This entry updates the July 14, 2011 post and discusses implications for economic recovery, real estate market development, and local government performance in 2012.

A number of recent positive indicators suggest that the United States is likely to continue its tepid economic recovery in 2012 despite uncertainty caused by the European debt crisis, economic slowdown in emerging Asian markets, and property value declines in China. While this news is causing volatility in the global markets, these factors are not likely to push the U.S. economy, which began recovering from the Great Recession in 2009, back into a recession.

The U.S. economy experienced a strong finish in 2011 with rising payrolls, increasing consumer confidence, and improved manufacturing (Bloomberg News). While the GDP has bounced back after Q2 2009, growth in employment has been modest, reflecting a substantial increase in output per worker over the last two years (NPR News and Bureau of Labor Statistics). Though unemployment remains high, the rate has gradually declined since its peak in early 2009. By the end of 2011, the seasonally adjusted unemployment rate in the U.S. declined to a 2.5-year low of 8.5 percent, a decrease of 90 basis points or approximately 118,000 jobs from a year ago (Bureau of Labor Statistics). However, some of the improvement reflects shrinkage of the labor force, as many job seekers left the labor market unable to find work or choose early retirement (e.g. baby boomers). EPS expects future employment growth to remain slow through 2012.

2012 Outlook by Industry

Although there is no consensus on the specific U.S. industry sectors leading the economic recovery, the majority of new employment occurred in the healthcare and manufacturing sectors, while many other private sector industries remain relatively stagnant (Grubb & Ellis). Meanwhile, the public sector has been shedding jobs since 2009 on a national, state, and local level, driven by decreased revenues and contracting governmental budgets. EPS expects the public sector to remain weak in 2012 as unemployment remains high and property values and wages are slow to recover.

2012 Outlook for Real Estate

Despite low interest rates and the availability of low-cost mortgages, U.S. housing market demand remained weak throughout 2011. Many homeowners were unable to refinance given the decrease in home values below existing levels of debt while banks still carry substantial foreclosed inventory that continues to weaken the housing market by adding to existing supply. Qualification for new debt has also become increasingly difficult given the new set of regulations and stringent mortgage lending standards facing home buyers. As a result, new construction was weak in 2011 as market prices have generally not justified new residential or commercial development. In an effort to stimulate the economy, the Federal Reserve has lowered short-term interest rates to nearly zero and has indicated that the rates are likely to be kept at these low levels through 2012 and beyond (Wall Street Journal).

Apartments were the only sector to experience substantial recovery in 2011. While rent growth in most markets has been modest, vacancies fell to the lowest level since 2001. According to Reuters, vacancies fell to 5.2 percent in the fourth quarter of 2011 relative to 8 percent in 2009. Apartment performance in the San Francisco Bay Area was particularly strong with 5.1 percent rent growth in San Francisco and 5.0 percent in San Jose. For comparison, single-family home prices in San Francisco increased by 3 percent, while prices in San Jose remained stagnant during the same time period (Rand California/Housing Prices and Transaction Statistics). While recovery in different markets will vary, EPS expects strong performance in the Bay Area apartment market to continue in 2012 and beyond, particularly in locations experiencing job growth, though potential recovery and new construction in single-family homes could dampen the rental market performance mid to long-term.

Office and R&D space vacancy rates in key markets also decreased in 2011, partly due to low construction activity. In certain inner Bay Area markets like San Francisco and the Silicon Valley, lower vacancy rates are reflective of growth in technology sector, driven by increased venture capital investment and the culture of innovation. Venture capital investment in the Silicon Valley and the Bay Area as a whole has been increasing with 2011 as the best investment year since 2008 based on the first three quarters (PricewaterhouseCoopers/MoneyTree Report). Space characteristics in these inner Bay Area markets are becoming more interchangeable with collaboration-conducive floor plans, open seating, and high ceiling features. EPS expects continued recovery in the Bay Area office and R&D market, particularly in well-established workspace locations.

