Then, he gives investment advice based only on the fact that a state may be one of his Death Spiral States. That’s where he gets it wrong. Here are a couple of quotes:

If your career takes you to Los Angeles or Chicago, don’t buy a house. Rent.

To lend money to California, Illinois or the other nine states perched on the precipice requires a leap of faith. So does buying a house in those locales. Don’t count on a property tax limit to protect your home’s value. If other taxes are high enough, there won’t be any buyers.

I can’t quibble with his comments on lending money to states that seem hell bent on achieving financial insolvency. It is the real estate advice that I have trouble with.

In most places, housing prices are tied to economic activity, or the lack of it. That’s why Rust-Belt cities are always among the most affordable housing markets in America. Think of it this way: Why would anyone voluntarily move to, say, Detroit if they didn’t have a job there?

California is not most places, though, and there are lots of reasons to move to California if you don’t have a job. There are even more reasons if you don’t need a job. Real estate will do just fine in large regions of California, even without a vibrant economy.

Santa Barbara is an excellent example. Santa Barbara County’s economy is anemic in good times. Its economy grew slowly even when California was booming. Here’s a list of its top ten employers as identified by Mark Schniepp at the California Forecast Project:

University of California SB

Vandenberg Air Force Base

County of Santa Barbara

Santa Barbara Cottage Hospital

Santa Barbara Unified School District

Santa Barbara City College

City of Santa Barbara

Chumash Casino

Marian Medical Center

Santa Maria Bonita School District

There is only one for-profit business on the list, and that’s a casino. Together, these ten large employers are the source of 35,659 jobs out of the top 55 employers’ 55,496 total jobs. That’s a weak economy.

Still, even with its lackluster economy, Santa Barbara house prices are high by anyone’s standard. The strength in home prices is because of the amenities, natural and manmade. Santa Barbara is a great place to be and to live. Because of that, unlike Detroit, Santa Barbara’s residential markets are independent of the economy. Santa Barbara’s residential markets are national or international.

Santa Barbara is not alone. California’s entire coastline is similar. They aren’t building many new houses in Coastal California, and if you can afford it and opportunity isn’t important to you, there aren’t many better places to live.
Suppopse, for example, you are retiring and cashing out, California looks pretty attractive. You may not be able to afford Santa Barbara or Marin County, but you might be able to afford Ventura or San Luis Obispo. Each is almost surely better than wherever you came from

It’s like this from Mexico through the wine country, from the ocean to at least the first mountain ridge. People want to live here, and some can afford it. Why not? It’s as good as it gets. As long as that’s true, real estate prices will not reflect the economy. I’m not selling.

This was previously published at the Orange County Register

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Downward revisions to United States gross domestic product (GDP) have driven most of the revisions. For about two years, we had trouble with the original GDP estimates. Our jobs forecasts were pretty accurate, but we forecasted productivity growth and consumer spending growth below the initial estimates. This caused us enough grief that we’ve been reviewing our models. Well, the revised numbers are entirely consistent with our original models.

Downward revisions to productivity growth and consumer spending are what drove the downward GDP revisions.

Enough bragging. What is happening to the economy? We’re seeing a weak recovery.
Increasing numbers of forecasters, spooked by weak numbers and downward revisions, are now forecasting a double-dip in the near future. We don’t think that is the most likely case.

We’ve said all along that this would be a weak and inconsistent recession, and that appears to be what we are seeing. Some encouraging data might come in this week. The next week could see weak data. This is exactly what we expect to see in a recovery where financial institutions are wounded, real estate is weak, and consumers over extended.

So, we don’t expect a double-dip recession. We expect continued slow growth, accompanied by weak real estate markets, weak consumer spending, slow job growth, and persistent high unemployment.

That would be the good news and the bad news.

Another recession is in our future though, and not just because the business cycle has not been repealed. However, the timing of the next recession is really difficult to forecast, because in part, the timing will probably be politically driven.

I have become convinced that the culmination of Europe’s problems will be a partial breakup of the Eurozone. Perhaps it will be complete breakup. It really doesn’t matter.

Any breakup will almost surely be accompanied by financial and political crises. These crises will initiate a new recession, one that will be impacting an already weakened economy. It’s likely to be very painful.

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It appears that California residential real estate is in the second dip of a double-dip decline. California home prices, and sales, crashed at the beginning of the recession. Then, last year they picked up in the first half of the year, a result of temporary government programs and optimism unsupported by economic fundamentals. Talk of green shoots and a real estate recovery was all over the internet and traditional media. Then, like air slipping out of a balloon, the optimism disappeared, as predicted gains failed to materialize. Finally, we started seeing declining prices again.

