Tom Heintjes: Hello, and welcome back to another episode of the Economy Matters podcast. I'm Tom Heintjes, managing editor of the Atlanta Fed's Economy Matters magazine. Today, we're talking about real estate in the Southeast with Jessica Dill, an economic policy analyst in the Atlanta Fed's research department, and Carl Hudson, director of the Atlanta Fed's Center for Real Estate Analytics. Thanks for making time to talk with us today.

Jessica Dill: Thanks for having us, Tom.

Carl Hudson: Thanks, Tom.

Heintjes: Carl and Jessica, discussing real estate is a challenge because it's made up of a number of smaller areas of activity, so I wanted to start out by asking you about commercial real estate, or as we call it, CRE. There's been talk of another bubble forming in CRE, but are there really strong parallels to the symptoms we saw around 2004, 2005, and 2006?

Taking the Temperature of Real Estate Carl Hudson and Jessica Dill

Dill: It's really difficult to call a bubble, which by definition is when the price of an asset deviates from its fundamental value, and that's because it's not possible to observe a fundamental value. So while the answer is isn't completely clear, we have some evidence that we'll discuss today on both sides of this debate.

I'll go ahead and take some of the evidence that suggests there might be a bubble. On the one hand, there has been a steady increase in CRE prices for many property types. Specifically values associated with apartments and central business district office properties. They have surpassed their 2007 peaks by 4.4 percent and 48.4 percent, respectively. Also, there has been considerable cap rate compression across the property types, particularly in the six major markets. And those markets are Boston, Chicago, Los Angeles, New York, San Francisco, and Washington DC.

A lot of people also point to a record amount of foreign capital of that's been attracted in 2015 to commercial real estate. Through the third quarter of 2015, $72 billion was attracted across the various property types. To put this in perspective, the prior record was $51 billion in 2007. According to contacts that we talked to, the inflow of foreign capital is likely to continue increasing, especially given recent regulatory changes and global uncertainty that will likely result in the flight of capital. There has also been some evidence to suggest that leverage is increasing in commercial mortgages. When this happens, a lot of people start getting a little concerned.

Heintjes: You mentioned high leverage. What would be an example of high leverage?

Hudson: Well, leverage refers to the amount you're borrowing, relative to the value of the asset that's being pledged as collateral. So, think of it with a house—usually the lingo is LTV; that is, loan to value. How much is the loan relative to the value of the house? So, higher degrees of leverage mean you're borrowing money. You're using other people's money to fund your investment. So, that's one thing that bank examiners are concerned about because the adage goes, "The worst loans are made in the best of times." So, right now we're seeing the economy growing at an OK rate, problem loans are at a low level, so times are actually pretty good. This is probably the time where examiners are hoping that banks are being vigilant in their underwriting practices.

Heintjes: That's great information, but if that's on the one hand, there must be something on the other hand, right?

Hudson: One thing that makes me not as concerned as all those points Jessica mentioned is the fact that there hasn't been as much construction activity. That is, we're not seeing a big pipeline of new office properties, retail properties, and warehouse properties that we saw in the early 2000s. One thing that really exacerbates the price increases is if we see builders and developers react to these higher prices and start to build new product. This is typically what happens, because supplying product takes a lot longer than demanding it. I can decide I want a business and go try to sign a lease and get more office space. But with a builder, it's going to take time to go through the construction process. So, if you look at the data—and I don't have the specific numbers with me—we have far less square feet of office and retail product under way compared to 2000. And not only is it the stuff that's under way is lower, but the pipeline—that is the number of square feet that are under various stages of planning—is a lot lower. So one of the things that might really save us is the fact that it's going to take time for new supply to come on the market and react to these higher prices that Jessica cited.

Heintjes: So, to your mind, these factors you just mentioned sort of tamp down talk of a bubble?

Hudson: Yes, and one thing to add—since this was going to focus some on the Southeast—is that these trends I was talking about are national. However, if you dig down and look at Atlanta, it's very low. For example, the amount of retail starts over the past year are about 10 percent of what they were at the peak before the bubble. If you look at office, it's maybe 50 percent of what was under way at the peak of prerecession.

