Debating the Flat Earth Society (Part 2)

This is Part 2 in a debate with the Flat Earth Society.
Please read Part 1 first if you have not yet done so.

This debate came about when I informally responded to the Salt Lake Real Estate Blog on Silicon Investor. Salt Lake (SL) then sent out a "challenge" along with a rebuttal to my brief responses.

Part 1 of my response discussed Corporate Balance Sheets and Real Estate Appreciation.
Part 2 of my response discusses Building Costs and Rents.

My responses were broken in half simply because the amount of material supporting the notion that corporate real estate expansion is NOT about to pick up where residential real estate left of is massive. Even broken in half, each piece is lengthy. Part 2 now resumes with a discussion about Building Costs and Rents.

Building costs are coming down / Projects are being restarted

SL: With residential real estate waning, costs of building have come down to the point stalled building projects are being restarted.

Mish: There is a desperate need to finish stalled projects just to get rid of the carrying costs. Then what? Why is commercial capacity needed? It isn't is the correct answer.

SL: I didn�t say commercial projects were desperate. I said they had been stalled due to higher costs brought on by the residential boom. BusinessWeek�s blog said:

During the housing construction boom, homebuilders bid up the price of construction labor as well as building materials like copper and cement. Prices got so high that some non-residential construction projects became unaffordable, so developers put them on the back burner. Now, with residential construction slowing down, labor and materials costs are coming down, making non-residential projects affordable again.

This makes sense to me. How about you? Additionally, government construction rose to an all time high in October:

Public construction, namely government building projects, rose 0.8 percent to an all-time high of $273 billion. Federal construction saw an 11.6 percent boost in spending.

Most supportive of the theory residential construction jobs will be absorbed by commercial construction is the fact the hardest hit bubble areas including Denver and Los Angeles are seeing huge commercial growth.

Mish: Yes building costs dropped. That is called lack of demand.
In fact here are charts of Lumber and Copper.

Lumber



Copper



Exactly what is Dr. Copper and Lumber telling us?
To me it is obvious.
This economy is in trouble.

At any rate collapsing commodity prices is certainly NOT any indication of demand. It is an indication of weakness. What you are seeing is a mad scramble to finish some projects that were stalled due to costs. That real estate when finished will just add to additional supply.

But even as you state projects are being restarted you provide no examples while cancellations are everywhere. Here is a typical one. Please consider Developers rethink plans in slow market. Ok So Palm Beach is just one city. But projects are being canceled in Las Vegas, San Diego, Boston, Chicago and other places. Do a search. You will find them.

But let's zero in on some rock solid hard data: Builders are taking enormous writeoffs on land. If land was cheap or expansion was coming, builders would not be bailing hand over fist on land options, and/or taking other land writeoffs.

Here is a typical article on the subject: Homebuilders Take Another Hit.

Shares of industry players dipped Tuesday after Hovnanian posted a big quarterly loss on a hefty land write-off

Finally, just because some cheerleader states "labor and materials costs are coming down, making non-residential projects affordable again" does not really make it so, now does it? Even if it was so (from a construction standpoint) that does not make the projects viable from an overall economic point of view. Overall viability must be factored in and overcapacity is rampant.

Summary

• Falling materials prices are a sign of economic weakness not strength.
• Land writeoffs are an enormous sign of weakness.
• Projects are being canceled even as building costs are dropping.
• Expansion does not happen because building costs are coming down. Projects have to be viable before it makes sense to start them.
  

Rents are Up

SL: Rents have increased, so those in the apartment complex business are getting more apartment buildings online and refurbished. More potential homebuyers are sitting on the sidelines and renting. See the continued performance of REITs as evidence...many apartment buildings in those portfolios.

Mish: You point to a bubble in Reits as Zell and other vultures are selling as proof of something. It is like pointing to the bubble in the Naz in 2000 and saying everything is OK. There is ZERO fundamental reason for a continued strong commercial expansion.

SL: Rents for both commercial and residential functions have increased, making apartment buildings and commercial space more attractive to investors. On top of that, interest rates have leveled off and both companies and individuals are doing well financially. It makes sense for investors to continue to develop this sector of the economy.

The NAR reported just last month:

With healthy job growth, office market vacancy rates continue to fall in most major markets and are expected to average 13.0 to 12.0 percent in 2007 -- a steady downtrend since exceeding 16.0 percent in 2004. After falling in the first part of the decade, average office rents are projected to grow 7.5 to 8.5 percent next year...

Vacancy rates in the industrial sector should average 9.7 to 9.0 percent next year, a steady downtrend since early 2004 when they were close to 12 percent. Rents are expected to increase 3.5 to 4.0 percent in 2007...

