Kicking the can

The fiscal cliff has been delayed for two months. Fears about how the government would handle the fiscal cliff — the tax hikes and budget cuts that were set to start on January 1st — frightened businesses into delaying capital spending and hiring, diminishing what little momentum the economy had going into 2013.

At the eleventh hour, Congress managed to pass a compromise bill. They extended the Bush tax cuts on all earners making less than $400,000, raised capital gains and estate taxes, extended unemployment benefits, ended the payroll tax holiday, and delayed the sequestration (deep cuts to military and domestic spending) for another two months. The next fight will be over raising the debt ceiling again to avoid the sequestration.

Businesses have reacted to this continued uncertainty by putting off key decisions on investment and hiring. Orders for nondefense capital goods excluding aircraft have tumbled over the past few months and are currently more than 7 percent below year-ago levels. Moreover, new orders are trending below shipments, which in the past has been a warning of recession. Hiring has not pulled back anywhere near as much, however, but hours worked have leveled off. A whole host of businesses have also announced plans to alter their employment strategy now that the new healthcare law is an absolute certainty. Even with these changes, we should expect nonfarm payrolls to rise roughly in line with their gains of this past year and look for the national unemployment rate to remain in line with the current rate through 2013.

Small businesses (which are responsible for about 50% of the national nonfarm, private sector GDP) remain unusually cautious. The Wells Fargo Small Business Index tumbled 28 points during the fourth quarter, which was the largest drop in four years. The quarterly survey, which was taken shortly after the presidential election, was led lower primarily by increased concerns about future conditions. Fewer businesses see revenue growing over the next twelve months, while more see them declining. Businesses are also concerned that they have less ability to control expenses, which has led to even more caution about investment and hiring decisions. For the eighteenth consecutive quarter, more businesses plan to reduce capital expenditures than increase them.

National GDP is expected to slow to an annualized growth rate of just 1.8% in the current quarter, according to The Wall Street Journal’s November forecasting survey, but then accelerate through 2013. By this time next year, the economy should be growing at a 2.7% rate, or about what it did in the third quarter just past. For the full year, however, GDP is expected to expand just 2.4%. That’s far enough above stall speed to keep recession worries at bay — but not nearly fast enough to make a dent in perniciously high unemployment.

That said, there are three economic positives going into 2013: employment, debt, and housing – three things that have been lacking for the past five years.

Jobs are coming back. Hiring is hardly robust, but the national unemployment rate is well down from its 10% peak. By this time next year, the economy should be adding 173,000 jobs a month, up from this year’s 157,000, according to the National Association for Business Economics.

Job growth here in Texas has re-bounded since the end of the recession and the state is expected to see even more growth next year. The Dallas Fed predicts statewide job growth of 2 percent to 3 percent in 2013, down slightly from this year’s estimated 3.2 percent growth, but up from 2011’s job growth of nearly 2 percent. Dallas Fed president Richard Fisher sent out the employment forecast — as well as outlooks on other state economic trends — after “a thorough briefing of the Texas economy” by his staff. Energy, exports, and construction have driven Texas employment above its pre-recession level this year, but growth has slowed since June as energy and export activity have declined.

Still most states and metros would be happy to have 2 to 3 percent job growth. How quickly we see a shift in economic uncertainty depends in part on how soon the fog over taxes and budget cuts lifts. Businesses are in a holding pattern, but they’re in far better financial shape than since the credit crisis.

Where will these jobs be? Low mortgage rates and tight inventories have boosted construction and related jobs. Texas leads the nation in construction job growth, adding 46,900 jobs in the 12 months through October, according to the Bureau of Labor Statistics. Last month, existing home sales were up 29 percent from a year earlier and the inventory of existing homes for sale fell to a five-month supply — the lowest level since February 2007, according to Texas A&M University’s Real Estate Center.

The Dallas Fed expects housing growth to continue at a strong pace next year. While industrial, office and infrastructure construction has been somewhat subdued this year, it recently picked up. In addition, a recent decline in office vacancies in Texas, particularly in Austin and Houston, suggests a gradual improvement in office construction could start in the next 12 months, according to the Dallas Fed.

Compared to the national unemployment rate of 7.8%, Austin’s 5.5% unemployment, San Antonio’s 5.6%, Houston’s 5.8%, and D/FW’s 6.4% lead the nation’s metros on low unemployment. Midland led the state with 3% unemployment. Below is how most of the cities in Texas fared through November of 2012. Most are the envy of the rest of the country.

While Midland had the state’s lowest unemployment, the highest was in Brownsville-Harlingen with 9.7 percent. 2013 should show continued improvement in these numbers.

The preliminary local jobless rates for November were:

The national unemployment rate is still elevated at 7.8% as of December 2012. For the last two years, we’ve been too pessimistic on the unemployment rate because most analysts were expecting some minor bounce back in the participation rate. Instead, the participation rate of the unemployment surveys have continued to decline. Maybe 2013 will be the year the participation rate increases a little, or at least stabilizes.

The recent recession was unusual in its depth and its duration. National labor market conditions have remained difficult for a long time. As a result, large numbers of discouraged workers stopped looking for jobs. A big unknown is whether these workers will stay out of the labor force permanently or enter as the economy recovers. If these workers join the labor force, increasing participation could have a major impact on the unemployment rate in the coming years.

As a result, the unemployment rate likely will stay uncomfortably elevated in 2013. Indeed, by this time next year, the unemployment rate is forecast at 7.5%, or just 0.2 percentage points below November’s reading. The economy is predicted to add 1.9 million jobs during the next 12 months — essentially just enough new jobs to keep up with population growth.

Nationally, with the current uncertainty, the national unemployment ‘headline’ (BLS – U3) will be hard pressed to be under 7%. Here in Texas, the continued strength of energy as well as the West Coast port labor problems should allow Texas to creep under a 6% average for the year. It continues to be a blessing to live and work in Texas.