So in the Southeast especially, we're not seeing this wave of new construction. As Jessica pointed out, if we break it down and look at the six markets—New York, San Francisco, Chicago and the others—that's where most of the action is. To me, part of that is that's where foreign capital has been attracted because they've heard of those towns. If we were to name towns in China, what do you name besides Shanghai and Beijing? Can you name the number eight city in China? I can't, so maybe I wouldn't be as tempted to invest there. Just like they might not like to invest in cities they're not really familiar with.

Heintjes: Well, we used to hear a lot about “frothy markets,” and we don't hear so much about frothy markets on a national basis right now, do we?

Hudson: Well, on a national basis, again some of these prices have gone up and I would want to break down what is happening in the major markets and what is going [on] in the secondary markets. Now one other point, she mentioned how the cap rates have fallen, one important difference I see is in the early 2000s, the cap rates went down much more quickly than did 10-year Treasury rates. So if you look at the spread between an average or cap rate and the 10-year rate, those got mighty narrow. That means there's not much pricing for risk. The risk premium you want above a 10-year Treasury isn't very much. Now, cap rates are lower, there's no doubt, but the spread between the cap rate and the 10-year bond is still pretty wide. It's about the same as it was in 2003, prior to the buildup of the last bubble.

Heintjes: And that was obviously well over 10 years ago.

Hudson: That was well over 10 years ago. So it does appear that if cap rates have fallen. It's really more likely due to a decrease in the overall level of interest rates, versus this lack of pricing for risk.

Heintjes: I noticed that in your remarks, you didn't mention the apartment sector, and I wanted to get you to touch on apartments, in terms of its relation to CRE.

Dill: Thanks for prompting us on that, Tom. We actually left out apartments intentionally, and that's because it's a bit tricky. Apartments, depending on who you talk to, are considered both commercial real estate and residential real estate. So when you asked us to speak about commercial, we left it out. They're considered commercial real estate because they're income-producing, but they're considered residential real estate because it houses people. So that's one reason we skipped over it.

Another reason is, when you look at trends in apartments, they don't behave the same way as other commercial real estate properties or in the same way as other homes. So we left that out intentionally.

Heintjes: Some metro areas have seen a fair number of apartment units added, not only in the Southeast, but across the U.S. Aren't there concerns about overbuilding in the multifamily sector, and how does that fit into the larger real estate picture?

Hudson: Well, when you consider overbuilding, we would look at starts, but we would also want to look at household formation. After the recession, if you went to any gathering where they were discussing housing, there's always the joke about having kids living in the basement.

Heintjes: The boomerang generation.

Hudson: The boomerang generation. So if that was in fact the case, but it had to be. You see it on TV commercials, the kid living at home. That's taking away demand for housing units, be they rental or a single-family house…multi-family, single-family, rent, own. If you look at the population statistics by cohort, that 25 to 35 year cohort is growing. And while they may take longer to get out of their parents' house, eventually they're going to want some form of housing on their own.

Heintjes: And their parents will want them to have it.

Hudson: Probably—I can't speak for all parents. So, the household formation—though it was dampened or depressed during the recession—there's signs that it's coming back. If you look at the total starts, be they single-family or multifamily, look back over the last 50 years: the worst four years for starts were 2009, '10, '11, and '12. So we've only seen starts really increase over the last three years. And the levels are still, on an absolute level, commensurate with just coming out of a recession. If you look at the long history of starts, the current level of starts about 1.2 million is consistent with either the trough of past recessions or the early stages of a recovery. We're into years—we're in the late stages, by some measures—of a recovery and starts still haven't really bounced back. Especially if the household formation numbers come back to where we think they should be.

Heintjes: Guys, not to belabor the point, but I wanted to touch again on the question of a real estate bubble. I guess after the events of recent years, we're all still hyper-aware of the possibility of a bubble recurring, and while house price-to-rent ratios are not quite where they were in years past, they are heading in that direction. Is it a cause for any concern?

