Don’t Expect Interest Rates to Go Up Much

Okay, so the Fed may finally start raising the one-day rate of interest, otherwise known as the Fed Funds rate. The financial news media and the stock market seem to be infatuated with this possibility.

Whenever good economic news is reported, the stock market falls. Wouldn’t you think that American stock investors would be happy when 300,000 people get jobs in one month? So why does the market decline when it receives good economic news?

The answer is that the stock market has been propelled upward to record highs in the past five years because of artificial stimulation from zero interest rates. It’s a good gambit. Borrow money for virtually nothing and then invest it in stocks that continue to go up with each passing day that the Fed allows it.

So you have stock prices at artificially high levels and bonds at artificially high levels. Investors fleeing from high-priced stocks and bonds have been pushing up commercial real estate values to prices even higher than the golden year of 2007.

So is this the end of the “low-rate environment?” I don’t think so.

Do you think that investors will stop buying our Treasury bonds because they think prices might fall? I don’t think so.

Why? Because there is nowhere else for bond investors to go.

The rate of interest on a U.S. Treasury ten-year bond is about 1.9 percent. Compare this with bond yields in other countries around the globe.

march26_fig

Bond investors have no place to run. The U.S. ten-year bond is still very attractive compared with Europe and Japan. It’s hard to imagine earning less than one-half of 1 percent for ten years on a Swedish or German bond. How about a whopping quarter of a percent for a Japanese bond?

Then of course there is the ten-year Swiss bond that actually costs you to own it. Maybe you buy it for $1,000 and ten years later you get back $925. I doubt most financial calculators in the world actually have a negative interest rate button.

For you commercial real estate types, plug in a negative interest rate to calculate the present value of a commercial property. I’m guessing the poor little machine will spin for a second and then shut off.

I read recently that up to 16 percent of government bonds around the world now offer negative interest rates.

In this environment, I doubt increasing the one-day borrowing rate will have much impact on the ten-year U.S. bond that largely determines borrowing rates for commercial real estate and residential real estate mortgages.

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Signs, Signs, Everywhere Are Signs

Besides the fall in oil prices to approximately $50 dollars a barrel, other signs point to a decline in the Texas oil industry. Recently published employment figures show the number of persons employed in the state’s oil and gas extraction industry has declined for three consecutive months, registering a much bigger decline in January (Figure 1).

march13_fig1

The last time this happened was early in 2009 when the global economy was in the midst of the Great Recession. This time around the U.S. economy is not suffering a recession, but various indicators are signaling a possible downturn in the oil industry. The number of operating rigs in the state fell to 599 in the month of February (Figure 2).

march13_fig2

Rigs are a good indicator of oil industry activity because when the number of rigs increases, so does demand for other industry services, generating positive job growth in the process. This is nothing new for the Texas economy, which has weathered other periods of falling oil prices, including in the 1980s and the Great Recession of 2008–09. This year many oil companies bought insurance against falling oil prices and are weathering the downturn by eliminating extra work hours, implementing hiring freezes, and asking their service providers for discounted prices. The level of contraction in the Texas oil industry will depend on how long oil prices will hover around $50 a barrel and if oil prices continue to fall. Fortunately, the U.S. economy continues to grow, allowing the Texas economy to balance out the downturn in the state’s oil industry.

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Apples to Oranges: Understanding Market Data Discrepancies

Every quarter, real estate market analysis firms send us reports containing their latest data for various Texas markets (e.g. office/industrial/medical office data for Houston/Austin/San Antonio/DFW). Often, there’s a significant difference in the data provided by each firm even though they are covering the same cities and categories of buildings.

For example, one firm might say that Houston’s office market had six million sf of positive net absorption in fourth quarter 2014, while another might say that market had four million sf during the same period.

A few weeks ago, RECON subscriber “Sky” Pulford with REMAX Commercial in Houston emailed me asking if we could shed some light on this.

I posed the question to Center Research Economist and commercial real estate specialist Dr. Harold Hunt, who said the answer is two-fold.

To begin with, most of the companies have been gathering this type of data for a while. Years ago, they picked the markets they would cover, but they each drew their own lines.

“There are no ‘market police’ out there saying ‘Here’s the Houston market for industrial or for office,’” Harold said. “So they all get to pick their own boundaries. They’ve grown up with that over time, and now you see different geographic areas.”

The other issue is the size of the buildings each firm chooses to report on. One company may survey only office buildings containing at least 100,000 sf, while another may go down to 50,000 or 20,000 sf.

“If you survey down to 20,000-sf buildings instead of 100,000, the difference in the data can be dramatic,” Harold said.

Even so, he said he’s more concerned with trends than with the magnitude of the numbers.