Consumer debt continues to shrink. The balance sheets of American families look fairly healthy as well. Consumers have been working down their levels of installment debt, and that, combined with low borrowing rates for houses and cars, has eased payment burdens significantly. Consumers’ out-of-control debt loads helped spark the recession, but households are rapidly getting their balance sheets back into shape. To put it in perspective, before the recession, consumers went into the recession carrying debt of nearly double the nation’s gross domestic product. That’s down to below 85% now, and on pace to approach 75% by late next year. Consumers were spending more than they made, to put it simply.

Revolving debt, mostly credit cards, has fallen 19% since 2007. Revolving balances dropped at a 6.8% seasonally adjusted annual pace in July, after falling 4.5% in June. Non-revolving debt has risen, mostly because of student loans. The country has started saving again.

If consumer spending doesn’t come back strongly, it might be because incomes are still well below where they were before the recession, and that households lost about $7 trillion of home equity as housing prices plummeted. That could make them keep the brakes on spending for a while longer. On the plus side, low interest rates have pushed the ratio of consumers’ monthly rent and debt payments to their income to the lowest level since 1984. That’s a function of slightly lower debt and much lower rates, all good news.

Finally, housing is coming back. The best news coming out of the economy should be in the housing market. It has taken nearly seven long years since the bubble burst, but housing looks to have definitively stabilized, with more home-price gains ahead. Housing prices should post an annual gain of 3.43% on a national basis, a significant acceleration over 2012′s increase of 3.31. Because of that rebound strength, we here in Texas will continue to reap the benefits of a stronger real estate market through the year.

Nationally, the inventory of homes on the market is down 20% or more from just a year ago. Nationwide, there are 1.8 million houses for sale. At the peak, in the summer of 2007, that figure was more than twice as high. Sales of existing single-family homes, meanwhile, jumped 11% in the twelve months through November. Demand should remain elevated as the Fed keeps buying bonds so mortgage rates stay low. Why is this important? For most families, their home — not stock portfolios — is their biggest asset.

The wealth effect tied to housing can be quite powerful, as evidenced by the number of refinances in the sand states (California, Arizona, Nevada and Florida) from 2000 through 2006, where appreciation was so high sometimes running as high as 45% annual, year after year. That appreciation went away with the recession and lack of speculation in those markets sometimes to the tune of over 60% decrease in value.

That all has changed. Housing inventory is at its lowest level (4.8 months) since September of 2005. This represents 22.5% decrease as compared to the same time last year. Shadow inventory, the inventory of distressed properties coming to market, is also shrinking. This is for a number of reasons:

1. We are clearing more foreclosures and short sales nationally and locally.

2. Fewer families are falling behind in their mortgage payments.

3. Demand remained strong throughout the year. Home sales numbers continued to increase throughout the year suggesting that the country’s belief in homeownership still remains strong. Even the last “Existing Home Sales Report” from the National Association of Realtors revealed that home sales were up 5.9% from the previous month and 14.5% from the same time last year.

4. Prices first stabilized and then increased – nationally as well as locally, perhaps the biggest story of 2012 is that home values turned the corner and headed upward. By the end of the year, home values were up 10.1% compared to the end of 2011. And they shouldn’t slow down. Pricing of any item is determined by supply and demand. The supply of homes ready for is shrinking in all of our Texas Metros. There are only 5,700 for-sale listings in Austin and 3,500 rentals available with over 60,000 people annually moving here, with a population of 1.8 million. Houston has just over 35,000 listings and 94% rental occupancy with close to 100,000 people moving there annually. The same goes for the other major Texas metros – there is not enough supply for the demand.

Even in the areas that are still dealing with high foreclosure rates and short sales, prices have not tumbled dramatically. The increase in demand will absorb much of this inventory.

Because of this, in 2013 we will see the demand for housing continue to surge. The housing market has turned the corner and there is no reason to believe that buyer demand will not maintain momentum throughout 2013. Household formations shot up to boom-time levels in 2012 and are projected to increase at even a faster rate over the next twelve months. A lack of inventory will be more of a challenge to sales increases than will a lack of demand.

5. Fueling that demand is both move-up and move down sellers who are returning in great numbers. Perhaps what many will find as the biggest surprise of 2013 will be the return of the ‘move-up’ and ‘move down’ seller (often baby boomers seeking to downsize). Over the last several years negative equity has prevented many of these sellers from moving up to the house of their dreams. However, with prices recovering, more and more of these sellers will realize that now may be their greatest opportunity to make the move to a lifestyle they always wanted. Between plummeting property values, severe market depression, and falling incomes, the 2008-2009 recession had an enormous impact on the personal finances of middle-aged Americans. Overall, the median net worth for pre-retirement households fell 36%, reaching its lowest level since 1998, which hit those within one to two years of retirement particularly hard. The financial forecast is improving thanks to the gradual recovery of housing prices, but if that 45-64 demographic stays in the job market and maintains their high savings rate in an effort to shore up their personal finances, consumer spending and the subsequent economic growth could help the local markets dramatically.

6. The group under 40, called Generations X and Y, have been delaying household formation since the recession. What happened to all those buyers? Recent studies from the FHA and FNMA show that they believe in homeownership. Contrary to what many have hypothesized over the last few years, young adults (18-35 year olds) are just as committed to homeownership as previous generations. Recent studies have shown that 43% already own a home, 72% see homeownership as part of their personal American Dream, and 93% of those currently renting plan to buy a home

This, along with the increase in household formations mentioned above, makes us believe that 2013 and 2014 will be the year that many of these young adults will jump into homeownership.

All of this is good news: Housing starts surged to an annual rate of 872,000 this year (2012), the highest since the financial crisis. And that’s expected to rise to 900,000 in 2013.