California led the original real estate collapse, though California home prices remain well above prices in most other markets, and California appears to be leading the new decline. In fact, this decline is very unlikely to be as widespread among states as was the previous decline. Home prices here are likely to decline more than in most other states because California is now seeing an economic feedback from economic activity to real estate prices. States like Texas and North Dakota are unlikely to see residential real estate markets anywhere near as weak as California’s.

While home price declines originally caused economic declines, economic weakness is now contributing to yet more California’s home price declines. California is almost unique in its weak economic prospects, a result of almost continuously bad policy initiatives over the past couple of decades. This weak economic activity, particularly weak job growth is providing a new source of weakness in California home prices.

The impact is not universal. Upper-tiered markets remain stronger than more affordable markets. This is a reflection of the fact that demand for many of California’s most desirable areas is independent of local economic activity. Monterey, Santa Barbara, and Napa are really national, perhaps international markets.

By contrast, demand for many of California’s inland areas is only driven by local economic area job creation, within a remarkably large commuting radius. No job growth; no housing demand. End of story.

California’s commercial markets were hit much later than its residential markets, because it was falling economic activity that caused the decline. Commercial lease rates and property values are directly tied interest rates and the economic activity the property generates. As economic activity declined, vacancy rates increased and lease rates fell. Unfortunately, California’s economic recovery will almost surely lag the United States recovery. This implies that commercial prices are unlikely to significantly increase within the forecast horizon.

Retail properties, in particular, are likely to be very weak for a very long time. Besides weak economic activity, brick and mortar retailers are facing increasingly tough competition from internet sellers. Ultimately, it is likely that we will need less retail space per unit of population. California industrial space may also see long-term weakness, as the State continues to de-industrialize.

Office space markets are a harder call. California retains its natural and cultural amenities, even as its economic vigor subsides. Because of new communications technology, many, particularly top end, office jobs can be located just about anywhere. That would allow, say an executive suite in Santa Barbara or an engineering unit in Orange County, while much of a company’s workforce is in Texas, or even China.

Construction of residential and commercial properties has collapsed, a result of the weak demand we’ve outlined above. We see nothing that would cause any significant change in construction activity.

With few exceptions, it appears that 2011 will be another tough year for those who make their living in California real estate markets.

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If you are looking for a summary statistic on the United States economy, I recommend you consider bank charge-offs. These are the loans that banks have written off their books, because the probability of collecting them is so low. It doesn’t mean that the borrowers are off the hook, or that the bank will stop trying to collect the loan. It only means that a bank can’t consider a charged-off loan an asset.

Most people use GDP growth as a summary statistic for the economy, which leads to the current situation where policy makers and talking heads have declared a recovery while millions who have been unemployed for months or years continue to be unemployed. Indeed there were two recessions, based on GDP, in the 1960s where all of the job losses occurred after the recession was declared officially over.

OK, so why not use jobs as an indicator of prosperity? Actually, I’m sympathetic to that. It is certainly a better indicator of well being than is GDP. However, I think that charge-offs, particularly now, give us a little more information. Jobs tell us what businesses are doing. Charge-off data tell, at least in some sense, what business can do. That’s because banks don’t lend much when charge-offs are high, and without loans, businesses can’t grow.
So, what are bank charge-off data telling us?

They are telling us that a robust recovery is a ways off. Below is a history of real, inflation adjusted, bank charge-offs:

Prior to 2007, quarterly bank charge-offs had never exceeded $15 billion a quarter in today’s dollars. Then, they skyrocketed to almost $60 billion a quarter. Since then, bank charge-offs have fallen, but they remain well above $40 billion a quarter. You have to conclude that our banking system is still crippled.
This impacts small business much more than it impacts big business. Big businesses have direct access to capital markets and don’t need financial intermediation.

There are more reasons to be bearish on American small business growth. People who own small business own real estate, much more than the typical American. About 98 95 percent of all small business owners own their own home, but only about 66.5 percent of all American households own their own home. This means that small business was disproportionally hurt by the collapse in real estate values. Their balance sheet was suddenly over-leveraged, impairing their willingness and ability to borrow.

The inability of small business to use real estate equity to finance growth has impacts that are exacerbated by a banking sector that has forgotten how to lend to small business without the use of real estate as a secondary repayment source.

It used to be that small business had access to lines of credit secured by inventories or receivables. These were expensive loans, but they did not require real estate equity for the firm to grow, and in cyclical businesses they were self-liquidating, something that bankers just loved.

As real estate values climbed, banks lowered costs by moving away from these loans. Consequently, while some inventory and receivable financing remains, it is less important than it used to be. Perhaps worse, many bankers don’t know how to make and supervise inventory and receivable lines of credit. It was always a specialty. Today, asset-based lending, as this type of lending is referred to, is an almost forgotten specialty.