“If two reports both show positive absorption, then the difference in the numbers really isn’t a big concern,” Harold said. “But if one firm shows positive and another negative, then you probably need to dig into the numbers and see what’s happening. Maybe it means the larger buildings are performing better or worse than the smaller buildings.”

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Economy Still Has Plenty of Room to Run

The American economy is dynamic. It runs in cycles. When economic activity and hiring are increasing, we call that an expansion. When economic activity and hiring are decreasing, we call that a recession. This phenomenon of economic cycles is part of the fabric of American life.

Recessions are short and painful. Since 1950, the United States has recorded ten. On average, they lasted 11 months. The longest recession in the last 65 years was our most recent downturn that began in January 2008 and lasted 18 months.

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Fortunately, expansions last a lot longer. Since 1950, the United States has recorded 11 expansion periods. The average length of these expansions is 61 months. As you can see, some expansions can last for a long time. The longest was 120 months from April 1991 to March 2001.

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Notice how our current expansion began 61 months ago, exactly the length of the average expansionary cycle.  Does this mean that we are close to the end of this recovery?  Clearly that is not the case.

Employment is expanding, spending is increasing, car sales are robust and wages are starting to grow again.  Single-family home construction is the one part of the economy that has been slow to recover.  As the number of new homes under construction increases, this will be another engine of economic growth in the coming years.

Nobody can predict future economic activity with any precision, but this economy feels like it still has a lot of room to run. Car sales are expected to be strong again in 2015. If home building picks up at all, that will add more fuel to the fire.

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Houston’s Industrial Real Estate Outlook

I got to keynote the 2015 Commercial Real Estate Forecast Competition for the Houston CCIM chapter this month. There were lots of numbers flying through the room, with some of the best brokers in town sharing their expertise. Here are some of the comments I heard regarding industrial space in the Houston market.

We are likely to see eight million square feet of new industrial space come into the market in 2015. Absorption is expected to be between 4.5 and 6.0 million, so the occupancy rate is expected to decline. Look for more concessions this year and possibly some decline in asking rental rates. New product will be developed in all quadrants of the city, but the vacancy rate in the northwest sector is currently at an all-time low.

Occupancy rates for dock-high warehouses are forecast to be a healthy 93 to 95 percent by the end of the year.

Oil pipe yards and other energy services companies have been hit hard. But higher levels of construction and growth in the petrochemical business is still creating a need for warehouse and industrial space. Bulk distribution is the healthiest segment in the sector. Bayport, the Houston Ship Channel and the east side of Houston should continue to do well in 2015.

Land prices have skyrocketed virtually out of sight. Some land has been selling for $5 per square foot. At this price, very few real estate development deals make sense. Expect to see some downward pressure on land values throughout the metro area.

New development funding has virtually dried up. But stabilized buildings still have plenty of bidders. Foreign capital was buying a lot of real estate in Houston last year. One advisor told me he sold an entire city block to buyers from Eastern Europe. Cap rates on Class-A properties have dropped to the 5 to 5.5 percent range. Class-B and -C buildings are yielding 7 and 8 percent respectively.

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How Were We Useful Last Year? Tierra Grande Readers Told Us

Every so often, we at the Real Estate Center pause for a moment to try and get a sense of what’s on our customers’ minds. Most recently was in December, when we surveyed Tierra Grande readers to find out which TG article from 2014 they found most useful.

The most popular responses will likely come as no surprise to anyone who’s picked up a newspaper lately. The top three articles selected were about water, oil or both (who says oil and water don’t mix?).

What To Do About All This Fracking Water,” Harold Hunt’s look at how water used in the fracking process is being reused, was considered the most useful by far.

Charles Gilliland’s analysis of the correlation between oil prices and rural land prices (“Oil Prices Lead, Land Prices Follow”) ranked second alongside “Whose Water Is It Anyway?,” Judon Fambrough’s discussion of Texas water rights.

Speaking of Fambrough, readers also appreciated his detailed explanation of when electronic correspondences hold up in court as a legally binding contract (“Electronic Transactions: When Email Becomes a Contract”).

The beginning of the year brought a new federal law intended to reform the mortgage lending industry, so it stands to reason that an article discussing its effect on the housing market would resonate with readers. Sure enough, “The Pendulum Swings: Dodd-Frank’s Impact on the Housing Market,” by Jim Gaines, rounded out readers’ picks of the top five most-useful TG articles of the year.

By the way, the first 300 survey respondents received a copy of our 2013-14 Annual Report/2015 Calendar. If you missed out this time around, be on the lookout next fall. You might just have another chance.

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Why Central Bankers Fear Deflation

Almost all Americans can tell you what inflation is. When the price of hamburger goes up or the cost of medicine goes up, that’s inflation. Inflation is a way of life in America. We expect it. The cost of living goes up every year.