The timing couldn’t be better. Historically, housing has accounted for 5% of GDP. Today it’s half that. If real estate investments jumps by a percentage point or slightly more of GDP next year, the economy could absorb the shock of the national fiscal austerity and hit its expected 2+% growth rate. Not great, but much better than the last 5 years.
And as Texas has shown the last 5 years, we should continue to lead the market in real estate opportunity.

The fiscal cliff in-depth

Talk of the impending fiscal cliff has been dominating the news cycle, and for good reasons.

First let me get this disclaimer out of the way – I am an analyst, not a CPA, lawyer, or lobbyist. I am an interested onlooker to the dysfunction in Washington. So keep that in mind as you read this. Also this is being written before Christmas, so a lot can happen as negotiations get closer to the deadline.

This budget brinkmanship will have an effect on the economy, Texas included. Try to imagine the effect of not receiving Federal funds will have on all states. Texas received about $55.1 billion during the 2010-2011 biennium money from the federal government. San Antonio, Austin, and Killeen would be greatly affected.

“Fiscal cliff” is the popular shorthand term used to describe the conundrum that the US government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

There are two major factors when combined that produce the ‘fiscal cliff’. The first factor is budget cuts. Back in August of 2011, Obama and Congress, under pressure from the ‘Tea Party’ and fiscal conservatives signed in to law the Budget Control Act of 2011. This was designed to cut the budget deficit in half by cutting $1.2 trillion across the board from the federal budget over ten years. This kicks in December 31st, 2012. According to many analysts, over 1,000 government programs – including the defense budget and Medicare – are in line for ‘deep, automatic cuts.’

The second factor is tax hikes. A host of tax breaks, including the Bush tax cuts which were signed in 2001 and extended by Obama for two years in 2010, are set to expire.

They include payroll tax cuts (workers will face a 2% tax increase if these expire) and changes to the Alternative Minimum Tax (which would in turn be a larger tax for many consumers). The pending expiration of estate and gift tax cuts has left many people of means scrambling to use what has been billed as a once-in-a-lifetime way to give tremendous amounts of money to heirs tax-free before death. The child tax credit would include lowering the amount of the child tax credit from $1,000 per child to $500 per child, narrowing the tax bracket for married couples causing them to pay more, and reducing itemized deductions and personal exemptions. These all expire at midnight, December 31st 2012. In addition, the beginning of taxes related to President Obama’s health care law will also go into effect.

Understand that we need deficit reduction. But cutting $700 billion – all at once and across the board – out of the Federal budget sets us up for another recession and rising unemployment. Those cuts are equal to about four percent of GDP, which is, according to the Congressional Budget Office, more than enough to throw us into a recession.

Economists and analysts disagree on exactly how quickly the recession would begin. That’s why the “cliff” metaphor is inappropriate. If financial markets freak out, it might happen very quickly, proving the “cliff” imagery correct. But it might happen gradually, affirming those who’ve argued it’s a “slope.”

Either way, both parties agree it shouldn’t happen at all. But that’s the rub. The reason that the fiscal cliff could push us into another recession in 2013 is because it enacts too much deficit reduction upfront, not too little. And yet, deficit reduction is something that most members of Congress and their voters support, at least in the abstract. So both sides want to replace the fiscal cliff with…something. The question is, with what? And can they come to agreement?

It’s important to recognize that this austerity crisis is a collision between deficit reduction and stimulus. The good news is that if you look at the various components of the fiscal cliff separately, you’ll see that the parts that do the most for deficit reduction do the least for the recovery, and vice versa. This suggests the possibility of “a la carte” approach to the fiscal cliff, in which we extend the most stimulative policies and wave goodbye to the most costly policies

What is the fiscal cliff in one sentence?

Too much austerity, much too quickly – like quitting the spending habit cold turkey. Not many addicts can quit cold turkey without harm from withdrawal.

If it’s not a cliff, what is it?

The term “fiscal cliff” comes from testimony Fed Chairman Ben Bernanke delivered before Congress earlier this year. A better name would be “austerity crisis.” That solves two problems. First, the danger the economy faces is too much austerity too quickly, so swapping the term “fiscal” for the word “austerity” actually better reflects the situation. Second, while we don’t know if it’ll be a cliff or a slope, we do know that it will, if permitted to go on for long enough, be a “crisis.” Thus, the “austerity crisis.” And yes if there is uncertainty, then job creation slows.

There are four types of spending cuts that take effect next year.

The sequester
The sequester was mandated by the Budget Control Act of 2011, better known as the debt ceiling compromise. This institutes a 2 percent cut in physician and other providers’ Medicare payments, and a 7.6 to 9.6 percent across the board cut in all discretionary spending, except programs for low-income Americans. The cuts are evenly divided between defense and nondefense programs, with most analysts predicting a crippling effect on all affected departments, agencies, and industries.

The sequester can be averted by repealing the portion of the BCA mandating the cuts, which amount to about $110 billion next year.

Budget caps
Also in the Budget Control Act, these set a firm limit on discretionary spending within which policymakers must operate. They are set to reduce spending by $78 billion next year.

Doc fix
The Medicare Sustainable Growth Rate (SGR) is a method currently used by the Centers for Medicare and Medicaid Services (CMS) in the United States to control spending by Medicare on physician services. This policy, passed every Congress for 15 years now but lapsing at the end of 2012, reverses temporary cuts that Congress passed, and former President Bill Clinton signed, as a deficit reduction measure in 1997. The cuts, known as the “Sustainable Growth Rate” or SGR, require that growth in provider payments not exceed growth in Gross Domestic Product. If the doc fix is not extended, physician payments would fall by an estimated 30%, dwarfing the cuts enacting as part of the debt ceiling deal. That would cut spending by $14 billion next year.

