to start cutting benefits. Over the years, many states have built into their constitution these guarantees that say that while the rest of us out in the world may see losses in their 401k or see their pensions cut, somehow or other public unions cannot be touched. This goes back to the Detroit situation, although Christopher said it is not just Detroit. There are three cases out there today which are going to end up setting some precedent. One is Detroit, another is San Bernardino, and another is Stockton. In all three cases, the question asked is if Federal bankruptcy code trump these local protections for pensions. The answer is probably yes. We have seen a lot of precedent in many different parts of legal discussions in the U.S. in which absolutely Federal law takes precedent and these local conditions will not supersede.
Christopher Thornberg will be featured this year on the panel at I Survived Real Estate 2013. The Norris Group would like to thank its gold sponsors for supporting I Survived Real Estate 2013: Adrenaline Athletics, California Property Solvers, Coldwell Banker Town and Country, Claudia Buys Houses, Elite Auctions, FIBI (For Investors By Investors), In a Day Development, Inland Empire Investors Forum, Inland Valley Association of Realtors, Investor Experts Inc, Keystone CPA, Las Brisas Escrow, Leivas Associates, Mike Cantu, Northern California Real Estate Investors Association, Northern San Diego Real Estate Investors Association, Orange County Real Estate Investors Association, Orange County Investment Club FIBI, Personal Real Estate Magazine, Pilot Limo, Primary Residential Mortgage, Realty 411 Magazine, Rick and LeaAnne Rossiter, Southwest Riverside County Association of Realtors, Sonoca Corporation, Spinnaker Loans, uDirect IRA, Tony Alvarez, and Westin South Coast Plaza.
See www.isurvivedrealestate.com for more on the event and all of our sponsors.
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