Although 2006 started off with strong economically, the year finished on a lower note. In the first half of the year, GDP growth surged forwarded at a 4.1% annualized rate. Third quarter GDP growth slowed down to an annualized rate of 2.0% and it is likely that fourth quarter GDP growth will be similar, though slightly higher at 2.5% due a slowdown in personal consumption expenditures and an increase in the savings rate. We expect this trend to continue into the first half of 2007. Job growth will slow to an average gain of 125,000 jobs a month, from an average of 165,000 jobs gained a month in 2006. If credit conditions continue to normalize and don’t retract, as we expect, growth should recover in the second half due to an increase in net exports, a stabilization in the residential housing sector, and inventory rebuilding, which we predict will rebound after a decline inventories. Other key indicators such as demand for office space are also showing a slowdown after strong gains in the beginning of 2006. Equipment Leasing is still growing strongly year-over-year, but has shown some leveling off, which according to past data is a leading indicator of economic activity. Both of these statistics combined paint a picture of a slowdown in growth, and not an outright recession. Anecdotal evidence has suggested that small businesses especially, are having difficulty attracting and retaining talent. This is backed up by an increase in jobs posted online compared to the labor force. Higher demand for skilled labor will increase compensation in certain areas, and raise the overall skill level in the economy, which initially will lower productivity growth as we are seeing now, but will increase overall productivity growth, and by a matter of course, raise wages. Consequently the increase in income, and low unemployment will support growth in personal consumption expenditures.
Continued below-trend growth will contribute to an easing in pricing pressures. This trend is already evident, as the annual rate of inflation as measured by CPI has tailed off towards the end of 2006, from a high of 4.1% in June 2006, down to 2.0% in November. The less volatile “core” CPI, which excludes energy and food, fell from a high of a 2.9% annual gain in September 2006, to an annual gain of 2.6% in November. The acceleration in the rate of inflation that was propelled by energy prices seems to largely have subsided, lessening the pressure on the Federal Reserve to raise rates. If this deceleration continues, the Federal Reserve will be able to lower short-term rates as most observers expect them to.
Inflationary expectations, while still elevated from over comparable periods in 2005, have started to recede back to more comfortable levels.
Job growth will continue to be concentrated in service sectors jobs, with manufacturing employment falling slightly. Metropolitan areas with strong professional business sectors, and new household formation will continue to benefit, whereas slower growth metropolitan areas with strong base employment such as the San Jose-Santa Clara MSA, will continue to have a stratified labor market with strong gains at the very top end for skilled workers, but slow overall growth in employment and median income.
The Investment Climate
Low interest rates and a continuing improvement in average NOI moderated out the effect of a severe reduction in condo conversions. Low interest rates kept cap rates at a low level and improvements in NOI held pricing steady despite the absence of the aggressive bidding of the condo conversion buyers. Average seller cap rates fell slightly from 6.4% to 6.1% in 2006, despite a rise in equivalent bond rates from a 2005 average of 6.0% to a 2006 average of 6.5%. This indicates bullish investor sentiment for the future of multifamily properties. However, we believe that, pricing will stabilize in 2007. Gross yields and average cap rates will shift slightly higher, representing a broad stabilization of pricing in the market, as NOI expectations will shift slightly. We believe that operationally, the broad market hit a cyclical peak in expected rent per unit in the third quarter of 2006. Some markets, especially in the Midwest will experience favorable investment conditions, but slow in-migration will temper any gain in pricing power by owners. Given the expected trends, we expect the average yield per unit to increase slightly reflecting a leveling off of and possible decline in some markets in price per unit.
New apartment building starts will increase over their levels last year. Some previously planned for-sale projects will shift over into rentals due to strong rental traction and a slowing for-sale market. Also, rising construction costs, which had put a heavy damper on new apartment construction in many markets and had skewed new construction toward Class A product, have eased and will allow builders to pursue a wider variety of new construction projects. In addition, many properties that were set to be converted to condos, in fast rising markets like Phoenix, Las Vegas and Florida will revert back to rental properties. All of these factors will increase the available supply of apartment units.
In the longer term, a deepening of the available finance pool via CMBS debt, market indices and other financial tools, will lower the cost of capital, and allow investors greater flexibility in taking on risk. Financial innovation has deepened capital markets in other industries and will lead to lower lending rates, and hence better pricing.
Cap rates have fallen significantly since 2000, and part of this is a reflection of capital deepening, and partly due to an overall lower cost of capital throughout the economy. Fed Chairman Ben Bernanke has described this as a global savings glut, by which he means that global capital availability has increased faster than the available projects to invest in. Lower default rates, and sustained disinflation throughout the world, have also helped lower the cost of capital. We are projecting a slight rise in cap rates in 2007.
The slowdown in job growth will manifest itself in slowing household formation, and therefore a lower rate of absorption for apartments. We are forecasting that demand will fall about 30% in the major metropolitan areas that we track, from approximately 93,000 units in 2006, to around 63,000 units in 2007, the vacancy rate will increase 10 basis points to 5.5%. Construction in the major metropolitan areas will total 70,000 units in 2007, slightly exceeding the rate of demand. Overall, the level of concessions should rise slightly because of a slackening in demand. Uncertainty in the for-sale market is currently benefiting apartment operators. In the last half of 2007, we expect that the for-sale market will firm up, contributing to a slackening in demand for apartment units as mortgage rates remain at historically low levels. A general fall in for-sale housing prices via HOA concessions, payment of closing costs, and other non-price concessions, and even in some markets outright year-over-year price declines, will help raise the level of affordability. Some of the gains in affordability will be offset by stricter lending standards, particularly in the subprime market. Overall, though capital is abundant in the mortgage markets, which means that lending rates will remain low and demand should firm up.