Bubble of Offices and Shops Follows Housing
by Fred E. Foldvary
US economic growth slowed almost to zero in the last quarter of 2007, consistent with a coming recession. Government’s data on current national income accounts or GDP (gross domestic product) can be found at the web site of the US Department of Commerce Bureau of Economic Analysis. GDP is reported by quarters, three-month periods. In the fourth quarter of 2007, US GDP is reported as $14.08 trillion. The GDP is added up from four categories: private consumption, private economic investment, governmental spending for goods and services, and net exports. The Bureau also publishes the "Percent Change From Preceding Period in Real Gross Domestic Product." Fourth quarter 2007 growth was .6 percent, down from third quarter growth of 4.9 percent.
GDP growth was also .6 percent in the first quarter of 2007, so to understand the trend, we need to also look at the components of GDP. Personal consumption tends to be rather steady, its growth dropping only a little, from 2.8 percent to 2 percent in the last two quarters. The growth in government spending dropped from 3.8 to 2.6 percent, not a large change. Exports grew faster than imports due to the lower value of the US dollar, but that is a small part of GDP. What contributed most to the GDP growth decline was investment.
“Investment” in GDP refers to the production of capital goods during the year. Gross private domestic investment is reported as falling by 10.2 percent in the fourth quarter, in contrast to the 5 percent growth of the previous period. The biggest decline was in residential investment, i.e. the construction of new houses and apartment buildings. Residential investment declined by 23.9 percent from the third quarter, a huge fall. This was partly offset by nonresidential construction, which continued to grow.
To understand where we are in the real estate and business cycles, we need to also examine commercial real estate. The news media have focused on the crumbling of the residential sector, with big declines in sales, a fall in average prices, and growing mortgage defaults especially in the subprime loans. But nonresidential non-farm real estate is subject to the same economic structures as residential: the same money supply, interest rates, taxation, and land tenure.
The residential real estate cycle tends to come before the business cycle, and we have seen residential real estate peak out and fall while GDP is still expanding. So long as business expands, commercial real estate grows. But the same speculative boom that afflicted residential real estate has affected commercial properties. Prices have zoomed up, fueled by the credit created by excessive monetary expansion.
High rentals and purchase prices for commercial real estate increases costs for enterprise, which reduces its profits, and thus results in less economic investment. In a global economy, many enterprises cannot raise prices by as much as the increase in costs. Furthermore, even though the Fed has lowered short-term interest rates, the huge mortgage loan losses has drained banks of loanable funds, and borrowing has become riskier, which reduces credit availability.
All these elements point to a crumbling of the commercial real estate market in 2008. Even in the booming Manhattan real estate market, the rise in office rentals has slowed, and the credit contraction has made it more difficult to obtain loans for purchasing condominium offices.
Apartment rentals have risen as folks who now can’t buy a house are renting instead. But as unemployment rises, then those laid off will move to more crowded and less expensive dwellings, vacancies will rise, and the price of apartment buildings will fall. Less business will also result in less hotel use. Lower sales volumes will reduce rentals and prices for shopping centers.
One can track the iShares Dow Jones US Real Estate index, an exchange traded fund, symbol IYR, based on the prices of real estate investment trusts (REITs). The IYR index fell from over 90 in its peak in February 2007 to less than 60 in mid January 2008, and then rebounded to 68 at the time of this writing (Feb. 3, 2008). The Vanguard REIT Index (VGSIX) shows a similar pattern.
The Fed’s expansion money and lowering of interest rates boosted the REITs since mid January, but the structural problems have not changed, so the financial injection will have but a temporary effect. Foreign buyers may keep the commercial market propped up in New York City, but elsewhere real estate will most likely not recover anytime soon.
There was a slight increase in US office vacancies and industrial space availability in the fourth quarter of 2007. National Real Estate Investor reports that commercial mortgage delinquency rates are heading up. The final plunge down the financial waterfall into recession and depression will be given a big push by the coming decline of commercial real estate. Watch for the other shoe to drop.
This article first appeared in the Progress Report, www.progress.org. Reprinted with permission.
Dr. Fred Foldvary teaches economics at Santa Clara University and is the author of several books: The Soul of Liberty, Public Goods and Private Communities, and the Dictionary of Free-Market Economics.