Up, Down or Sideways

Every few years the UC Berkeley Haas School of Business hosts a real estate conference in Los Angeles.

At this conference, three PhDs (Dr. Chris Thornberg, former chief of UCLA’s Economic Forecast and now a principal with Beacon Economics; Dr. Robert Edelstein, co-chair of the Fisher Center for Real Estate and Urban Economics at Haas School of Business at UC Berkeley; and Dr. Richard Green, director of Lusk Center for Real Estate at USC’s Marshall School of Business) present a plethora of charts, graphs and analysis to back up their views as to where the real estate economy is heading.

Every few years the UC Berkeley Haas School of Business hosts a real estate conference in Los Angeles.

At this conference, three PhDs (Dr. Chris Thornberg, former chief of UCLA’s Economic Forecast and now a principal with Beacon Economics; Dr. Robert Edelstein, co-chair of the Fisher Center for Real Estate and Urban Economics at Haas School of Business at UC Berkeley; and Dr. Richard Green, director of Lusk Center for Real Estate at USC’s Marshall School of Business) present a plethora of charts, graphs and analysis to back up their views as to where the real estate economy is heading.

Dr. Robert Edelstein, co-chair of the Fisher Center for Real Estate and Urban Economics at Haas School of Business at UC Berkeley.

Dr. Richard Green, director of Lusk Center for Real Estate at USC’s Marshall School of Business.

At these conferences in 2005 and 2006, professors Thornberg, Green and Edelstein called the coming real estate crunch — long before others realized what was on the horizon. Many in attendance probably wish now they had paid more attention.

Now everyone wants to know what’s coming next. In this Q&A with Drs. Green and Thornberg and Edelstein, we get a preview of what will be presented at the conference.

Moon Tide Media, publisher of this magazine, is co-hosting this year’s confab, to be held the evening of September 17 at the Luxe Sunset Hotel in Brentwood.

This event sells out every time it’s held; to attend, you are encouraged to register in advance. See “How to Attend” information, below.

Jeff Hall: You gentlemen are widely credited with having called the coming real estate debacle at the Haas real estate events held back in 2005 and 2006. What data were you looking at that led you to your conclusions?

Dr. Thornberg: Recessions are driven by major imbalances in the economy that, once they break, cause turmoil in the labor and capital markets that slow economic growth or actually cause it to turn negative. In this case there were two massive imbalances in the economy that, at least in my opinion, should have been completely obvious. First was the massive increase in housing prices to levels that were completely out of whack relative to incomes. The second, are far more important, problem was with consumer savings rates that fell to nearly zero. And while many are claiming the recession is over, at this point in time, half the increase in savings rates is due to nothing more than the temporary tax cuts put in place at the start of the year. We are not out of the woods yet.

Dr. Edelstein: In 2005 and 2006, it was clear that the growth in cheap debt was becoming a driving force for the pricing of assets and general economic activity. The credit risk spreads, or the low cost of credit, were at historical lows causing housing prices to rise, commercial real estate prices to accelerate, and corporate buy-outs at extraordinarily high valuations. This was augmented by the perceived ability of investors to reduce risk through credit swaps and other financial engineering devices. It was clear this “boom” had to come to an end.

Hall: Have we hit bottom? Are we on our way back up? What appreciation rates might we be looking at?

Dr. Green: There are three good indicators — and three bad ones. The good: prices in many markets have fallen below replacement cost, which is a pretty robust fundamental in the absence of population declines. Morris Davis at Wisconsin has shown that rent-to-price ratios have returned to be more in line with long term ratios, and given how low mortgage rates are, this is comforting. And inventories in California have dropped to under four months. On the down side, we may have a lot of foreclosed houses coming at us in the next year. The employment picture is still atrocious. And if rents keep falling, prices will follow.

Dr. Thornberg: We have hit bottom but with a half a million more foreclosures to deal with in the state we will sit on the bottom for some time.

