To most people, real estate and housing are synonymous. While housing is, actually, just one segment of the real estate industry, it is the most visible and, arguably, most important indicator of the economy. “You cannot have a strong economy without a strong housing market,” states Elliott Pollack, CEO of Phoenix economic and real estate consulting firm Elliott D. Pollack & Company. “So until we get single family construction picking up, the economy is going to be difficult.”
“Think of what goes into a house — appliances, carpets, all kinds of materials from thousands of industries, including financing,” says Bill Spart, senior vice president with Wells Fargo in Arizona. Building homes adds to the Gross Domestic Product, explains Wells Fargo senior economist Eugenio Aleman, affirming, “The housing market creates value for the economy.”
With housing recognized as such a fundament of the economy, is anything new being done to spur activity in this sector?
Not in lending. If anything, in fact, loans have become harder to acquire. Howard Lein, owner of RE/MAX Excalibur, predicts that the 2011 FHA mortgage guidelines that set standards on income and assets will remove 70 percent of the buyers who would have previously qualified for a home loan. Aleman says banks will stick with the “normal” loans — adjustable-rate, 30-year and 15-year mortgages — and what he terms the “weird loans,” such as those based on supposed appreciation rather than actual value, “are not coming back.” Even loan products that have not changed are now structured differently, notes Spart, such as requiring more cash down or more of a guarantee.
Nor is the pattern of location expected to change. Phoenix’s experiment with moving back to town was nonsense, according to Pollack, who describes the trend to urban high-rise living “a dismal failure.” “Phoenix grows like a balloon; it has to pulse out,” he says. “Growth will continue where the land is and where utilities are — the periphery. Jobs [in the local area] will follow.” That’s the way it’s always worked in Arizona, he points out, and he believes that’s the way it is likely to continue to work.
What all the old truisms about real estate fail to take into account, however, is the investment activity in Arizona real estate. Foreclosures are down, inventory is being absorbed and there is a shift in the real estate dynamic. Investors have been busily buying properties to such an extent that Lein reports there is a shortage of inventory. “We have more homes pending and in escrow than active listings,” he says. “It rivals what we saw at the peak of the market.”
Arizona Housing a Magnet for Foreign Investment
“We are viewed as the blue-plate special of real estate in North America,” says Lein, explaining the market is good for a toe-hold in the United States for investors from Asia and Canada in particular. The investors are looking to buy in quantity — from 20 to 200 homes — and most pay in cash.
The foreclosure market and diminished values — homes selling at 20- to 30-percent of their top-of-the-market price — have created a tremendous opportunity for residential investors. Dean Selvey, an investment specialist also at RE/MAX Excalibur in Scottsdale, notes that the commonly reported housing market numbers are based on national data and the situation in Metro Phoenix is quite different. Not only is inventory down more than 50 percent from Jan. 1 this year to Aug. 1, but “prices are increasing in almost every submarket in Metro Phoenix,” he says. Explaining the typical ratio is three active listings to one pending sale, he says now is the first time in Phoenix history that pending sales outnumber active listings and predicts that investors who don’t buy now will find little inventory to choose from next year.
Today’s investors are not the traditional low-bid bottom feeders, Lein notes; these investors look at the expected rate of return and base their offer on a 10- to 12-percent return from rental of the properties.
And rental prospects are very strong. Explains Lein, the 2010 Dodd-Frank Act’s financial regulatory overhaul and this year’s new mortgage lending guidelines have put home ownership out of reach of so many that the tenant of today is likely to continue to be a tenant in the future. It’s an over-regulation that has gone too far, he believes, pointing out that the maligned Freddie Mac and Fannie Mae institutions functioned with no issues for 40 years. “Somebody got in the middle of their good programs four to five years ago and destroyed what they’d built,” he says, advocating a roll-back to those earlier programs rather than what he characterizes a harsh over-reaction that removes a mainstay of the American financial system. “I expect it will be at least two to three years before somebody realizes we need to correct it,” he says. For investors, however, the situation has made rental property now a “phenomenal investment.”