Hudson: Many people are definitely concerned. For example, the president of the San Francisco Fed, John Williams, suggested there are signs of imbalances starting to emerge. And this price-to-rent ratio that you mentioned is cited. Why do we look at that? Well, looking for a housing unit, you can either buy or rent. And so if prices get far ahead of rents, then you may see people decide not to buy and start renting, which would then lower the house prices, lower the demand.

Part of the housing bubble of the 2000s, was prices shot up—much more quickly than the rents. Then when demand fell off, the prices fell more commensurate with the rents. So anytime the rent and price don't really grow at some reasonable correlation, there's probably going to be a correction. Now, one thing we have going for us is, because there were a lot of people that, for whatever reason—they lost their job, they had a bankruptcy, they've had their credit record tarnished—they're not able to buy. So they're renting. So we have seen rents grow in addition to house prices grow.

Heintjes: People who were previously homeowners are now renters.

Hudson: And I believe younger consumers are also delaying when they would actually consider buying a house and are renting longer than they would.

Dill: I can pick up here. In an effort to better understand house price trends, we took a look at the data and we went ahead and charted house price trends at a ZIP code level, in a stacked bar chart fashion. So basically, if you live in ZIP code 30309 and you experienced 5 percent house price appreciation from this year to last year, you might fall in a green category. And if Carl lived in 30319 and experienced a 5 percent decline, he would be in a different category, in red. So we did that across the nation and aggregated it up so that we would have a chart in variations of green and red showing whether you experienced house price decline or house price increases.

Heintjes: Did the data tell you anything in particular?

Dill: So the data was really interesting. It painted this picture that was much more detailed than a single line chart. It showed us that the majority of ZIP codes across the U.S. are experiencing some degree of house price increase, but very modest levels—not like we saw in the bubble. So we did this over time, and you can see in the bubble years that you saw a lot of dark green—high appreciation—from year to year, and now you're seeing modest, light levels of green.

And so we thought this is pretty interesting. Why don't we see how this looks with the house price-to-rent ratio overlaid on top? So let's see what's going on with prices and rents at the same time, and we see that even when the house price-to-rent ratio is rising, as it was in bubble territory, we're not back to where we were. We did this at the national level and at regional levels, and you could see certain markets, like San Francisco, looked a little alarming. But other markets like Atlanta—that also was affected in the past bubble—don't look like much is going on in terms of prices to rents.

Hudson: And to bring that back to the Southeast, if you look at metropolitan areas such as Miami, if you think of what Jessica described—also maybe as a pie chart, where you're looking at the percentage of ZIP codes that are experiencing various degrees of home price appreciation—Miami's pie would have gone from a green pie, where almost all ZIP codes were really going up in price in the 2004–05 level, to almost a completely red [pie], where [in] every ZIP code in Miami, house prices were falling dramatically. If you look now, it's more of a green pie, but it's a light green pie. It's not really being dominated by very high rates of home price appreciation.

Heintjes: Right.

Dill: So, while there might be some reason for concern, where we're at now is not quite, in our opinion, where we were at before. And that gives some reassurance.

Hudson: And the other thing, if you look at different MSAs [metropolitan statistical area], house prices, and rents, they're going to be related to what we call a housing elasticity—that is, how quickly does supply react to a change in demand? Certain cities, like Miami and San Francisco, they have natural barriers to growth. That is, they've got an ocean next to them. So they have a very low elasticity. That is, if there's a big increase in demand, it's difficult for supply to react. And that's why you would see volatile prices. Prices have to go up to clear the market.

Heintjes: And it looks lie Atlanta has greater elasticity because we don't have those boundaries.

Hudson: We don't have any boundaries. In fact, just this morning I was hearing one person say we're basically unlimited; we can go in any direction. Maybe north, there's some mountains—but then again, north of downtown Atlanta is where we've seen the most building activity.

Heintjes: You mentioned the region, and I wanted to bring this back to the Southeast. In the southeast—and in some Florida markets specifically—we hear some talk about foreign investment in real estate playing a significant role. How observable are the effects of this type of investment, and is it more prevalent in CRE, or residential, or both?

