Reports of the Phoenix real estate market's demise have been greatly exaggerated
Phoenix, now the fifth largest city in the United States, could be the poster child for metropolitan areas where a bursting residential housing bubble has created economic discord. However, after parsing data from both the commercial and residential sectors, the Phoenix real estate market appears much stronger than the national press paints it, report Larry Seay, chief financial officer of Phoenix-based Meritage Corp., and Crocker Liu, McCord Chair in Real Estate at the W.P. Carey School of Business.

Speaking at an April 5 seminar in Phoenix entitled "Frontiers in Real Estate: Hedging Your Bets," both Seay and Liu were optimistic along all points of Phoenix's real estate continuum. The seminar was presented by the W. P. Carey School's Center for Real Estate Theory and Practice.


A builder's view of residential

The national press has jumped hard on the fact that the inventory of Phoenix's existing single-family homes has jumped from about 5,000 homes in early 2005 to over 45,000 today, Seay points out. But he says the statistics look bleaker than they actually are.

Phoenix generally has an inventory of about 25,000 homes, he says, and the dip to 5,000 was an anomaly during the height of the bubble. A lot of this dip can be attributed to speculation; as much as 50 percent of the inventory ended up unoccupied or investor-owned. More importantly, Seay adds, with so many people moving into the Valley of the Sun, this "will burn off very quickly."

"Is an inventory of 45,000 homes too many? Sure, but consider that you have 65,000 homes being built every year in Phoenix and 128,600 people moved into the metro area last year. That extra 25,000 will burn off," Seay says. "Phoenix has gotten a lot of bad press about the overhang, but Phoenix is a strong market."

In regard to commercial (office, industrial, retail and multifamily) markets, Liu expects the Valley of the Sun "to experience greater growth." In addition, he adds, investors will be very active in the market this year and the next.


A new look at the commercial market

To discern the health of Phoenix's commercial market, Liu employed an unusual matrix combining corporate earnings and property returns, which begs the question, how does the change in corporate profits relate to property returns? As Liu explains, since land represents one of the four factors of production (which in turn generates the rents that comprise cash flow to property and the demand for more space which leads to price appreciation) and corporate profits are the residual after all production costs are paid, expect increasing profits to increase property returns.

"If you take a look at all the major corporate players, i.e. General Dynamics, Motorola, Intel, etc., in the Phoenix metro area as defined by the Greater Phoenix Economic Council, take the number of local employees for each of these different companies, and then take a look at forecasted earnings for the next 12 months, what this would give you is some sort of predictive measure of how real estate is growing," explains Liu.

There is a catch, however. There's another corporate index -- from Bloomberg -- that tracks the local economy. The difference between the two is that Bloomberg solely tracks companies with a headquarters in Phoenix, such as P.F. Chang's China Bistro Inc. The Bloomberg index includes a large number of high-tech and start-ups so it would show more volatility. Indeed, using the GPEC index as a base, the average forward looking EPS is $3.34 and has been on a moderately upward trajectory, while the Bloomberg index trajectory looks more like a hockey stick with a large inclining handle and the forward looking EPS closer to $14.

Showing both indexes, Liu overlaid the price per square foot for office and retail space, and the resulting graph showed similar upward trajectories for both price per square foot and earnings per share. "You can see there is a relationship between what happens with our local corporations, the kinds of profit they are generating, and to our local real estate markets," he stresses. "The same is true for industrial and apartment."

After looking at earnings per share data, Liu concludes Phoenix should experience a growth rate of 1.4 percent for 2007 and an even greater expansion in 2008.

Liu also parsed existing data to discern the local investment market. What he saw, for example, was a capitalization rate (estimates value of real estate investment; net operating income divided by sales price) for the Phoenix office market that has been running correspondingly to the national average, from about 9 percent and above in 2001 to under 7 percent at the end of 2006. In the same vein, the trend line for price per square foot for the Phoenix and the national markets both head upwards at about the same pace. However, the national price per square foot average is consistently ahead of Phoenix.

A similar pattern takes place in regard to the apartment market. Cap rates have declined from about 8 percent in 2001 to below 6.5 percent in 2006. The only difference is that Phoenix cap rates have declined more precipitously and the cap rate is actually below 6 percent. On a price per unit basis, the Phoenix and national average moved upwards over the same period of time. Again there was slight difference, with the Phoenix market trending north moderately, while the national price per unit average trend line showed volatility and was steeper. The result is that the national price per unit for apartments has remained higher than Phoenix.


Price pop?

That is actually good news for Phoenix, notes Liu. "My suspicion is, investors will probably be coming into the Phoenix marketplace if conditions persist for office properties. Prices will pop!" But in the industrial and retail markets, Liu concludes, investors will have to look hard to find bargains.