Aleman’s assessment supports this forecast, as he notes prospective homeowners will likely need to save for five to 15 years to amass a 20-percent down payment, plus “it’s difficult to save in this environment.”
Selvey finds real estate is now attracting investors who are leaving the volatile stock market for this long-term, stable, rental market. And present currency exchange rates are adding to the attraction for foreign investors.
Canada is by far the largest source of foreign direct investment right now, according to Glenn Williamson, founder and CEO of Canada Arizona Business Council. Explaining this has been building for the past 50 years, he calls now a “perfect storm”: the value of the Canadian dollar has gone par with the U.S. dollar, attraction has shifted from another mainstay of Canadian interest — Florida — because of its hurricanes and higher non-resident taxes, and the number of direct flights between Canada and Phoenix has more than tripled from five years ago.
“Homebuilders, from Fulton to Beazer to Shea, have Canada on their radar screen. And every real estate agent is marketing to Canadians,” says Williamson. Naming Arizona Commerce Authority, Arizona Office of Tourism and Scottsdale Convention & Visitors Bureau among the government agencies with an active presence in his country, he says also, “The State of Arizona spends time in Canada.” He finds it’s not just a snow-bird scenario; in many cases, young executives are looking to also buy or invest in companies here or influence their companies to move operations to Arizona.
A Push on New Home Construction
While there are factors hindering the resurgence of the new-housing market, such as the difficulty of first-time homebuyers to qualify for a loan and fewer household formations — of which the number falls dramatically when no jobs are being created, Pollack notes — construction is not at a standstill.
The lack of significant shadow inventory in the pipeline from foreclosures and short sales plus the migration to new home sales of buyers tired of trying to bid on such property — including individual homebuyers who cannot act fast enough against cash-wielding investors — is leading to an increased demand to build, according to Selvey. He reports two new projects broke ground in late August on land acquired cheaply from foreclosure.
Builders are responding to the new market with new products, such as one in Casa Grande being built by Terra Verde Builders to appeal specifically to Canadian residents looking for vacation homes — fully furnished (“Down to the dishes,” says Selvey) patio homes at affordable prices. And Scottsdale-based Meritage Homes recently debuted “net-zero” homes that incorporate such extensive green design elements that they cut the previously touted Energy Star® ratings by more than half on operating costs while also providing a cleaner indoor environment. With energy-consciousness on the rise — for economic as well as environmental reasons — Meritage Homes Vice President of Environmental Affairs C.R. Herro notes that buildings account for the largest consumption of energy and states that, with standard construction, “twice the energy is consumed as is necessary, so it wastes half.”
These homes, however, produce as much energy as they consume, incorporating energy-efficient design and details previously confined to either custom-built homes with price tags to match or homebuilder spec-display homes. It’s a basic change in the way production homes are built, and some in the industry predict it could impact resales of older homes whose energy ratings can’t come close to what these offer. The viability of this design in creating a market for itself has already prompted Beazer Homes to develop its own green-style product, and successful sales numbers can be expected to spur other major homebuilders to follow suit. According to Eric Rosson, Meritage Homes’ vice president of marketing, Meritage has sold 35 homes with the net-zero option since unveiling them in Verrado on Earth Day. These numbers, he says, “are extremely good because it’s an incremental expense at a time when people are trying to get more value for their dollar.”
Master-planned communities and the unique demographic of the Hispanic market — a market he says builders in Arizona “ought to be” targeting — are areas in which Pollack predicts industry strength. Another trend he anticipates is “Gen X and Y will probably go for smaller homes.”