When you retire on a fixed income, you really notice it. Every year that goes by, your retirement income buys less and less.

Inflation is not pleasant for consumers.

So why wouldn’t everyone be in favor of deflation? Wouldn’t it be great if the cost of orange juice, bacon, milk and cable TV all dropped. Americans would be able to buy more things even if their paychecks didn’t increase.

In theory, deflation should be no big deal. Prices fall and maybe wages fall. But your quality of life hasn’t changed.

If the price of my house falls by $25,000 and the price of your similar house falls by $25,000, who cares?

I can still sell my house and buy yours. If my wages fall 5 percent and the price of everything I buy falls by 5 percent, then I’m still living the way I have been accustomed.

So why is deflation such a fearful thing to central bankers around the world?

When people think that the price of something could be lower in a few months, they tend to postpone buying it. So the economy starts to slow down. This is part of the concern.

But here is the bigger concern. It has to do with being in debt. Individuals all over the globe have borrowed money to buy things. Corporations have borrowed money to finance growth, business takeovers, dividend payouts and stock buybacks. Governments have borrowed money to buy things they can’t afford to pay for out of tax revenues.

When you have high levels of debt, prolonged deflation becomes catastrophic.

If my wages fall by 15 percent, I may no longer be able to make my mortgage payment.

If car prices fall by 15 percent, car companies may not be able to pay interest on their loans.

If government tax revenue falls by 15 percent, the government may not make interest payments on its bonds.

If prices and wages fall too much for too long, here is the outcome.

  • Homeowners lose their homes to foreclosure.
  • Businesses lose their businesses through bankruptcy.
  • Local, state and federal governments default on their bonds.
  • Pretty much the entire economy collapses under the massive weight of too much debt.

So this is why you see so much panic in Japan and now Europe to put a quick end to deflation. The Japanese intend to print money until there is no more ink. The European Central Bank has announced a similar strategy.

What is the moral of this story for Americans? Be careful with debt.

All of the central banks on earth are launching a full-scale war on deflation. They will probably win, but they might not. Our Fed launched the initial charge with a $3 trillion assault on deflation. Currently our guns (printing presses) have gone silent. But now Japan and Europe are the new fusiliers, launching a massive new barrage against the global enemy. And don’t forget; our guns can easily be redeployed in a moment’s notice.

Meanwhile, all of this money printing is likely to cause prices for commercial real estate to continue to increase as long as the presses are running and the ink supply is adequate.

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‘Clearing Market’ is Good News

During 2009 and 2010, the federal government was being encouraged to “do something” about the large number of families that were delinquent on their home mortgage.

I’m sure that some of the people in my audiences then thought that I was very calloused and uncaring. But, being from the “old school,” I was suggesting at the time that the housing market would not return to normalcy until these houses were actually foreclosed and sold to other buyers.

In a free market, this is referred to as “clearing the market.” Until the market clears, there is much uncertainty about the overhang of potential foreclosures. Buyers are hesitant to purchase, unless the discounts are substantial, because of concern about what happens when distressed homes finally come on the market.

Looking back, we see that this logic holds. Housing markets in states with nonjudicial foreclosure have recorded a strong rebound in prices. States like New York, New Jersey, Florida, Illinois and Nevada are lagging behind.

In my presentations back then, I suggested that our housing market has always been resilient. This is how the market has always worked:

  1. You miss your payments; you get foreclosed upon.
  2. You move into an apartment and rent for several years.
  3. When your credit is repaired, you buy another house.

This logic still holds today.

Here’s a real life story of how the market works. I was speaking in Las Vegas a few days ago to some commercial Realtors. I mentioned how the housing markets were finally clearing except in areas that had restrained the foreclosure process.

After the speech, a young woman in her 40s came up to me and said she had filed for bankruptcy in 2010. She said she cried for a week before finally going through with it. She lost her business in the process.and now works in the commercial real estate industry.

She wanted me to know that she had just bought another house. She was so excited and proud of the fact. She said she bought the house for $160,000. Initially the lender wanted a down payment of $17,000, but at closing, reduced it to $7,900. It was a conventional loan at current interest rates.

This is really good news for the housing market. Thousands of people lost their homes through foreclosure in the past eight years. For several years after foreclosure, it can be hard to get a mortgage to buy another house. But the calendar pages just keep turning. Many of these people that have been shut out of the market to buy a home because of foreclosure or bankruptcy are coming back into the market.

Capitalism works. The free market works.

What is the market? It’s simply the amalgamation of the decisions and thoughts of millions of buyers and sellers each day. Government intervention can postpone reality, but in the end, the market will clear. The quicker this happens, the quicker we are on the road to recovery.