Liu looked at annual acquisitions in the Phoenix area by market sector. First off, he says, about a third of the investors in the Phoenix market are institutional players, another 15-25 percent are private out-of-state buyers, which means some 50 percent of the acquirers are regional or national players, Liu says.

In the industrial sector, institutional investors are the biggest players, while in the office sector the big investors include opportunity and hedge funds, although institutional players are also major participants. As for retail, the big investors are real estate investment trusts (REITs) and private out-of-state players. Finally, for multifamily, in the past five years, the action has been with condo-converters, with some institutional and private out-of-state investors.

As noted, in the single-family residential market, things look a lot uglier than in the commercial sector, but again, as Seay observes, one really has to look deeper to see that this market is healthier than it first appears.

From the beginning of 2002 through the first three quarters of 2004, the median list price of a Valley of the Sun home basically plateaued, hanging about the $200,000 range with no significant appreciation. Then the bubble came to town and by May 2005, prices shot up like a rocket to a peak of over $350,000. Since then, the median list price has drifted back down to just above $300,000. This was a significant price decrease, says Seay. Prices dropped, he adds, even in the Multiple Listing Service "and you usually don't see the price of resale houses come down a lot."

Added to this was the overhang of new homes on the market. In fact, Seay says, there was an "inventory correction," with high contract cancellations, sales and backlogs declining, spec inventories on the rise, adjustments to house and land prices and finally to inventory write-offs.

But don't despair, Seay cautions, because the Phoenix market is one of the most attractive in the nation based on:
• Population -- The greater Phoenix metro area boasts 3.8 million people, with a growth of 128,600 last year. Arizona was the fastest growing state in 2006.
• In-Migration -- Over a 10-year period, from 1993 to 2003, in-migration was up 60.9 percent.
• Employment -- The metro area employs 1.9 million people. In 2006, the market added 90,700 jobs. Unemployment as of the beginning of the second quarter 2007 stood at 4 percent
• Job Growth -- In 2006, Phoenix ranked second in terms of job growth right behind number one, Nevada, and ahead of number three, Idaho, two states with a much smaller population base. From 2005 to 2015, the Phoenix job market is expected to expand by 24.3 percent. In comparison, Dallas/Fort Worth will expand 19.4 percent, but Las Vegas should grow by 35.5 percent.
• Household income -- The median household income stands at $50,651, which is above the national average. Says Seay, "Phoenix gets a bad rap for not having good jobs, but the median is higher than the national average."
• Lifestages -- Again, says Seay, people talk about Phoenix being a retirement areas, but the percentage of the local population that is in the "mature years" is just slightly ahead of the national average.

Concludes Seay, for the period 2005 to 2010, expect Phoenix population growth, household growth and household income to run ahead of the national average.

Meritage ranks as the fifth largest homebuilder in the Phoenix area, so in regard to the outlook for homebuilders in the area, Seay sums it all up this way: the market will be difficult in 2007 as the inventory overhang must be reduced; price competition will pressure margins, but eventually cancellation rates will slow; and then favorable economic conditions will bring underlying support to the market.

Adds Seay, "long-term demographic factors are still in place."


Bottom Line:

• After looking at earnings per share data, Liu concludes Phoenix should experience a growth rate of 1.4 percent for 2007 and an even greater expansion in 2008. "My suspicion is, investors will probably be coming into the Phoenix marketplace if conditions persist for office properties. Prices will pop!" But in the industrial and retail markets, Liu concludes, investors will have to look hard to find bargains.
• Seay sums it all up this way: the market will be difficult in 2007 as the inventory overhang must be reduced; price competition will pressure margins, but eventually cancellation rates will slow; and then favorable economic conditions will bring underlying support to the market.

By: Robert Holt

Have you noticed the nightly news running this same story for what seems like an eternity: “Real Estate: the bubble bursting”

Many media outlets have latched on to this as their mantra, especially in the wake of so many “amateur” investors pulling profits to go somewhere else. However, there is nowhere else better to go, as they will soon find out. The facts are clear to those that choose to see; Phoenix is the best market in the country.

Arguably, market conditions exist that might lead to a slowing in the market led chiefly by lower consumer confidence and higher interest rates. Nonetheless, the greatest enemy is misinformation, which can produce a self-fulfilling prophecy.

But one only has to look at the countless housing developments in progress to think otherwise about the future of real estate.

Real Estate is a local economy, and what happens in San Bernardino isn't necessarily true of what happens in Phoenix.

One only has to take a drive to the Desert Ridge area to see the plot of land Toll Brothers spent $50 million to build homes on or cruise Carefree Highway to see large plots of land being developed commercially or stroll over to Sonoran Foothills to find a 3000 sq. ft. home starting at 600K before upgrades. In addition, there was recently a 5400 sq. ft. Toll Brothers home to go pending for 1.38mm on the resale market.