Edward Robson, founder and chairman of Robson Resort Communities, also sees builders going to a smaller product, and notes this would allow homebuilders to offer homes at reduced prices as a way to stimulate sales. In his market — age-restricted communities that include the value of lifestyle amenities — he anticipates Arizona continuing to be a prime destination, trumping historical competitor Florida over issues of hurricanes and bugs. “Now is a good time to buy,” he says, noting older people are not getting anything out of their timed deposits and relating that a customer from Back East recently called to tell him he was getting out of the stock market and into real estate. “People realize if they wait two to three years, commodities — such as lumber — will go up in price.” As is also likely with prices of all the many products made from oil, all of which will add to the home price.
Commercial Real Estate as Economic Barometer
In the commercial sector, some of the woes are related to housing — such as unleased space in a strip mall built to serve a housing development that ended up not being built — but in general the lending was more rational than it was for residential, says Wells Fargo’s Aleman.
Still, there is a glut of commercial space and a dearth of tenants that has led to numerous foreclosures in this sector. Michael Ebert, co-founder and managing partner of Red Development, which has properties in 12 states, observes that growth in Arizona has been near the top nationally “but, also, the amount of overdevelopment here was greater than any other markets we were in.” Red Development first entered the Arizona market in 1995, and has been extensively involved here for the past nine years, with Downtown Phoenix’s CityScape one of its most recent development projects. The company now, however, is more focused on leveraging existing property, and in the past three years has been moving away from a development model to more of an operating company. “Buying land, developing it and selling it does not have as predictable an outcome as in the past.”
One of Phoenix’s problems may well be too much information. Mark Stapp, professor of real estate practice at A.S.U.’s W. P. Carey School of Business, notes that Metro Phoenix has very good data available about what the market is doing. “But everyone is looking at the data at the same time and implementing projects based on that data. Ten people looking at the same data and coming to the same conclusion can lead to an oversupply in that type of project,” he explains.
High unemployment is another factor, especially in office space. “The more jobs you create, the more demand there is for office space. As you have a lot of jobs go away, then office space starts decreasing as far as occupancies, so office space is the hardest hit,” says Bill Spart, senior vice president of middle market real estate for Wells Fargo. A project for the FBI and another for the University of Phoenix are the only new, local, office construction; there is nothing on spec currently in the pipeline.
Industrial is the area Spart sees as the strongest today in commercial real estate. “Everything is headed in the right direction for that,” he says. “As small businesses start expanding or move out of the garage and move up to bigger space, industrial is where you first see that [growth].” He relates that vacancies are down, lease rates are normal, and absorption is starting to pick up the space. Even more promising, construction is picking up for large projects of more than 500,000 square feet. “Distributions like Amazon, Google and Wolf Appliances are locking down large spaces and moving a lot of jobs here,” says Spart, noting that most of the activity in these large spaces is in the West Valley. “The West Side’s proximity to I-10 and L.A. encourages its industrial growth.” Availability is more Valley-wide for smaller businesses, like house painters, he notes, which generally locate in or near the area they serve.
In the current market, infill properties will recover sooner than outlying locations, as businesses take the opportunity to move into more desirable locations, says Craig Henig, senior managing director and Arizona market leader with CB Richard Ellis. And foreclosure actions, he feels, are sometimes premature. “By giving the borrower time to mitigate losses and lease out the buildings, some properties have regained some of the loss they experienced.” One of the challenges owners face in these economic downturns is the almost automatic assumption on the tenant side that they’ll get a good deal, Henig explains, noting, “To make money, the owners will have to operate the properties in a classy manner and stay close to their tenants.”
Ebert, in fact, observes that high-quality assets are now valued at near-peak prices, which he says surprises all industry people. “We’ve seen high-quality office and retail that are well-leased and have value back close to what it was at the peak,” says Ebert, adding, “The market has an interest in financing, buying and valuing well-located properties, but there’s a dramatic drop-off after that.” He describes the Phoenix market as “bipolar, with trophy properties and trauma cases (or distressed properties).” Still, he says, “We’re bullish on Arizona, and that’s why we’re continuing to invest in Phoenix.”