I hope we don’t forget this next time.

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How Low Can Oil Prices Go?

The price of oil is volatile. It’s like the GEICO commercial says “everybody knows that.” Texans in Houston know it. Texans in Midland and Odessa know it.

The oil companies know it, too. Some of their stock prices are off 40 percent in just a few months. Stockholders don’t like 40 percent losses. It doesn’t take a CEO long to begin postponing projects, laying off or furloughing workers and cutting costs everywhere.

Some experts have tried to estimate just how low the price would need to fall before new exploration shut down. The fact of the matter is that some companies have much lower production costs than others. Some companies have hedged their 2015 production. This means that somebody has agreed to buy all the oil they can produce for $95 to $100 a barrel, regardless of how low the market price falls.

How low can it fall? Nobody knows. This big drop in price has caught everyone off guard. Look at the chronology of comments from key players in the oil market.

  • October 3: Price drops below $90 after Saudis announce a price cut.
  • October 13: Kuwait oil minister says “natural floor for prices at $76 to $77.”
  • October 15: Price drops to $81.84.
  • October 15: Saudi prince says Saudi Arabia needs $80 to $90 to balance the budget.
  • October 28: Goldman cuts price target for oil for 2015 from $90 to $75 for West Texas Intermediate crude (WTI).
  • October 28: Citigroup expects Brent crude to be $92 in first quarter 2015.
  • October 28: Deutsche Bank predicts Brent will be $88.
  • November 4: Saudi price cut moves WTI to $77.
  • November 7: OPEC officials say “at $70 there will be panic in OPEC” and “were prices to fall below $70, there will be action from OPEC.” However, OPEC doesn’t expect price to fall below $75 in the near term.
  • November 13: Brent fell below $80 for the first time in four years.
  • November 13: The Energy Information Agency (EIA) forecasts WTI to average $77.75 in 2015, down from its previous $94.58 estimate.
  • December 4: Saudis say oil could stabilize at around $60, a price they believe they could withstand.
  • December 9: Morgan Stanley sees Brent average of $70 in 2015.
  • December 12: “Prices set to drop toward $50.”
  • January 6: WTI trades at $48.

As you can see from this sequence, even the smartest people in the industry were caught completely off guard. As late as October 28, Goldman Sachs thought oil would be $95 this year. As late as November 13, the EIA thought oil would be $77.75 in 2015.

OPEC countries signaled they would like oil to be $80, and that there is a natural price floor around $77, and that prices below $70 would cause a panic.

Oil is a commodity, like gold and silver. Commodity prices can fluctuate dramatically in a very short period. Speculators have a strong influence in commodity markets. This is why prices can spike upward in a violent fashion and collapse with astounding quickness.

Take a look at the price of oil in the chart below. Notice how oil collapsed from above $140 to $32 by December 2008. The world economy was imploding and the United States was in a credit/banking crisis.

Notice also how fast the price of oil recovered, even in the most difficult of times. In just 12 months, the price of oil had recovered to $79 by the end of 2009.

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My opinion is that the price of oil will bottom out this spring as speculators drive the price to the absolute bottom (whatever that may be). Marginal production in the United States will shut down first, because investor funding for new wells will dry up. As U.S. production slows, the price of oil will stabilize.

OPEC countries and Russia will suffer heavy damage with prices at these lowest levels. Internal social pressures will build to the point that these governments finally agree to cut production. This announcement will signal the bottom of the oil price decline debacle.

When will this happen? It will happen when the pain of low prices gets so intense that OPEC calls a special meeting and “adjusts” its production schedule.

Keep up with the latest Texas real estate news. The Center has several RSS feeds designed to help you make better real estate decisions.

RealtyTrac Knows if You’ve Been Bad or Good

You better watch out because Santa’s not the only one with his eye on you this year. Last Thursday, RealtyTrac released its lists of the ten “nicest and naughtiest” housing markets in the country. Six Texas cities can expect to unwrap something cool under the tree this year.

In compiling its lists, the housing market analytics firm studied various quality-of-life factors in 334 U.S. markets — factors that are often important to house hunters. Cities making the nice list had school scores that were nearly twice the national average; crime rates of no more than one-third the national average; average 4.6 unemployment rate or lower; no more than 24 foreclosures per 10,000 housing units; and no more than four sex offenders per 10,000 people.

At number three, Pearland ranked highest of the six Texas cities on the list. Frisco came in fifth, while Sugar Land, Richardson, Katy and College Station filled the next four slots.

The top two spots were claimed by Cary, NC, and Fairfax, Va.

And no Texas cities need to worry about finding coal in their stockings this year. None made RealtyTrac’s naughty list.

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