Unemployment insurance
Unemployment insurance was expanded following the recession, and due to the slow recovery this expansion has been regularly extended. Doing so again would cost $39 billion.

Debt ceiling
When exactly the debt ceiling is next reached depends on how much the government actually spends and taxes in the coming months. But most analysts think the next debt-ceiling increase will come due around February. The Bipartisan Policy Center estimates we’ll have to raise the debt limit by anywhere between $730 billion and $1.25 trillion to avoid the debt ceiling for all of 2013 (depending on whether the Dec. 31 fiscal changes measures are enacted or not) and between $1.3 trillion and $2.2 trillion in 2014.

A fiscal cliff deal is likely to include an increase to the debt limit. But in a world without a deal, an ongoing austerity crisis could be worsened by a default. The economic consequences of that are suggested to be along the lines of the financial crisis of what we saw in 2008.

What happens if we go over?

Analysts expect that the austerity crisis will weaken the economic recovery and quite possibly plunge the United States back into a recession. The CBO predicts that the US economy will shrink by 0.5 percent in 2013, and unemployment will spike up to 9.1 percent from its current level of 7.9 percent, if no fix is passed. However, if all policies, including the payroll tax cut, are extended, the economy will grow 2.4 percent.

Deficit reduction
If the austerity crisis hits in full, both short and medium-term deficit problems in the US would vanish. The CBO projects that under current law, debt held by the public will fall to only 58 percent of GDP by 2022, below the 60 percent mark that many economists warn against exceeding. By contrast, debt would climb to 90 percent of GDP if current policies continue, the highest point since after World War II.

Tax increases
The Tax Policy Center estimates that if we go over the fiscal cliff, the average American will see their tax bill rise by $3,446 in 2013.

That average obscures a bigger hit to the rich than the poor. Taxpayers making more than a million dollars will, on average, see a $254,000 tax hike, equal to about 11 percent of their income, while taxpayers making between $40,000 and $50,000 will see a $1,700 tax hike, equal to about 4.4 percent of their income, according to tax analysts.

Still, it’s a big hit to both groups, and that’s before you get into the effects of the spending cuts, which will hit the poor much harder than the rich.
Has Washington tried to solve the fiscal cliff in the past? The simple answer is yes, but so far with short-term solutions – which is the problem.

2010 tax deal
The Bush tax cuts were actually scheduled to expire in 2010. Republicans wanted to make them permanent when they were initially enacted in 2001 and 2003, but compromised to avoid a filibuster forced them to accept a 10-year expiration date.

In late 2010, both President Obama and Congress passed legislation extending the Bush tax cuts for two years, agreeing that the economy was too weak for a tax hike. Although the economy has improved, most analysts would agree that the economy can’t take this type of economic contraction. The deal was also contingent on a two-year extension of federal unemployment benefits, which were included in the 2009 stimulus, a one-year payroll tax holiday to replace another tax break in the stimulus (later extended to two years), and the extension of a few other tax breaks from the stimulus. All of these provisions are due to expire at the end of this year, which is why they’re part of the austerity crisis now.

Obama created the Simpson-Bowles commission in 2010, whose members created a recommended framework for $4 trillion in deficit reduction. But the plan did not attract the required 14-vote supermajority to be sent to Congress. Later, a bipartisan group of Senators known as the Gang of Six tried to build on Simpson-Bowles to formulate their own deficit reduction plan, but their effort, so far, hasn’t had any more luck.

Budget Control Act
Ultimately, to avoid a debt-ceiling crisis, Congress and the White House passed legislation in August 2011 known as the Budget Control Act, which had nearly $1 trillion in upfront cuts and established a Congressional committee to come up with $1.2 trillion more in deficit reduction by late November 2011. If the super committee failed to agree upon a deal, the across the board cuts to both defense and non-defense spending—i.e. the sequester—would be automatically scheduled to take effect after December 31st.

A 12-member super committee deliberated through the fall of 2011, but ultimately failed to come to an agreement by the deadline. The roadblock, once again, was revenue. Let’s just say that party lines were the disagreement with no compromise. Even after the super committee failed, Congress could have independently passed a deal that reduced the deficit by $1.2 trillion to avoid the sequester cuts. But the 2012 campaign soon took precedence and both parties agreed that nothing would get done until after the election.

That’s why we’re now facing the sequester, on top of the Bush tax cuts and other provisions that were already scheduled to expire on December 31st. They’re all policy decisions that Congress has made (or failed to make) over the past two years, piled onto a single deadline.

What do the parties agree on? They all agree it shouldn’t happen for all the right reasons…both parties agree that doing nothing and letting all the scheduled tax hikes and spending cuts to take effect for all of 2013 would be harmful for the economy, and something they want to avoid. No one likes the sequesters, which are described as indiscriminate, across the board cuts, and few want to raise taxes significantly on the middle-class.

What do they disagree on? They take traditional party lines. They don’t agree on taxes: Democrats want to hike taxes on the wealthy by about $1.6 trillion, and they want about $1 trillion of that to come from letting the top tax marginal tax rate snap back to its Clinton-era level of 39.6 percent. Republicans oppose tax increases in general and increases in marginal tax rates in particular.

The two parties also disagree about how and where to cut spending: Republicans want to make more dramatic reforms to Medicare, Medicaid, and other entitlement programs, as well as bigger cuts to domestic discretionary spending.

Now that we know what the fiscal cliff is, let’s examine some possible solutions.

Just go over
The simplest option for Congress and the White House would be to do nothing. Taxes would go up. The military and domestic spending cuts in the sequester would bite down. This would be the single largest act of debt reduction in American history, cutting some $1.2 trillion from the deficit over the next two years. Trouble is, that much austerity would likely also induce a recession. That’s why few policymakers advocate this scenario.
There’s another problem with this plan. Lawmakers can’t just sit back and do absolutely nothing. Even if the tax hikes and spending cuts kick in, Congress would still need to vote to lift the $16.4 trillion debt ceiling by February or so. Otherwise, the United States government would no longer be able borrow money to fund its obligations.

