I was sitting with whom I believe to be a very intelligent friend over coffee last week discussing general market conditions in the Phoenix Metro Area and where the “smart” money is going and where certain sectors are topped out. As I sat and listened to him describe a possible acquisition he was pondering I noticed him spend the next 15 minutes trying to talk himself into why this particular real-estate investment was a good target for his Investment firm.
His rationale was interesting. I watched him begin to talk himself into why they should pursue the acquisition, he threw around current; NOI’s, comparable values, cap rates, and upside potential on the rents, which were all generally positive indicators. He had clearly done his homework. His rationale included the major points to consider when making such an acquisition. I never heard him mention one negative factor, only a multitude of positive factors which he rattled off without hesitation.
After sitting back and letting him work out the deal verbally with himself I asked him a simple question; What happens tomorrow?
This is an obvious question and we all know risk is inherent with such transactions. However, we rely so heavily on current or recent statistics we lose sight of tomorrow. Projections and trends are helpful, however as humans I believe in good times we use forward-looking numbers formulated with assumptions that are often self-serving to the author’s point or formulated to encourage a transaction rather than push us towards the side of caution. Whether we are an Investor or a Lender we must look at transactions differently depending where we are in an economic cycle.
I use the following few examples on how you could look at an indicator differently based on what I consider to be the peak of the current cycle as I believe we will see more signs of contraction in the near future.
Population growth in the Phoenix Metro area has been strong, one of the strongest in the country. This is good, more demand for; real estate, goods, services, and general commerce. Per the US Census Bureau, Phoenix topped all cities in the US with a growth of 32,113 persons between July 2015 through July 2016. Although that sounds great, the claim needs some context. Remember this when you hear your sales guy talking about record population growth and see if they forget to mention that the referenced growth more or less reflects the return to the population level achieved eight years ago.
And where are all these people going to work, or should I say what Employment is going to keep attracting them here? Well the 32,000 jobs added in the 12 months from October 2016 through October 2017 should be a good start… right? Oh, wait a second, that number is less than half of the jobs added in the prior 12 months (65,000). These job numbers are according to Lee McPheters the Director of the JPMorgan Chase Economic Outlook Center and Research Professor of Economics in the W.P. Carey School of Business at Arizona State University. Should we use a number that represents a slowing trend in our rationale to support an acquisition or loan funding? Also, other cities are becoming more attractive to large corporations. Of the 12 largest metropolitan areas Phoenix is fifth in employment growth over the twelve-month period ending October 2017. Places such as; Atlanta, Boston, Dallas, and Miami show significantly more growth per the US Bureau of Statistics. And let’s face it, along with a handful of other cities these are our competitors.
Moving on, I am told the Housing Market is a good indicator of things to come. Well your local agent will tell you how the Median sale price of new homes as of June 2017 is about $310,000 (Per Colliers Greater Phoenix Land report 1H 2017). And including previously owned homes the median price is only about 8% below the median price of 2006. Not bad at all, or is it? I don’t think I need to remind homeowners, investors, or lenders the pain that has been incurred over the last 10 years due to the inflated values of our last peak in the cycle. Well let’s look a little further into this segment. The price will surely keep rising, right? I mean people are moving here and there are only so many places to live. There are dozens of the ever-popular multi-family developments going up each year, not to mention the robust single-family construction, combined with leading indicators like the large land purchases by single-family developers. No doubt many new roof tops will continue to be added to the market, approximately 22,000 single-family permits will have been issued in 2017 along with 7,000 multifamily permits with an additional 12,000 multifamily units underway and 16,000 planned in addition to the already added inventory (per Colliers Greater Phoenix Multifamily Q3 2017 Report).
Question to consider; didn’t people have places to live in 2009? And now that the population level is roughly at the same level and new rooftops are being added daily, what will the impact be of the new inventory be on values? I am going to keep this month’s edition simple and not even address the lurking “Shadow Inventory”. Finally, median household income barely reflects the ability to afford the median home price as of now, and home prices are outpacing the median income growth, therefore affordability will start to play a bigger role in home prices in the near future.
Commercial Sales performance for the major sectors shed some light on where we are at in the cycle. Industrial is showing an increased sales price with a lower volume of properties trading hands. Wherein Retail reflects a lagging drop in prices as volume has decreased. Office space shows a steady volume of trading while price has been volatile over the last two years as variation in specific product type is a key indicator to price. Keep an eye on the unleased space coming online for both Retail and Office over the next nine months. I will be paying close attention to whether the amount decreases significantly or not over this period as an indicator of things to come.
The end of the world is not coming tomorrow, that is not what I am trying to convince you of. What I am trying to point out is that you need to be aware of what part of the cycle we are in and how you should alter your investment or lending practices to mitigate risk and still reach practical goals. Investors are beginning to see which phase of the cycle we are in as activity is slowing. Commercial sales are mixed depending on segment. The slowdowns have outweighed any increases with an aggregate reduction in activity in the first three quarters of 2017 compared to the same period in 2016. This makes sense as prices continue to rise the shorter-term rate of return is being compressed and investors and lenders are becoming more selective. In addition, Q3 2017 Cap rates have compressed in the Industrial sector while ticking up in office and retail centers both averaging about 7.6%-7.7% average this year.
Look I get it, Lenders need to lend and Investors need to invest. However, be mindful of what phase of the economic cycle we are in. Things look pretty good today, as things looked pretty good in 2006. But in retrospect I bet those of you reading this can think of several instances in 2006 that were clear indicators that things were TOO good. Well now that a lot of various indicators have returned to the 2006 level shouldn’t you be viewing the numbers with a different perspective than you did a few years back?
In my career I have had the benefit of hindsight to see when and where errors are made when loans are originated, or acquisitions are funded. My suggestion for you is to be Proactive and Stress Test your existing portfolios and modify your investment or lending parameters based on the phase of the cycle we are in. Now is the time to be one step ahead and mitigate risk and possible losses when opportunities present themselves, not when it is too late.
Please contact our office to discuss how we may be able to assist you with developing or implementing a Proactive strategy to mitigate or eliminate your exposure.
Proactive Consulting, LLC