CRISIS OF CONFIDENCE–
THE EFFECT OF THE GLOBAL ECONOMY ON YOUR PROPERTY VALUES

Overview

Since the economy began to show signs of trouble, there have been several catch-phrases that have appeared with increasing frequency within the media. Sayings like, “Main Street versus Wall Street,” “the credit freeze,” and “the housing bubble.” Added to this, elections are dominated by one-liners, or even just a single word. Moreover, it often seems that the success of a campaign largely depends on which candidate can most succulently deliver a message that resonates with the most voters. If you don’t believe me, just ask “Joe the plumber.”

Although catch-phrases often fail to paint the whole picture, there does seem to be a general tone to our current economic situation. While efforts of historic proportion have been taken to avoid total financial collapse, the consensus view remains that the bottom may still have yet to come. Put simply, no one knows for sure what will happen. Things could get worse and we are indeed facing both a recession and an enduring crisis of confidence.

What is this crisis of confidence? Well, let’s summarize where things stand on a national, international, and local level. This may get a little thick with economic-speak, but stick with me for a few hundred words.

Crisis In Confidence

Here in the United States, the housing sector continues to suffer. In some areas, prices are down 30-40%, with defaults on the rise and a growing number of homes for sale with no buyers in sight. Unemployment is up, with many layoffs occurring in retail, manufacturing, financial services and the mortgage industry. Consumer spending is down substantially, marked by a notably weak back-to-school season. Retailers are also bracing themselves for equally lackluster holiday sales. A report that manufacturing had slowed considerably sent the stock market off a cliff. As for the stock market, well, it’s behaving like a yoyo. Consequently, many have seen their retirement savings butchered. People are now scrambling to figure out how to live on the scraps.

For many other countries the news isn’t good either. Finland almost went bust, while England has been undergoing an even worse version of a housing crisis. That, coupled with the fact that the British love credit cards even more than we Americans, has them gloomy for reasons other than bad weather. Furthermore, conditions abroad have become so dire that the European Union wants to restructure many of the fundamental aspects of the international economy. Given that our financial institutions and businesses are now inextricably linked, an overhaul of this magnitude would drastically change the free market system of the U.S. Although President Bush does not support the EU’s ambitious musings, many experts believe that if our economy gets any worse the U.S. may be forced to concede on some level.

What about California? As many of you are well aware, California had a small budget problem; in that, it did not have one. Teachers and other state employees almost did not get paid. Even after the budget finally passed, there was the other minor issue of the $6 billion deficit and cash shortfall. Luckily, the State’s $5 billion sale of short term notes has worked better than expected. However, the issue still remains of whether to raise taxes, cut spending, or both. Then there’s the economy. The unemployment rate is figured to be 7.7%. With that said, many estimate the real number to be even higher. Unemployment figures are not in real-time and also do not take into account those who have gone from full-time to part-time work. Basically, unemployment in California is high. Just to put this statistic in further perspective, California is the 8th largest economy in the world. In other words, this figure is kind of a big deal.
So this is a brief picture of where things are, right now. We are in the midst of a global economic crisis. Everyone is more or less affected. Many have already seen their investments diminish. The crisis in confidence reflects the reality that although our government has taken robust measures to stabilize the economy, no one knows for sure how far down the bottom rests. Even if we have already reached a plateau, experts anticipate the recovery will not occur until mid-to-late 2009– perhaps even beyond that.

What Does This Mean To Me, The Apartment Owner?

Given the instability of the overall economy, many of you are wondering about the value of your property investments. Everyday you see the stock market swing one way or the other. If you want to know a stock price, or the average of a particular index or mutual fund, it’s easy to go online and within a minute or two you have the answer. The internet is great that way. However, if you own an apartment complex then gauging the price is a little trickier. Okay, maybe it’s a lot trickier. Now more than ever is when you want to know where you stand and what to do about it. Since this magazine deals with Santa Monica/Westside apartments and that’s my area of expertise, let’s talk about values in light of the current economic climate. Perhaps it’s not as bad as you think. Whatever the case, we are going to pull through just fine.

Determining Value

“Capitalization Rate” is probably one of the most-often employed indicators of property values and market trends. I want to add that it is over-used and abused in its use, but everyone applies it in the same manner, so it tends to work. To summarize, the Capitalization Rate (“Cap Rate” for short) is the ratio between the Net Operating Income (defined as the Gross Income, less Vacancy and Operating Expenses, but before deduction for Debt Services) and the Value (price) of a property. As an example, if the Net Income is $90,000 per year, and the Cap Rate is 9%, then the Value is $1,000,000.

The Cap Rate is divided into the Net Income to determine Value. It is an inverse relationship, which means as the Cap Rate goes down, the Value goes up.

If a property already has a Value established, and the owner says it is being sold on a 7% Cap Rate, then you multiply the Value by the Cap Rate in order to determine the Net Income (example: $900,000 price x 7% Cap Rate = $63,000 Net Income). Cap Rates in various product sectors (i.e. Office, Industrial, Retail, and Apartments) have generally been trending upward for the past eighteen months in Los Angeles County. This cooling off of Cap Rates follows a five-year period of a major decline of Cap Rates (hence, prices were rising).

I will have more to say about the numbers in my next column when I summarize 2008 and make some predictions for 2009, so for now just note that transaction velocity and transaction volume is trending toward a continued decrease that began in 2006. On the positive side, Price per Unit continues an increasing trend.

Based upon my own research and direct experience though, prices have dropped only slightly from where they were 6 months ago. That said, and depending on how deep our current recession-like conditions extend, local-area rents will have to come down. With further hikes in unemployment caused by business failures and downsizing, it’s only inevitable that such trends will trickle down and affect values of multi-family real estate. Even in “A” locations, such as Santa Monica, values will come down before stabilizing.

While we are still closer to the “peak” of 2007, I predict that within 6-12 months, values are expected to correct themselves to the 11-12 x gross range, with Cap Rates going up to 6.0% - 6.5%.

Of course, as we see the market changing, it is best to stay current by consulting a real estate professional.