Dr. Edelstein: At this point I estimate the following for the U.S.A.:
1. 60% probability — The bottom has not been reached in the economy and/or most asset markets.
2. 30% probability – That the economy will be flat for the next year or two.
3. 10% probability – We are at or near the bottom, and the economy and asset markets will turn around in the next three to six months.

Hall: Can you talk a little more about California — and more specifically, how about the upper-end towns hugging the Southern California coast? These are neighborhoods that are a little more immune to normal market forces; there aren’t many foreclosures here. What are we looking forward to?

Dr. Green: Houses on the LA coastline are more like Monets than dwellings. And the art market is very soft right now. But it is hard to know what will happen with foreclosures unless we know how those houses were financed. If buyers bought with a lot of cash, we won’t see a lot of distress. But prices will almost certainly soften.

Dr. Thornberg: There are no safe havens in a down market. The problems started in the lower prices ‘starter’ neighborhoods, but those moving out of these markets (move up buyers) drive the higher-end spots. It is clear that even high-end areas have seen a significant drop in prices.

Dr. Edelstein: Companies are cutting costs, in part by reducing employment. But generating profits with less revenue does not lead to a positive long-run economic prognosis. High-end Southern California housing markets are down 10% to 20% from the peak in 2007. It is not unlikely that we will see a further decline of, say, 10% from the peak. In the longer run, the housing market will recover as the economy recovers, but the longer run could be 2 to 7 years.

Hall: Talk about interest rates. What are the key influences right now? How do you see things shaping up in coming years?

Dr. Green: Other than the fact that they can’t fall below zero, I don’t know. The yield curve is sloping upward, meaning the market is betting short rates will rise at some point. But I can’t get into Bernanke’s head, and neither can anyone else.

Dr. Thornberg: The Fed has aggressively expanded the money supply to help stabilize the financial system. Yet at the same time the Fed has created the potential for future inflation. Interest rates will certainly go up, but how much depends on the Fed’s ability to quickly unwind the same programs once the economy begins to grow again.

Dr. Edelstein: Treasury rates, starting at about two years, are relatively high and have risen significantly over the last year. In the short-run, we must re-inflate the economy to bring back economic activity. In the longer-run, the economic concern will be to avoid inflation.

Hall: What role does China play in all this?

Dr. Green: We hope their role is that they continue to lend us money at low-low rates. Some Chinese are also finding our real estate prices attractive — compared to Beijing, L.A. is cheap.

Dr. Edelstein: The Chinese economy, especially non-coastal China, is now growing at substantial rates. Chongqing, the largest city in the world, in central China, is growing at 12% this year. However, this past year China had 24 million people enter the job market, and could only find jobs for 12 million. If PRC does not find a way for a sustained recovery, it will be difficult for the Asian economy to progress and for ultimately the U.S. and the European economies to grow.

Hall: Will we see as many roller-coaster-like swings in residential real estate in the future? Or will things smooth out?

Dr. Green: The problem with houses is that they are durable. The problem with California is that its land markets are heavily regulated. This means housing supply is inelastic (doesn’t change much) regardless of prices, so changes in demand get mapped into prices. So yes, they will continue to have cycles.

Dr. Thornberg: Real estate is a highly cyclical industry. There will almost certainly be another bubble, but presumably not on the scale of what we just experienced.

Hall: With real estate maybe no longer the sure thing we all thought it was, would it be smart for people to simply rent these days, rather than buy?

Dr. Green: It has not been a sure thing in California since the 1980s. People should look at houses as consumables, rather than investments. Buy a house because you can afford it, you like it, and it is in a neighborhood in which you wish to live (for at least 3-5 years). Otherwise, rent. When I moved here a year ago, I bought a house. I was pretty sure it wasn’t the bottom, but I didn’t care, because I love the house, can afford it, and will live in it for 20 years — unless I get sick or something.

Dr. Thornberg: Prices have fallen to levels that make more sense in the long run. I think we are back to a market where either buying or renting could work.