On a national level, improvement in all major real estate sectors is likely in 2012 as the United States economy continues to recover from the Great Recession. EPS anticipates the real estate recovery to be more pronounced in established urban markets within proximity to existing infrastructure and urban amenities.

2012 Outlook for Local Government

Declining property tax and other public revenues will continue to hit local government budgets and spending. Reduced Federal and State revenue ultimately increase burden on local government as grant and subventions revenue decline. However, in many cases, costs continue to escalate, creating a structural imbalance and fiscal deficits across local governments that trigger reorganizations and other cost cutting measures.

The California Supreme Court’s December 30th ruling to eliminate redevelopment agencies could have significant implications. Over short-term, local government will be affected by formation and costs of the successor agencies and disposition of agencies’ assets. Over long-term, redevelopment elimination creates a challenge for financing new development in urban infill areas. This will likely have particularly severe consequences for production of affordable housing going forward.

Supreme Court ruling against redevelopment will hit some cities hard, especially those that relied on redevelopment to help fund related overhead and staff activities. Look for local government to explore alternatives to fund redevelopment activities, for example, through the use of tax increment from non-property tax sources. Other funding sources may include special assessment districts, impact fees, and tax credits. In addition, the use of Infrastructure Financing Districts (IFDs) is garnering attention in California as a redevelopment alternative to generate economic activity and improve fiscal prospects.

Current economic conditions show indications of a real estate recovery in some market segments and geographic areas; however, foreclosures continue to dampen prices, job and income growth have been weak, and lending practices have limited the availability of mortgages.  Global economies continue to stutter, adding to uncertainties about the political unrest in the Middle East, unemployment in the United States, European debt crisis, and concerns about inflation in China, the world’s second largest economy.  On June 24, the Fed downgraded its forecast for the U.S. economy for the remainder of 2011 and 2012 (Fed Downgrades Forecast for US Economic Growth).  This was followed by Standard & Poor’s downgrade of the U.S. credit rating in August, reflecting concerns about growing budget deficits and ineffectiveness of the political system following the debt ceiling debate (S&P Downgrades US Credit Rating to AA-Plus).  These factors indicate a bumpy road on a path to a slow and protracted economic recovery.

According to the Case-Schiller composite 10-city index, home values have reduced by 33 percent from their June 2006 peak by early 2011 (U.S. ‘Underwater’ Homeowners Increase to 28 Percent, Zillow Says).  Although new home construction in recent years has been well below levels of activity before the recession, economists generally predict a gradual stabilization and recovery, with rates of new home construction nation-wide approaching pre-recession levels by 2014 (Commercial Real Estate Outlook: Top Ten Issues in 2011).  An initial rebound in demand and price points is possible as a result of pent-up demand.  Over the mid-term, we are much less likely to see the dramatic boom-bust cycles of past decades; price growth consistent with income growth will tend to be the norm.

For residential uses, smaller rental product is likely to experience a faster recovery relative to larger single-family detached units in many urban locations, especially those with infill prospects in highly amenitized areas.  A desirability shift towards smaller lot infill locations and rental units is driven by several trends including the economics of home ownership, socioeconomic factors, rising energy prices, and changing quality of life preferences.  Many empty nester baby boomers, seniors, and first-time home buyers are seeking higher density living opportunities in walkable 24-hour locations within proximity to public transit, retail, and other urban amenities.

On a regional level, recovery is likely to be more pronounced in more established real estate markets with stronger economic fundamentals (ULI Emerging Trends in Real Estate 2011).  In California, these markets include urban coastal locations with higher skill jobs and higher incomes relative to many inland areas.  Primary markets have exhibited a stronger linkage to global commerce pathways and have experienced a less pronounced decline during the recession as measured by lower home price decreases and lower foreclosure rates.  For example, San Francisco home prices have decreased by less than ten percent from their 2007 peak, significantly below the Bakersfield metro area’s decrease of nearly 50 percent by early 2011, as reported by RAND (http://www.ca.rand.org/).