The loudest economic story of the first quarter was the same story that received the most attention in the fourth quarter: the federal deficit deal. Markets and leaders breathed a collective sigh of relief when the tax deal was cut as the New Year broke but the relief didn’t last long.
It is probably more baffling that consumers and businesses responded so positively to the January 1 report that settled on tax increases but pushed the mandatory spending cuts off until March 1. As could have been predicted, the optimism surrounding that arrangement was short-lived. While the deal succeeded in fixing some of the uncertainty about permanent tax rates it also ensured that the next round of negotiations would focus only on spending. With a set of across-the-board cuts already in place, Republicans had no incentive to negotiate on lesser cuts and Democrats seemed willing to let the so-called Ã¢â‚¬Ëœsequester’ cuts happen so that the repercussions could be blamed on the GOP. On whose shoulders the blame for any negative economic results will rest is still to be determined.
Because the Tax Reform Act had the most impact on the types of income that come from real estate and other investments, the increased rates for dividends and capital gains have the potential to cool off development; but it’s more likely that any economic damage will come from demand that is cooled off by the ripple effect of the spending cuts.
The total of the sequester cuts is actually fairly muted – a fact that most Democrats fear will mute any reaction to them – with only about $45 billion sliced from the 2013 outlay. At this point the greater damage seems to be coming from the rhetoric surrounding the negotiations – or lack thereof. Much like in the 2012 election cycle, both parties are describing the other’s position in extreme terms, which is having a chilling effect on confidence to some degree.
The cuts grow to $85 billion in 2014 when they apply over a full year, but even that austerity amounts to just over three percent of all discretionary federal spending. The Congressional Budget Office estimates that the cuts will trim 0.6 points off GDP and will result in the loss of about 750,000 jobs. Those are not catastrophic numbers but the impact could tip the economy into recession. Government purchasing declined in November ahead of the year-end deadline and the effect was sufficient to cause GDP to go negative in the fourth quarter. Such a damper on the economy would come at a time when the fundamental support for increased construction was recovering.
Real-estate consulting firm Reis Inc. reported that vacancy rates fell for apartments, retail and office buildings during the last quarter of 2012. Rents for apartments rose 0.6 percent in the quarter and 3.8 percent from 2011. Declining vacancy rates – falling to 8.6 percent – permitted retail rents to rise 0.2 percent in the fourth quarter, the sixth consecutive quarter of similarly modest increases.
And office asking rents increased by 0.8 percent for the quarter and 1.8 percent for the full year, while the vacancy rate fell to 17.1 percent.
For each of these building types the amount of new space added in 2012 was well below the historical construction levels. Both offices and retail construction were less than one third the volumes built during the 2005-2007 period. Barring a reversal in the job creation trend or a decline in consumer spending, these categories should see increased activity in 2013. Perhaps the most damaging outcome from the triggering of the sequester cuts will be if there is a slowdown in the economy that pushes planned commercial projects back on the shelf.
For the time being there should be no negative side effects from the political wrangling that will slow down the construction of multi-family units. There are the first signs of potential problems for multi- family housing – increased interest rates would make permanent financing difficult for large projects, further improvements in the single-family market could shift demand – but the overwhelming support for multi-family housing will keep the product hot for at least 2013.
National Multi- Housing Council president Doug Bibby spoke about the market at the NMHC’s recent annual meeting. He cited limited concerns by members about potential overbuilding and identified three potential problems that could chill the hot multi-family market: (1) housing finance reform could fix single-family while damaging multi- family; (2) further tax reform including carried interest that is important to the many Ã¢â‚¬Ëœpass-through’ corporations that own multi-family properties; and (3) another financial crisis. Bibby says all of these concerns are overwhelmed by what he calls the “math.”
“By that I mean the demographics,” Bibby explains. “Household formation, immigration, the undersupply of rental units, renewed interest in downtown living in urban America, all of which are in our sweet spot.”
Census Bureau reports of January housing starts show that strength is slowly returning to the single-family housing market as well. Although the data showed a decline in overall housing starts from December – which had spiked particularly in multi-family – the number of single-family starts increased by 0.8 percent over December and jumped 20 percent compared to January 2012. Building permits – which are an indicator of future starts – edged up 1.9 percent over December and 29 percent year-over-year.
Homebuilders remain almost evenly divided between those who view conditions as good or poor, based on the National Association of Home Builders (NAHB)’s report on Tuesday of its monthly Housing Market Index, which dipped one point in February to 46, near the breakeven reading of 50. Builder responses have remained between 45 and 48 for four months.
For non-residential construction the story is one of two divergent market sectors. In the private sector, spending for construction continues to be on a steady upward trend that is now two years old. While January’s starts were below the December levels, the overall activity is more than 22 percent above the cyclical low in January 2011. Looking forward the indicators are also positive. The AIA’s most recent Architectural Billing Index showed a large increase in January to 54.2, a level that
has not been seen in more than five years. Likewise, inquiries jumped to 63.2. Both of these responses point to increased construction six-to-nine months out.
On the public side of the ledger, however, construction spending continues to decline, falling to an annualized $270 billion. That is some $50 billion below the spending volume that peaked when the American Recovery and Reinvestment Act of 2009 was in effect.
Data from three national sources validated this trend in January. McGraw-Hill Construction (MHC) reported total construction starts in January increased 11 percent from the same month a year ago. Because of the declining public spending, nonresidential building starts declined one percent.
The Census Bureau reported construction spending totaled $883 billion in January at a seasonally adjusted annual rate, up 7.1 percent from January 2012. The November and December totals were each revised up by over $15 billion, reflecting a surge in power construction as contractors rushed to finish wind energy projects to qualify for tax credits by yearend. Private nonresidential spending rose four percent year-over-year, while public construction spending fell three percent.
Reed Construction Data reported that the value of nonresidential construction starts in January soared 25 percent from the previous January. Their data showed nonresidential building increasing 20 percent, but there were unusually large increases in industrial starts (more than 200 percent), institutional starts (27 percent) and what Reed calls heavy engineering (up 38 percent). It’s likely that the extraordinary moves in any or all of these categories were due to a single monumental project or a timing issue in their reporting. Even though the magnitude of Reed’s reported increases may be corrected in coming months the trend is likely accurate.
An important ingredient for commercial construction growth appears to be back in the recipe in 2013. While financing still bears no resemblance to the market in 2006 or 2007 – nor is it back to normal – the appetite for real estate risk seems to be returning.
Given that loan durations are short for commercial properties, lenders can see less rate increase risk compared to other mortgage types. With rates remaining low for at least another 18 months, commercial real estate may be the only place where increasing exposure makes sense. Federal Deposit Insurance Corp. data for the fourth quarter of 2012 showed that commercial real estate loans grew by $14 billion on bank balance sheets. At the Mortgage Bankers Association (MBA) annual conference in Dallas, TX it was clear that commercial real estate was one area that lenders were willing to work with in 2013. According to Dan Puntil, senior vice president for Grandbridge Capital Real Estate, the mood at the MBA’s conference was very upbeat.
“I think everyone is feeling better about commercial properties. The life insurance companies all increased their allocations for commercial real estate again. CMBS is coming back in a big way,” Puntil explained. “The relative value of commercial real estate to the bond market is very favorable.”