Go over and then make a deal
Another possibility is that lawmakers don’t reach a deal by December 31st, and we go over the cliff. But it’s only temporary. After all, those tax hikes and spending cuts don’t kick in with full force immediately. They’re spread out over two years. So there’s still time to make a deal when the new Congress convenes in January.

Why would lawmakers do this? It might make a deal easier. Right now, the two parties are having a tough time reaching an agreement because Democrats want higher taxes on the wealthy and Republicans mostly refuse to vote for any tax increases at all. But if we go over the cliff, taxes automatically go much, much higher than either party wants. Now the two parties simply need to debate how to cut taxes from this new baseline. That may be an easier discussion, in theory.

The downside is that Congress and the White House might not have much time to negotiate a deal in January or February before financial markets get nervous, which is never a good thing.

There’s nothing stopping Congress and the White House from postponing the fiscal cliff until 2013 or 2014. Congress would simply vote to extend all (or some) of the Bush tax cuts and payroll tax cuts. Then Congress votes to override the sequester, so that none of the military and domestic spending cuts kick in. Suddenly, the fiscal cliff is gone – or at least pushed back.

The upside here is that there’s no recession. The economy gets time to mend. The flip side is that deficit would continue to grow–the CBO estimates US debt would be $1.2 trillion higher over the next two years if Congress extends everything, compared with if we went over the cliff. Plus, we’d face another big showdown two years from now.

New deadline or trigger
One alternative to extending the fiscal cliff that wouldn’t require immediate deficit reduction, or the immediate formulation of a deal, would be to design a new trigger. There are several possible forms such a trigger might take, including cuts to tax expenditures, an increase in the capital gains tax, or more spending cuts.

Smaller chunks
Congress doesn’t need to make a big sweeping deal on the debt right now. It could do something smaller. One possibility being talked about is that Republicans would let the Bush tax cuts for income over $250,000 expire, as Obama wants. That would raise about $80 billion in 2013. In return, Democrats would find $80 billion in spending cuts. Then Congress extends (most) of the rest of the tax cuts.
That’s a small bit of austerity next year, but nothing like the full cliff. And lawmakers could continue working on bigger tax reform in 2013.

Grand bargain
At the moment, there’s a lot of talk in Washington about a “grand bargain” between Republicans and Democrats. This would involve avoiding sharp austerity in 2013. It would also involve some mix of spending cuts and tax increases that are gradually phased in over the next decade, so as to slowly bring down the national debt. It would also include substantial changes to entitlement programs like Social Security, Medicare and Medicaid. Examples of a “grand bargain” framework include the Simpson-Bowles plan, or the Domenici-Rivlin plan.

What about real estate? Here are four areas of concern.

Increase in Capital-Gains Tax

The White House wants “the rich” to pay more taxes. Republicans are opposed to any increases in taxes. But if the Bush tax cuts are allowed to expire, capital-gains tax rates will go up as of January 1, meaning anyone who sells their home could owe more on those sales. As a result, many sellers are racing to close before 2013. If the Bush tax cuts are allowed to expire, the current capital-gains tax of 15 percent will rise to 20 percent. Plus, the new federal health-care tax of 3.8 percent on investment income also kicks in next year for couples who make $250,000 or more. The combined tax-hiking impact of the Bush tax cuts ending and the looming 3.8 percent Medicare surtax.

Capital-gains rates could remain unchanged if a deal gets done in Washington. But don’t count on it.

Expiration of Mortgage Interest Deduction
The mortgage interest deduction — long considered the centerpiece of American homeownership — is on the chopping block. Presently, interest on loans up to $1 million can be deducted on primary and secondary homes. Be prepared for this Holy Grail of housing to either be eliminated or scaled back considerably.

Expiration of Mortgage Debt Forgiveness Act
Short sellers could be in for a big surprise come January 2013, if the Mortgage Debt Forgiveness Act expires. If this law perishes, short sellers will be taxed on unpaid mortgage debt, which the IRS considers taxable income.

If this law dies, thousands of distressed borrowers will avoid short sales (because of the tax hit) and simply walk away from their underwater homes, possibly sending foreclosure filings upward in 2013. Moreover, home sales would decrease nationwide, putting downward pressure on home prices.

Bailout of Federal Housing Administration
The Federal Housing Administration is nearly insolvent and it could require a taxpayer bailout next year. The 78-year-old agency is $34.5 billion short of its legal capital requirement.

These aren’t the only issues threatening the real estate market. Since Fannie Mae and Freddie Mac were taken over by the government in 2008, taxpayers have plowed $180 billion into them to keep them operational. A decision needs to happen within the next couple of years.

So what is the solution? Obviously, we cannot continue to delay decisions on the Federal debt. We’ve kicked this can down the road for too long. Some hard decisions need to be made, the question is when and which ones. There are no easy answers.

2012: A Year in Review

2013 is here and 2012 is behind us. 2012 started great and continued to gained steady momentum. We thought it would be worthwhile to review.

We started the year with a battered national economy, high unemployment and low credit liquidity, which hampered the economic recovery. However, by the end of the year, national markets have began healing as housing and other real estate inventory declined and demand improved.

In Texas, strong job growth and low inventory in the major metros created high demand for all channels of real estate, which in turn created more jobs in a state that has led the nation in job creation over the last five years.

When we look back, 2012 will have set a lot of milestones for each metro. I thought we would look at what we consider some of the biggest starting with Austin. We will follow up in future weeks with the other Texas metros.