Dr. Edelstein: To the extent we re-regulate the financial markets and credit standards become somewhat tighter, it would be wise to be a renter in the short-term horizon of, say, three years or less. If you are willing and able to stay in your house for more than three years, ownership may make sense. Ownership economics should take into account the tax benefits, inflation hedging, and long-run prospects for return to a more normal real estate market.

Hall: How are things looking in the commercial real estate sector? Can you break this out by office buildings, retail locations, apartment buildings and other categories you would like to address?

Dr. Green: I am bearish on retail because I don’t see consumption returning to previous levels anytime soon. Office and industrial are lagging indicators — so don’t expect them to look good until a few years after the recovery really starts.

Dr. Thornberg: Residential leads and commercial follows. Commercial prices continue to fall and the financial fallout in coming years will be substantial.

Dr. Edelstein: Commercial real estate is a train wreck about to happen. A large portion of the existing commercial real estate mortgage debt is about to become due in the next year or so, and cannot be re-financed at the existing terms. It is likely that the worst has not happened in commercial real estate.

Hall: Is this a good time to invest in real estate? Or should those with cash park it elsewhere? What looks good these days?

Dr. Thornberg: Residential prices look good, but don’t expect any quick returns.

Dr. Edelstein: This is a time to be patient; I would not be an investor in virtually any asset market at this point. The smart money is lining up, but has not been deployed in real estate and other asset markets. In the stock market, the smart money has been “trading,” not “investing.”

Hall: If you were advising President Obama and his economic advisers right now, what would you say to them?

Dr. Green: Make financial institutions bite the bullet and get their toxic assets off their balance sheets. This would involve doing a number of painful things.

Dr. Thornberg: Stop swimming upstream. There is little to do to prevent foreclosures, so it is best to simply help the process and get it over with.

Dr. Edelstein: If I were advising President Obama, I would suggest that he continue to be aggressive in providing an expanding money supply and simulative fiscal policy. While the world’s private sector is de-leveraging, the federal governments (for the U.S. and elsewhere) must lever to fill the void in aggregate demand. Obama should not worry now about the economy over-inflating.

Hall: How could the current downturn have been avoided? Have we learned our lessons going forward?

Dr. Thornberg: We need better regulations in our financial markets, and stop publicly ignoring clearly unsustainable trends in the economy.

Dr. Edelstein: The current downturn probably could not have been avoided unless we had the will to create fiscal and monetary restraint, commencing in 2001-2002. Have we learned our lesson? Who knows? We now need to reorganize and re-regulate the financial system, as well as coordinate future appropriate monetary and fiscal policies. In broad-brush terms, we need to institute fundamental changes in the way we do business: compensation must be related to economic performance and capital must be at risk in economic enterprises. This would represent a major change in the way the economy has operated over the last decade.

Hall: Now please look into your crystal balls. What changes can we expect to see in real estate in coming years?

Dr. Thornberg: We will experience more booms and busts. As for the state, we are having a tough time now, but long run prospects for the state are good.

Dr. Edelstein: The outcome for real estate markets over the next year or so will depend upon how the credit markets as well as the general economy perform. It is likely to be a difficult time for the real estate markets.


Note: This event has sold out both each time it has been offered. Advance registration is highly encouraged.

September 17, 2009

6:30 p.m. – No host cocktail hour, including generous complimentary hors d’oeuvres.
7:30 p.m. – Panel discussion begins.
9:00 p.m. – Program ends.

Cost: $35 by September 10; $40, September 11 – 16, 5 p.m. online; registration closes thereafter, $45, September 17 at the door (space permitting).

Cash only. No credit cards accepted.

More Information
RSVP: http://my.berkeley.edu/site/Clubs?club_id=1010&sid=5652&pg=event

Aaron Schechter
[email protected]

Luxe Sunset Hotel
11461 Sunset Boulevard (near 405)
Los Angeles, California 90049

Parking at the hotel is at your own cost. Street parking is generally available along Church Lane and neighborhoods south of Sunset.

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