The apartment rental market -- multifamily housing -- is strengthening as potential home buyers remain in rental housing. New supply is matching absorption, keeping vacancy rates fairly flat -- next year they are projected to average 5.2 to 5.3 percent. Average rent should rise 4.5 to 5.0 percent in 2007.

Retail vacancy rates are likely to rise to an average of 7.8 to 8.2 percent in 2007. After dropping about 1.5 percent this year, average retail rent is forecast to increase 2.5 to 3.0 percent next year...

Mish: Hmmm let's see. Do I want to believe what Zell is doing or the NAR is saying?
Please consider When Zell Sells, We Listen

Sam Zell built the largest publicly traded real estate firms in Equity Office Properties (EOP) and Equity Residential Properties (EQR). After years of acquisitions to build the portfolio, he is now cashing out just as many have called a peak in the real estate market.

For Mr. Zell, one of richest men in America and the owner of more real estate than Donald J. Trump, the sale is an opportunity to cash out of part of the empire he built while working from his office in the old Daily News Building in Chicago. But the sale by Mr. Zell, who made his first millions in the 1970�s buying distressed real estate, may also signal that he believes the market may have peaked.

Just last month, Ross L. Smotrich, an analysts at Bear Stearns, wrote in a note to investors: �REIT�s have outperformed the broader market in each of the past seven years, putting valuations at the high end of historical ranges.�

This guy was a real estate vulture and he is bailing. I am willing to stand up and take notice. Even in the article you quote I see "Retail vacancy rates are likely to rise to an average of 7.8 to 8.2 percent in 2007." History proves that the NAR underestimates every decline and overstates the smallest of bounces.

When it comes to rentals you are also ignoring condo towers everywhere. The supply coming online is enormous in Miami, Las Vegas, San Diego, Chicago, Boston, and many major cities. There is simply NO MARKET for condos right now except at absolute auctions.

I talked about this in Auctioneer's Perspective. Those towers under construction are hugely adding to future supply. At the same time demand is falling off. Nor is this just a "Florida Thing" says the auctioneer. Indeed if you do a search you will find examples of condos being converted back to rentals or condo-tels. Thus there is certainly no pent up need to build more rental towers. Nor is there any pent up demand for housing either. Crashing building permits should be proof enough.

Summary

• I believe what Zell is doing rather than what the NAR is saying. Is this even close?
• There is pent up supply of rentals with huge numbers of towers under construction in many major cities.
• Condos are only selling at absolute auctions.
• The idea of pent up demand in homes is laughable. Supply is easily overloading demand.
• Building permits (a leading indicator) plunged yet again.

Wrapup

I sit in amazement of the challenge:
I look forward to your responses Mish, hopefully supported by hard data. If you don�t respond within seven days, I will take that as a surrender.

For the record, I did not come close to meeting the deadline. I had other priorities than debating the Flat Earth Society. But what strikes me the most is a challenge to be supported by "hard data".

I provided hard data and/or charts on

• Permits
• Construction job employment
  
• Insider sales
• Auctions
• Leveraged buyouts
• Reits
• Charts on historical correlations (from CalculatedRisk)
  
• Building materials
• Land writeoffs
• Foreclosures
• Retail Stores
  

as well as an overall thesis backed up by logic. I also would like to point out at this time a massively inverted yield curve that is now pointing strongly towards a recession.

On the other hand, the only hard data point provided by SL was on the AIA, a point I agree is valid but whose timeframe is questionable. Otherwise all SL provided was supposition by the NAR and ideas that were 180 degrees twisted from reality such as corporate buybacks (a clear indication of unwillingness to expand).

Addendum:
I want to include a few comments from from Professor John Succo on Minyanville:

As central banks rain liquidity (credit) down on markets, its long range effects eventually cause the very thing central banks are trying to avoid: deflation. The reason people don�t understand this is that it is cumulative: the accumulation of debt is in itself inflationary, but at a certain point it becomes unmanageable. Why is this?

Easy or free money (when central banks drive real interest rates below inflation rates) is irresistible. It wouldn�t be if people managed risk properly but they do not. Easy money causes competition for �projects� to increase: companies with free money take risk with it for less and less return. We are seeing deals getting done in LBO land and commercial real estate being built using very aggressive assumptions and low cap rates. With all that �money� out there rates of return drops dramatically. Everyone is starved for income.

At the very time that income and returns are dropping debt is increasing. Less income with more debt means that eventually it gets impossible to service that debt.

These posts (minus the addendum) originally published in WhiskeyAndGunpowder.
This concludes my debate with the Flat Earth Society.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/