Biggest successful groundbreaking: Formula One

The announcement of the Circuit of the Americas track took many people in Austin and Texas by surprise. While there was some skepticism in racing circles about plans to bring a Formula One event to Austin in 2012, there has been plenty of support and enthusiasm for the project both locally and internationally.

By many measures, Austin’s Formula One debut was a big success. The nearly two years of planning and prepping paid off: Circuit of the America’s state-of-the-art track and facility in Elroy won widespread praise from drivers and fans, many of whom said they would be returning for next year’s race. Despite some long shuttle lines and bottlenecks, Capital Metro efficiently moved thousands of fans to the event without the expected hours-long traffic jams. Many downtown businesses benefited from larger crowds, and the city of Austin came across as welcoming and charming on an international stage, which could boost tourism in the future.

It is premature to declare the event a winner without a final analysis of the costs and benefits. Also, there were some financial disappointments and rough patches that should serve as lessons for next year, when Formula One’s US Grand Prix again is staged in Austin. But from the initial evaluation, it was a success.

Formula One’s economic impact to the Austin area was estimated to be $483 million, according to an economic study from COTA supporters; costs for direct expenditures were estimated at $293 million. The race was supposed to generate $26.4 million in new tax revenue for the state and $6.1 million for the city of Austin. Taxes for other local entities were not included.

Such an analysis is important because the Texas Major Events Trust Fund is supposed to provide $25 million a year to Formula One, plus certain expenses. If the race generates less than that in sales taxes, the investment will be deemed unwise. The city, which provided water and sewer lines to the facility and used its police, fire and EMS departments to provide public safety, will do its own analysis about whether its investments paid off. The county’s costs also must be assessed, including what it spent on constructing roads and providing security and traffic control through its departments.

From this analysts view point the potential of the surrounding land improved dramatically with the F1’s success no matter what hiccups occurred.

This figure does not even take into account anything beyond the race itself. Other tracks around the world often become the site of development or hubs for nearby growth, including condos, amusement parks, driving schools, concert venues, technology centers, auto manufacturers’ testing labs, etc.

Grand Prix events in 2008 generated approximately $221 million in Malaysia and $394 million in Bahrain. The Texas Comptroller’s office projects an economic impact of around $300 million annually if the race were to be held in Austin—a larger windfall than that of South by Southwest and an entire season of The University of Texas football home games combined. Stay tuned, it should be interesting since Texas and the south have generally been considered a NASCAR market.

Biggest sustained trend: Apartment market strength

A continued surge in leasing activity, apartment occupancy, and rising rents have made the Austin apartment market the development darling since late 2010. And based on building plans, 2013 is likely to be an even bigger year for apartments, with thousands of rental units on the drawing boards. Developers have already started a handful of projects, and more are in the pipeline.

Regionally, most ‘A’ and ‘B’ sites have been tied up, with activity picking up in the ‘C’ and ‘D’ Class. Even with all the new construction, all four metros see continued strong absorption keeping pace with new properties coming on the market. Many institutional investors strongest focus this year and next is Austin, Houston, San Antonio in that order of preference in acquiring sites and communities.

Biggest improvement: The Austin housing market

We continue to see a better market than the rest of the nation in terms of supply and demand. Yes, other markets are rebounding with higher appreciation, but it is because they fell so far and are just now rebounding. We have seen a healthy rebound (8.4% city wide) in appreciation and sales. Over the last twenty years the metro area has had about a 7.1% appreciation.

We saw demand increase and a strong start of 2012. Sales (new and resale) continue to improve, forcing higher values. However, with continued job creation, lack of speculative building and developing, and pressure on supply should help focus builders and lenders fill the need.

What is happening?

Supply is shrinking
With inventory declining in many submarkets, finding the home of your dreams may become more difficult going forward. There are buyers in many markets surprised that there is no longer a large assortment of houses to choose from. The best homes in the best locations sell first. Don’t miss the opportunity to get that ‘once-in-a-lifetime’ buy.

Rents are skyrocketing
Rents locally have historically increased by 3.2% on an annual basis. Average rent for Austin apartments increased by 6.1% over the past year, which was the 6th-largest increase in the nation. Austin was the only Texas metro among the top ten growth leaders. San Francisco topped the list with a rent increase of 12.6% last year.

Price increases are on the horizon
At the start of 2012, analysts knew that there was a limited inventory of new and resale homes as well as a limited number of rental units coming on line. That said, no one could predict just when the market would turn, but appreciation was sporadic per submarket, and minimal in the five county area. However, many pricing indices (examples: CoreLogic, FHFA, MLS) are reporting that prices are continuing to rise through 2012 and based on the demand, will rise through 2015.

Although the Federal Reserve has said that they will keep borrowing rates low, interest rates are projected to rise. The Mortgage Bankers Association has projected that the 30-year mortgage interest rate will be 4.4% by the end of 2013. That is an increase of approximately one full point over current rates. Interest rates are currently some of the best in history, so why not buy now? Remember the rule that for every point that rates go up, you are able to buy 12% less.

Buy low, sell high
We would all agree that, when investing, we want to buy at the lowest price possible and hope to sell at the highest price. Housing can create family wealth as long as we follow this simple principle. Today, real estate is selling ‘low’. It’s time to buy. Based on prices, mortgage rates and soaring rents, there may have never been a better time in real estate history to purchase a home than right now. Presently we see production builders tying up almost any lot. The top quality lots were taken, so to keep their machines going they have to accept and secure less than desirable lots, due to the lack of inventory in the market.

Biggest office deals

Starting in March of this year, Apple Computer announced the expansion of its Austin presence with a $304 million campus that will ultimately create 3,600 new jobs. In addition, General Motors plans to open a new information technology center in Austin that will staffed by at least 500 people initially with the potential for continued growth. Also, Visa Inc., the international credit card giant, tentatively agreed to build a major global information technology center in Austin that would create 794 new jobs within five years. All of these have a tremendous effect on our limited office space with few new projects in the pipeline.