Still, those banks that are well enough capitalized to be aggressively seeking lending opportunities would be well advised to consider setting up asset-based lending units. It may be the only way for them to significantly increase loan volume in the near term. It would also be a service to small business and the economic well being of all of us.
The other alternative for small business expansion would be for real estate values to suddenly increase. That is not going to happen in this or next year. I go into the reasons more in the Real Estate Essay, but I have another summary statistic for you, Home Ownership Rates.

Home ownership in the United States is generally about 64 percent. That is about 64 percent of households own the home they live in. When the homeownership rate gets much above 64 percent, we have problems in our financial sector. Remember the Savings and Loan Crisis?

The United States homeownership rate climbed during the second half of the 1990s and the first half of the 2000s, until they peaked at over 69 percent. Since then, it has fallen, but not by enough. Until the United States home ownership ratio drops to below 65 percent, there will be no generalized upward pressure for home prices.

I think we have to conclude that this recovery is weak, because the normal drivers of a robust recovery, small business and real estate, can’t contribute.

Updated February 29th to correct data error.

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Dan Hamilton
October 28, 2010

The first estimate of United States third quarter Gross Domestic Product came out today. The preliminary estimate of third quarter real GDP growth was 2.0 percent, which follows a 1.7 percent growth rate during the third quarter. This preliminary estimate of third quarter economic growth is not very different from the previous quarter’s growth rate. However, one aspect of the composition of growth changed dramatically from the previous quarter, which was residential real estate investment. This measure, which grew 26 percent during second quarter, fell 29 percent during the third quarter.

I have argued in this blog-space that the 26 percent second quarter growth was a temporary, stimulus driven result, and not a sustainable recovery in residential real estate. This data release supports that argument and is congruent with our September 27 United States Economic Forecast of a contraction in this investment segment.

I should say that with respect to the recently ended recession and the currently weak recovery that we are now experiencing, “it’s the residential real estate, stupid!”, and we see continued weakness for that sector for some time. There are too many homes yet to be foreclosed on and too many unemployed that cannot consider a home purchase at this time. The stock of ownership housing is too large for demand, and it will remain too large for demand this same time next year.
Other aspects of the data release are counter to my forecast, namely stronger consumption expenditures, stronger inventory investment, stronger government expenditures, and stronger commercial real estate expenditures. Stronger consumption expenditures boost GDP now, but given that household sector debt levels are still too high, I worry about the long-term consequences of such consumption. Continued consumption growth, if it occurs, will be accompanied by rapid inventory investment.

I continue to be surprised by the strength of government expenditures. The preliminary estimates show federal spending growing with such strength to offset state and local weakness. I continue to expect that state and local expenditure weakness will be a greater drag on growth during the next few quarters than the previous couple of quarters.

Third quarter GDP was reduced by trade as was the case in second quarter, although this effect was weaker this time, 200 basis points, versus 350 basis points during second quarter. These results are driven by extraordinary import strength, which most forecasters, as well as I, do not believe is sustainable. Once this import strength subsides, GDP growth will benefit.

I do not see many fundamental support factors for United States economic growth at this time other than trade, technology, and manufacturing. However, these are not large enough to create a strong economic recovery from the Great Recession. The next couple of quarters might see offsetting factors that create moderate growth for some time to come. The positive factors will likely be: federal government expenditures, equipment and software investment, and import growth reductions. The negative factors will likely be: state and local government expenditures and real estate.

A major difficulty with forecasting at this time is the question of how households will behave during the next couple of quarters. Will they save for the future or consume? There are economists on both sides of this question. We have been thinking that they would save, and we will probably continue to forecast this.

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“Home Vacancies Rise as U.S. Ownership Falls to Lowest in Decade.”

Most will take this as bad news, and it is, but not for the reasons many will think.  Most will lament the decline in home ownership, as if it is somehow a slide away from the American dream.  It’s not.

The real problem with the data release is that it shows us that too many still own their own home, and the rate of home ownership is not falling quickly enough.  Bear with me while I explain.

First, we need to agree that not everyone should own their own home.  Some people’s circumstances or personalities are such that home ownership is just not appropriate.  They may need geographic mobility.  Perhaps their income is not steady.  They may lack the discipline home ownership requires.

Once we agree that not everyone should own a home, the question becomes: What is the appropriate percentage of home ownership.  Economic theory gives us no answers, but the data do.  For the United States, it appears that about 65 percent is the highest sustainable rate of home ownership.

Home ownership rates started climbing above 65 percent in the 1990s, a result of well intentioned and deliberate public policy.  Eventually, America’s home ownership rate exceeded 69 percent.  That is when things began to go seriously wrong.

Unfortunately, governments have been doing their best to prevent or delay us from getting back to the stable 65 percent.  The result is that it has taken us two years to get from our high to today’s 66.9 percent.  Getting under 67 percent is encouraging, but we need more before our real estate markets are healthy.  At the rate we’re going, that could be a while.

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