As for the big companies who have a lot more money to spend on research, it doesn't look like they're too worried about a “bubble.” If large-scale developers such as Standard Pacific, Centex, and Toll Brothers, a leading developer of “luxury homes” are developing more land in the north valley so aggressively, what do they know that the media doesn't?

Perhaps it's the mass exodus of California residents looking for affordable housing. Phoenix is STILL the most affordable major metropolitan area in the country that also happens to be ranked number one in job growth. People move because of affordability and jobs. Add to this a great climate and proximity to the west coast and Las Vegas, and you are left with a recipe for dynamic growth. Currently, the greater Phoenix area population stands at 3.8mm people and is to grow to 4.6mm in 3.5 years and to 6.1mm by 2010.
What drives prices? That’s right, you guessed it. The number one economic reason is supply and demand. For every 2.5 persons that move into the valley we need another housing unit. As long as we have 150,000 people moving into the valley, which is projected to continue for the next 15 plus years, there will be a need for 60,000 homes a year.


It should be remembered that the developers have marketing and research departments with multimillion-dollar budgets and a finger to the pulse of the economy in a way that the media doesn't. When it comes to predicting real estate trends, watch the developers, not the nightly news. News Media is a business that needs to get your attention and what better way than through FEAR, which is more often than not unfounded.

Food for thought

The housing market across the country remains strong despite the phantom of a real estate bubble.

Economists say it may take a little longer to sell your house, and you may not be able to ramp up prices as much as in the past few years at least in some markets especially those where it has been hot for an extended period. However, unlike areas such as our neighbors to the west in Nevada and California where housing has been appreciating for 4 and 10 plus years respectively, the greater Phoenix area has just recently (the last 12-18 months) started to see double digit appreciation. I will explain a bit later why this fact is of importance and how it relates to Phoenix being positioned to continue its double digit appreciation for at least a few more years with steady appreciation for some years to come.

Even one of the worst natural disasters in U.S. history seems likely to add fuel to the real estate market. In many metro areas, prices are still on their way up and sales are still chugging along according to the National Association of Realtors. The organization expects record sales this year sparked in part by rebuilding and relocations resulting from Hurricane Katrina, even as the storm drives up the cost of construction and housing prices. It is important to remember that in an area like Phoenix where new home construction prices often set the pace and the ceiling for the rest of the housing market, you will see construction costs continue to rise due to the effect of Katrina, scarcity of materials, demand for housing and fuel cost all of which will lead to higher priced new construction homes resulting in higher overall housing prices.

Nationwide, the NAR is expecting existing home sales to increase 3.4 percent to 7.02 million in 2005. New home sales are expected to rise 6.7 percent to 1.28 million. The national median home price is expected to rise to $205,100.

Of course, the housing market depends on location, location, location.

While there is softening in some markets, mainly in the Midwest, reports from the Federal Reserve indicate strong residential real estate growth for September.

Florida and the Southwest including Phoenix are red hot. Southern cities outside Florida saw growth continue at a steady pace. California and the Northeast continue to set record prices, even as the time it takes to sell a house stretches in some markets. The Northwest is still a healthy place to sell a house. And in Hawaii, property is still both pricey and easy to sell.

As for the Valley of the sun, Phoenix shines bright!

Phoenix was near the top of the nation for the first half of the year for annual increases in median existing home prices, as reported in the Phoenix Business Journal. According to some local economists, it is the kind of market where increases are likely to continue, even if there is an overall downturn in the national real estate market. Why? Simple economics 101, when demand outpaces supply coupled with higher cost add inflation into the mix and there is your answer. With the population of Phoenix continuing to grow at a record pace, expect higher home prices to persist and consider what Lee McPheters, contributing editor to Arizona Blue Chip Magazine recently stated, "It is reasonable to expect faster-growing states such as Arizona and Nevada to continue to see stronger housing markets."
As of September 20, 2005, the Phoenix, Mesa and Scottsdale area was rated #1 in an MSN housing report as the best place in the country for value in home buying both presently, as well as into the future as compared to all other national cities. The article went on to state that due to affordability and positive job prospects, Phoenix will continue to outpace the rest of the country for years to come.

As I stated at the top of this newsletter, it is important to keep in mind that Phoenix has only recently started to experience high appreciation levels. In fact, Phoenix never showed up in any report showing the top cities with double digit appreciation stretching back 3 years or more. Compared with other cities both large and small, Phoenix is still the most affordable metropolitan area in the country. One recent statistic showed that if Phoenix continued to appreciate at a rate of 25% each of the next four years and all other cities remained flat, it would only fall from the number one most affordable city to number four. This fact alone should bring comfort to those who think we are over priced.