With every job, you can count between 2 to 2.5 people moving here, so job growth will continue to put a strain on the limited amount of office space in desirable areas. In Texas, Austin is not unique – we are seeing the same dynamics in San Antonio and Houston.

Biggest worry for the New Year: Financing

Shouldn’t the worst be over? Don’t bet on it. Regulation continues to hamper mortgage financing as well as development financing. The good news is the stricter capital requirements of Basel III have been delayed (Basel III would take all real estate financing from 100% risk to 150% risk, causing larger capital requirements from buyers/developers as well as the lenders). Dodd-Franks and the Consumer Finance Regulatory Board are forcing stricter guidelines, which in turn cause the cost of finance to go up and make it more difficult to qualify for.

We don’t see this getting better in the next four to five years. It allows opportunity for large equity, but really handicaps the consumer and small mom and pop builder’s developers who don’t have the capabilities of large equity.

Biggest news in residential development

In January 2010, there were 24,300+/- developed lots in the Austin area not under contract. Of those, 12,000+/- were desirable lots for production builders. By March 2010, 11,000+/- were under option (no longer available), showing the desirability and belief in the Austin housing market by national builders and their management. This flurry of activity in 2010 is looked back at with envy as a time when you could still get quality lots cheaper.

Over 6,000 lots in the Austin area that have not started entitlement or development have been tied up in the last twelve months. Builders and developers will point back to 2012 as the year they really saw the market take a strong turn positive. Are they seeing high appreciation to make up for the last five years? No! No one is overpaying on acquisitions yet. This is typical of markets coming out of recessions – consumers are overcautious about overpaying, and some miss the boat.

Residential and commercial real estate should continue to gain strength in 2013 through 2016, locally and nationally. If you are waiting on the sideline for a better deal, it may be a while.

Where is the economy headed in 2013?

Discussion over the impending “fiscal cliff” and continued fiscal instability from the Eurozone, combined with a still sluggish recovery are leaving many Americans feeling pessimistic about our economic future. However, that fact remains that we are recovering, and there are some less-reported economic barometers that show we are moving in a positive direction. A great place to start is FRED, the economic research of the Federal Reserve Bank of St. Louis.

Household debt is way down over the last five years

For the quarter-century leading up to the Great Recession, American consumers accumulated ever-larger piles of debt, both in absolute terms and relative to the size of the economy. Home mortgages were the largest portion of that, but it also included credit cards, auto loans, and student loan debt. The good news is that in the past three years, Americans have made remarkable progress cleaning up their balance sheets and paying down those debts. After peaking at nearly 98 percent of economic output at the start of 2009, household debt was down to 83 percent of GDP in the spring of 2012. That represents debt reduction of $636 billion, or more than $2,000 for every man, woman and child. It should be noted that some of the decline came from debt being written down (such as in mortgage foreclosures), not from being paid off. But the simple fact is that excessive household debt played a major role getting us into this mess; we are well on our way toward fixing it.

A huge obstacle in recovering from this recession is decreased consumer spending. That trend may have reversed in the latter part of this year, particularly after a 12+% increase this last weekend over previous years in spending during Black Friday. For the first time since the Great Recession hit, American households are taking on more debt than they are shedding, a shift that might represent a more resilient recovery.

For two of the last three quarters, American households’ total outstanding borrowing on things like credit cards, mortgages and auto loans has increased after falling for 14 consecutive quarters. Many analysts even see an end to the long, hard process of deleveraging. That process has been a central reason for the sluggishness of the recovery.

Closely watched economic figures underscore households’ sense of strength. Despite tepid growth and still-high unemployment, consumer confidence has been up dramatically, and last month was at a five year high. It since has slacked off a little this week with concerns over the fiscal cliff, but it is still higher than it’s been in the last three years. Economic growth numbers for the third quarter showed household spending picking up pace as well.

The drop in overall debt is in no small part because of foreclosures. Delinquencies and write-offs by lenders are slowing but have not stopped. But the struggle to pay down old debts might not prove such a drag on economic growth in the future.

Now, with the economy more stable and interest rates at generational lows, Americans finally feel more comfortable taking out a loan on a new car or putting money down on a mortgaged home. With their finances more in balance, workers have started spending less of their paychecks paying off old loans and more on leisure or household goods.

Given the importance of consumer spending to the American economy, those changes translate into a more resilient recovery. Consumer spending still drives 65 to 70 percent of the US GDP growth. The end of deleveraging and the recovery of the housing sector will be strong engines for the United States economy.

Experts estimate that the overall level of debt, compared with income or economic output, would continue to fall for the next one to three years — with the earliest prediction for the end of deleveraging coming in mid-2013 and the latest at the end of 2015.

In addition to household debt being down, the cost of servicing that debt is way down. Not only do American families owe less money than they did a few years ago, the price of maintaining that debt is much lower than it once was. In late 2007, debt service payments added up to a whopping 14 percent of disposable personal income. Now it is down to 10.7 percent, about the same as in the early 1990s. That reflects both Americans reducing their debt burdens (see above), and ultra-low interest rate policies from the Federal Reserve that have reduced rates paid on debts. Translation: It costs Americans $403 billion less, or about $1,300 per person, to make their debt payments than it would if debt service costs were still at their 2007 ratio. Ultimately, the consumer is in a better place to purchase, ultimately driving our economy.

Electricity and natural gas prices have fallen

Americans who cook or heat their homes with natural gas are seeing big savings, thanks to falling prices for fuel. The retail price for consumers’ gas service piped into their homes is down 8.4 percent in the year ended in October. The lower wholesale price of natural gas is also pulling down electricity prices; they are off 1.2 percent over the past year.

A shale-driven glut of natural gas has cut electricity prices for the US power industry dramatically and reduced investment in costlier sources of energy.

