What happens in 2002?

A push-me pull-me economy this year could lead to the most challenging real estate market in quite some time.

by Mark G. Dotzour   This past year has been a challenge to all of us. The slowdown in the national economy was expected. The difficulties facing the telecom and computer industries were well documented. The relentless job growth in Texas continued, albeit at a reduced rate. However, no one could have anticipated the criminal acts of terrorism on the U.S. that are still having social and economic repercussions throughout the world. How does a rational person make business plans for their future in a climate full of uncertainty?

Writing the script for a happy economy

The first step is to look at the overall condition of the U.S. economy. The good news here is that the American economy is like a three-act play that has been totally scripted and choreographed by Alan Greenspan and the Federal Reserve. Up to this point, the play has unfolded exactly as planned.

The first act began in 1991 and lasted until 2000, with nonstop economic expansion and job growth combined with low inflation rate. No one in the 1980s could have guessed that we could have nine years of strong economic growth and still have mortgage rates under 8%!

Act II began in early 2000 when the inflation rate started to creep up. Remember when mortgage rates jumped from near 7% to almost 8.5% in just a matter of months? This set off alarms at the Fed, and Greenspan raised interest rates to keep the economy from overheating.

Act III began in the fall of 2000 when the rate of inflation leveled off and started to fall as the economy slowed. Job growth slowed dramatically with the economy weighted down with high interest rates. Greenspan has responded by dropping interest rates to historically low levels and by increasing the money supply at the same time. This double-dose of financial engineering is very potent. It is only a matter of time before the patient starts to respond.

Of interest rates, job growth, and home prices

In the meantime, America enters the first month of 2002 in a recession that officially started in March. How long will this recession last? No one can answer that with perfect foresight. One of the greatest economists of our era, John Kenneth Galbraith, in October 2001 was quoted in Money saying there are only two kinds of economists currently: those who don’t know what will happen in the future and those who don’t know they don’t know. And it’s not just economists who are struggling to sort out the answers. Many corporate CEOs are admitting that their "visibility" for future earnings and sales is extremely limited.

Despite this extreme uncertainty, business people still must make plans for the future. For those of you in the residential brokerage business, the question is "how many homes are we going to sell in 2002?" Previous Real Estate Center research has shown that home sales volume is largely determined by three factors in Texas: interest rates, job growth, and rising home prices.

When interest rates are low, buying a house is nearly irresistible to American consumers if–and this is a big if–they are confident that they will not be laid off from their jobs. As we come to the close of 2001, mortgage rates are around 7% after a dramatic rise from under 6.5% in just a few weeks. Mortgage rates are likely to hover between 7% and 8% for 2002. Rates are likely to stay at these low levels because there is very little threat of renewed inflation on the immediate horizon. However, the Fed is aggressively trying to reignite the economy, pumping huge amounts of cash into the system. If they overdo it, inflation will pick up and mortgage rates could push 8% or above.

What about home-price trends? Home prices in Texas have increased substantially in the past five years. Prices tend to move upward when demand exceeds the supply of available houses. The most common measure of this relationship is the "months supply of homes for sale." From August 1998 through March 2001, there was less than a five-month supply of homes for sale. When inventory is low like this, home prices can rise dramatically. Newspapers have widely reported that the inventory of unsold homes has risen in 2001. This is true, but some perspective is needed here. As of the date this is written, the latest figures in October 2001 show a 5.5-month inventory, up from 4.8 at the first of the year. However, this is still substantially lower than the 7.4-month inventory in May 1997 (when I was describing the market as "red hot").

Clearly there are more homes for sale today, giving buyers more selection in the market. Some Texas cities have nearly twice as many homes for sale as they did a year ago. These conditions will slow down the rate of appreciation in house values in 2002. The likelihood of slower appreciation will have a dampening effect on sales volume as well.

Job growth is the most important determinant of home sales volume and the most difficult to assess. As we near year end, the economy continues to cool off. The rate of job growth in most Texas cities is declining, while some are experiencing actual declines in employment. The oil and gas industry, computers, and telecommunications are probably going to have another soft year in 2002. When the economy is in recession, the threat of bankruptcy and mergers of large companies in these areas becomes more likely. The airline industry is struggling, but should be able to pull through its current difficulties. About the second time you make that drive from Austin to El Paso is when you decide "next time I’m flying." I’m confident that Americans can make their skies safe for business and tourist travel.

The Mexican economy is slowing dramatically as well. Substantial layoffs are occurring in border communities as the maquiladoras adjust to reduced activity in the U.S. The border communities have been leaders in job growth for nearly all of 2001, but slower truck traffic at the border will soften the explosive growth there as well.

Texas agriculture continues to deal with difficult market conditions. Grain prices and cotton hover at very low levels, and beef prices have softened after gains in recent years.

Along the gulf coast, chemical companies have experienced poor profit conditions due to high cost of inputs and low prices for their final products.

The construction industry will slow down as well, due to reduced construction of office, industrial and retail properties. However, significant increases in state highway expenditures could provide some offsetting strength in this area. Without a doubt, many of the big engines of the Texas economy are sputtering as we enter the new year.

A slight dip from outstanding is still pretty good

So what can we conclude from these observations? Low interest rates are likely to keep homes attractive to purchasers. Conversely, the uncertain job market may dampen enthusiasm to buy homes in the first half of the year. Slowing house-price appreciation may exert a similar dampening influence. It is very likely that home sales volume in Texas will decline in 2002, compared to last year. The decline could range from 5% to 10% from 2001 levels.

Real estate professionals who have been in the business for a long time know that while a slowdown in the market is not pleasant, it is a normal part of the business cycle. A slower year or two are almost always followed by years of dramatic growth in sales volume. For Texas families who need to sell a house this year, 2002 could be the most difficult year we’ve seen in several years. They will need the services of a real estate professional more than ever. Good years or bad, there is always demand for real estate professionals who stay on top of local market conditions and provide quality service. So roll up your sleeves and get ready for another year of helping Texans achieve their housing dreams.

Mark Dotzour, Ph.D, is chief economist and director of research for the Real Estate Center at Texas A&M University.

Illustration © Digital Vision.

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