There are however, a number of other forces driving up home prices: rising wages and increased buying power being two of the reasons prices continue to push higher.

Home prices tend to grow at the rate of income growth, which over time, is usually about 1.5 to 2 percentage points over the rate of inflation.

In addition to wages increasing, the falling mortgage rates have allowed home prices to go up even faster than income growth. Compared to the average 1980-vintage mortgage at 15 percent interest the cost of buying a home is less than half what it was 25 years ago. Based on overall buying power and affordability, housing in the United States is as cheap as it's been in 25 years.

Furthermore, the next time you hear the doom and gloom scenario of how the “housing bubble” will pop due to the lending practices of the mortgage industry consider this point: the fact is that the banking industry is in far better shape than at any other time in the last 30 years and certainly much better than during the time of the savings and loan crisis in the 1980s. So far loan loss rates have remained extremely low. Only about 1 percent of mortgage loans are currently in foreclosure, according to the Mortgage Bankers Association, a rate that has fallen slightly over the past year.

So why is Phoenix positioned to outpace the rest of the country and continue to see double digit appreciation?

Best value in the nation. I know it is hard for some of you to imagine this to be true, but facts are facts and despite the run up in prices, Phoenix is still the most affordable metropolitan area in the country.

Population Growth. Maricopa County surpassed Riverside, CA and Clark, NV as the number one fastest growing area in the country posting the largest total number of people moving into the area. With an estimated 3.5 million people currently living in greater Phoenix and with that number expected to double in the next 10 years the simple fact is demand will outpace supply which will continue to drive up prices.

It is just as important to remember who is moving here. Over 75% of all new residents are coming in from California. No matter what your opinion may be of our neighbors to the west they are becoming your new neighbor next door. And, who better? After all, the best buyers (for the economy anyway) are those that are selling from one place for a great profit and reinvesting in their new community, such as Phoenix.

An influx of retirees and second home buyers. Arizona has long been a retirement haven and as more baby boomers hit that age there will be even greater numbers enjoying the 300 days of sunshine Phoenix has to offer. A factor that is not been talked about much is the enormous wealth of the baby boom generation, whose members are in their prime years for owning first and second homes. Also, do not discount generation X, a whole group just starting to hit the beginning of their strongest earning power years.

Job growth & bustling employment. The cliché is that the three biggest factors to real estate success are location, location, location. But equally important to appreciation: jobs, jobs, jobs. Few places can thrive for long without a growing job market and steady in-migration.
Arizona boasts the fastest job growth in the country.

Cost of construction for new homes. This number will no doubt continue to climb, which will force new home prices higher.

A few other points you might not have considered. Much of the growth this last year was spawned by a small number of people mostly from the west coast recognizing the opportunity which lies here in Phoenix. Now get ready for the rest of the country to find out about what has been largely overlooked for years. As more news sources such as MSN and Fox report on the value and appeal of Arizona, expect more and more people, ones that had never considered making Phoenix their home, to start doing just that. Furthermore, do not discount the affect an event like hurricane Katrina has on the mind set of someone who is either already in an area that has the tendency to be a target of those types of storms or of the person(s) that have planned on retiring in the sunshine of Florida. All of a sudden the warmth of Phoenix looks pretty good. Not to mention the cost of home owners insurance is about ¼ of the cost here compared to Florida. Also, imagine if you will that you are in California and the ground beneath your feet starts to move a bit, where might be a great place to put your million dollars worth of equity from your 2100 sq.ft. fixer- upper? Yes, right again, Phoenix.

At the end of the day rising home prices are being supported by fundamental economic factors including low mortgage rates, rising employment and incomes, a growing population, and limited supply of homes or land. Yet, it is not hard to look a little beyond the obvious to see even more valid and compelling reasons why Phoenix will continue to not only be a great place to live, but why so many others will be joining us from across the country and the world. Whether you like it or not and for the better or the worse, Phoenix has been discovered. The opportunity lies ahead not behind, but only if you choose to take advantage of it.

Of course no one can predict the future and anytime there is something to gain there is most certainly something to lose. As one looks with open eyes at the facts, it is reasonable to surmise that whether by luck or hard work, we that live in the Phoenix area and are able to take advantage of the opportunity that presents itself should consider ourselves fortunate. And, as for luck, I will leave you with a few quotes about that topic from those that walked before us.

“Luck is when opportunity meets preparation” Paul “Bear” Bryant
“The harder I work the luckier I get” Thomas Jefferson
“Man cannot discover new oceans until he has the courage to let go of the shore” Anon.
“Life is ether a daring adventure or nothing at all” Helen Keller
“Go confidently in the direction of your dreams, live the life you have imagined” HDT
“Be bold and mighty forces will come to your aid” Basil King

Give us a call or send an email anytime to discuss the market… We would love to hear your thoughts.