These are both utility costs that people can’t control much in the short-run, so low prices here translates directly into more disposable income for Americans to use for everything else they want or need to buy. And in percentage terms, it is most helpful for the middle income and poor, who spend a greater proportion of their income on basic energy needs.

This may appear to be blasphemous in a state whose economic growth is so tied to energy and the natural gas boom. However, due to the quality of the natural gas produced in Texas, we have not been as hard hit as other areas of the country. There are different levels of natural gas generated off of natural gas produced from shale. The Eagle Ford shale south of San Antonio benefits from a higher amount of liquid yields across much of the play, which bring higher prices even while natural gas prices are low. Higher oil prices have helped spur development as oil, condensate, and NGLs (ethane, propane, and butane) all command better prices than natural gas pumped from other shale plays in North America that don’t have as much oil mix or liquid natural gas.

Additionally, although energy is a big portion of the Texas region GDP currently (around 10%), the amount of economic impact it has compared to the ‘Texas oil recession’ of the late 80’s has lessened when 20+% of the states GDP was directly tied to energy. Also unlike the late 80’s, there is a lack of real estate development ‘boom’ presently, potentially softening the economic risks we saw in the ‘oil region’ in the late 80’s.

Businesses quit laying off people

If you are in a Texas metro, you know that businesses are hiring. The national job market has been underwhelming in an economic recovery that officially began more than three years ago, and unemployment remains high at 7.9 percent. But there is some hidden good news in the jobs numbers. While businesses aren’t adding new workers at a pace that would put a dent in the millions of unemployed back on the job very rapidly, they also aren’t slashing jobs at a very rapid clip. Private employers laid off or discharged 1.62 million people in September, according to the Labor Department’s Job Openings and Labor Turnover data. That may sound like a lot, but it’s near the lowest level in the decade the data goes back. During the depths of the recession, employers were slashing more than 2 million jobs a month. And even during 2006, which was in theory a good year on paper for the economy, employers slashed an average of 1.66 million workers a month, more than they are now. It is a sign that even though employers aren’t adding jobs in large numbers, they also are reasonably happy with the workers they have and are not dismissing workers in unusually large numbers. It’s a good time if you already have a job.

In addition, government layoffs have slowed down, helping the economies of Austin and San Antonio who felt the effects of Federal and state budget cuts over the last few years.

Nationally housing is dramatically more affordable

People often speak as if higher home prices are an unambiguously good thing, but that can be misleading. Sure, a retiree looking to sell off a large house and live in a small condo benefits from high home prices. But as we all know, the majority of the ‘boom’ states saw homeowners taking equity out of their homes to fund a lifestyle, so when the market corrected, their was minimal equity left due to the homeowners spending. But most everyone else is better off when buying a home is more affordable rather than less. Six years ago, an average of 40% of each month’s wages were used to pay for housing. Today that amount is closer to 26% of the average private sector employee’s pay. For young people just starting out, young families, or those looking to buy a bigger place, that is hard to beat.

As the media has stated, a housing comeback is now underway; that much is clear. Adding to a steady drumbeat of positive data for the sector, the latest monthly data has showed steady gains in housing starts in the last three months.

The question now is how strong it will be and where it will take place. And to answer those questions it helps to look into the fundamentals of the major US housing markets. These numbers suggest the future for housing is looking bright in the Texas metro areas. But that’s getting ahead of things. A good way to look at which housing markets are potentially overvalued and which are undervalued—and where the market seems to be begging for new home construction and where there is still a surplus of unneeded houses—is to look at the relationship between rents and home prices. Over long periods of time, the price to rent a given house should rise at about the same rate as the price to buy one.

But over shorter periods of time, the two can diverge. And when they do, it is usually a sign that something is up in that market. For example, from 2000 to 2005, prices in the Miami metro area rose by 136 percentage points more than did rents, a sure sign that it was one of the nation’s most bubbly housing markets. Those numbers come from comparing changes in the S&P Case-Shiller home price index for different major metro areas compared with the Labor Department’s consumer price index measure of “Owner’s Equivalent Rent,” for those same areas. Owner’s equivalent rent is a measure of what it would cost to rent the housing stock that people in that city own.

Sure enough, in Miami, in the four years starting in 2005, rents kept rising, up 23 percent, while home prices fell 38 percent. Essentially, the imbalance reversed itself.

Few places have experienced booms and busts quite that dramatic, and we definitely did not see this type of appreciation in rents or home prices in Texas. Nevertheless, the same analytical tools can help explain what cities are poised for a rise in prices and construction in the future. When rents are rising faster than home prices, it is a sign that purchasing a home is becoming relatively more affordable, and so it will behoove people to seriously think about buying. That in turn should create upward pressure on prices in the future and coax builders into the market. These things can move in slow waves, so it’s not necessarily proof that the markets flashing green lights for improvement will get better next year. But over time, this is a solid indicator of where new construction ought to occur.

Here in Texas we never saw the rapid appreciation the rest of the country was experiencing. In the boom years of 2001 through 2006, Texas was 50th in appreciation according to OFHEO, which tracks each state’s residential appreciation. The best news out of this analysis, though, may be this: All of the Texas metros have housing markets that have been in pretty good balance over the last year, with prices rising at about the same rate as rents. And that may be the best sign for the housing market of all. After all these years of bubbles and busts, ups and downs, there finally is a measure of stability. And that is a shift that bodes well for the economy.

So where is the economy headed in 2013? We are optimistic. After the past five years it is easy to continue to be negative, everyone expects it. Third quarter GDP growth was announced this week at 2.7%. We’re not back to the ‘boom’ years, but we are improving. Housing is improving, employment is improving, GDP has some legs underneath it, and all in all the economy shows to be improved in 2013-14 with sustainable demand fueling its growth.