Phoenix is attracting a lot of investors, in fact. “It’s amazing how many people we have coming in from Southern California, Canada, the Midwest,” says Spart. While he finds they’re interested in everything, he says he has seen the most activity in multi-family and industrial. “Prices are down,” he explains, “so looking 5-10 years down the road, this is a great buy.”
Development Due for a Comeback
Pollack describes the present real estate situation here as dire. But he insists that, although this time it’s more severe and protracted than in the past, “it’s just a cycle.” He sees Phoenix already growing out of this one, with a good part of the excess housing supply eaten up and job loss easing up, and expects the real estate market to normalize in 2015.
And Metro Phoenix has a lot on the plus side to appeal to a developer, according to Stapp. “There are few constraints on development,” he says. It’s a relatively easy entitlement process to obtain the needed approvals to develop a property for a desired use; it’s easy to add infrastructure such as roads; it has a flat urban economic landscape, with multiple centers of business rather than all development focused on Downtown; and no natural disasters. It also has highly protected development rights. “Arizona, like most of the West, has very strong private property rights protection and mentality,” says Stapp, giving Proposition 207, the Private Property Rights Protection Act, as example. “This deals mostly with eminent domain and compensation,” he explains, “but it reflects the importance of private property rights. This [position] makes it hard for government to restrict land use.”
Experience — a Guide for the Future?
“When there are really good projects needing financing, it’s not unusual to see multiple bidders from the finance world,” Spart says. He explains the challenge in lending, however, is finding loans that make sense — where the equity is there and borrowers are in good shape.
“The theory is that capital is supposed to enforce discipline,” affirms Stapp, but adds, “Look down the value chain and see how many fees are generated from that one deal, and you realize how many people are motivated for that deal to happen.” Himself a developer as well as executive director of the Master of Real Estate Development program at W. P. Carey, he says people’s motivators are sometimes out of alignment with what’s good for the overall economy. “We need to try to align those motivations better. It’s important to tie capital to what the community’s needs are.”
Henig, who has been through recessions before in his 24 years in the business, believes it’s important to have checks and balances in place when it comes to lending, and to learn from the mistakes made this time in over-valuating. “Banks need to be flexible on the interest rate, to make sure the borrower succeeds in the project.”
And Stapp makes a case for making development a local investment. “Big banks … want big, national merchant tenants. They believe those tenants are less risky, but in reality, this can be a false sense of security,” he says, noting that local merchants are typically great for the community because they’re very committed and more of the money stays local. He also points out that 88 percent of retail firms employ 20 or fewer people, so the great majority of businesses are small businesses. “Those are the ones having the toughest time getting a loan now,” he notes.
“In order to achieve community redevelopment, we need to look at the uniqueness and sense of place involved in different properties,” Stapp says. “We need local lending sources that are willing to help individuals and small businesses, that aren’t dependent on the formulas used by larger banks and decisions made far from the actual real estate locations.”
But Pollack does not anticipate another real estate crunch of today’s magnitude even in the industry’s normal up-and-down cycle. “This was caused by a bunch of one-off events on a national scale. There was a new financial instrument in the market, and banks securitized but didn’t know what they were getting into,” he says, drawing a parallel between the common wisdom that single-family housing never went down in price to the belief of 400 years ago that the world was flat — something that everybody “just knew” was true. “People bought into what was a bad job by rating agencies, Wall Street, banks and borrowers.” Such a confluence of events, he says, “is unlikely to happen in tandem again … not for decades … not until there’s a new instrument.”
CB Richard Ellis cbre.com
Canada Arizona Business Council canaz.net
Elliott D. Pollack & Company edpco.com
Meritage Homes meritagehomes.com
RE/MAX Excalibur excaliburrealestate.com
Red Development reddevelopment.com
Robson Resort Communities robson.com
W. P. Carey School of Business wpcarey.asu.edu
Wells Fargo wellsfargo.com
Article appeared in the October 2011 issue