Dill: That's a great question, Tom. As I alluded to earlier in my response regarding fears of a potential bubble in commercial real estate, in part due to attracting record amounts of foreign capital, foreign investors are indeed quite active around the U.S. It's hard to say whether it's more prevalent in commercial or residential real estate, though, and I think it just depends on your vantage point—whether you're a homeowner or maybe a business. I did pull a few data points, though, to help put foreign investment into perspective. I'd like to talk a little bit about the national picture, and then contrast it to the state of Florida, because the state of Florida, as you mentioned, does attract quite a bit of international capital.

So nationally, residential real estate attracted $104 billion in foreign capital between April 2014 and March 2015. So that would be the 2015 data, the latest data we have on hand. And this is according to survey data released by the National Association of Realtors, or the NAR. That represents the sale of 209,000 homes, or approximately 4 percent of all existing homes sold in the U.S.

When looking at the countries of origin of that capital, Canada, China, Mexico, India, and the United Kingdom accounted for approximately 51 percent of that capital. Those were the big players. And where did all of the foreign capital go? It primarily went to home sales in Florida, California, Texas, and Arizona—about half of it went there.

Heintjes: I thought you'd say New York, too.

Dill: Surprisingly, no. Let's think about commercial real estate, then. You asked which one's more prevalent. If you go on dollar value, it's going to be residential real estate because as I mentioned, residential real estate attracted $104 billion…commercial real estate only attracted $56 billion during the same period. The commercial real estate data comes from a firm called Real Capital Analytics. So, that dollar amount represents investments in about 1,800 properties as it compared to 200,000 residential properties.

When we look at countries of origin on the commercial side, Canada is, again, one of the big sources of investment, as well as Singapore and China. Those three countries accounted for approximately 56 percent of the investment coming in. And who were the big receivers of this investment? Well, not surprisingly, we talked about the six top markets—from this data source, Manhattan, Dallas, and Boston were the top market destinations for that capital.

So when we look at those top lists, Atlanta and south Florida did make the top list—they weren't the top markets, but they made the list. So I dug a bit deeper into Florida to see what was going on there.

Residential real estate attracted about $23 billion in foreign capital in the state of Florida last year between July 2014 and June 2015, according to the latest survey data released jointly by the National Association of Realtors and the Florida Realtors. That represents the sale of about 44,000 homes, or approximately 12 percent of all sales in Florida.

When we look at the top countries of origin, it changes a bit. Venezuela, Canada, and Brazil accounted for the top countries, and that money went mostly to South Florida and Orlando. Commercial real estate attracted only $4 billion in the state of Florida during that same period. Canada, Norway, and Singapore were the top sources of investment, so again we're looking at different players, hence my point about "depends on your vantage point". And again, Miami, Broward County, and Orlando were the top market destinations.

Heintjes: Jessica, in a discussion about foreign investment in real estate, where does the condo market fit in?

Dill: In all of the data that I spoke about previously, that was strictly about existing home sales and commercial real estate. It didn't really talk about foreign capital going towards condo development. The last time around, a lot of condo development was financed by banks, but this time around, there's not much of an appetite on the part of banks to make loans for construction development of condos. So in South Florida there's a lot of construction going on, but that money is coming from foreign investors. I don't have a lot of data on the dollar volume of investment, but I do know that there are 416 condo developments under construction in some form or phase in south Florida—that's just under 50,000 units that are under development, and that's being paid for, in large part, by foreign investment.

Heintjes: I should note that that's in January 2016, for our listeners' benefit.

Dill: Exactly. That's data as of January of 2016.

Heintjes: I wanted to talk briefly about office buildings. How have rents changed since the recession? I see lots of cranes in the Atlanta skyline. Are office buildings going up at a greater rate these days? We always hear how exorbitant rents are in Manhattan and San Francisco, but we haven't seen those types of increases in the Southeast, have we?

Hudson: It's interesting. There are a lot of cranes in the Atlanta area. Most of the cranes are either building stadiums or multifamily apartment buildings. There's been very little office development. What little there has been, has been what they call "build to suit," where there's a business such as NCR that decides "I want to locate in midtown Atlanta,” and they are going to build a building. So that's not very risky because the builder knows there's going to be a tenant. The other kind of office development would be spec, where they are going to build it and try to lease out the building to various tenants while the building is being built.

Heintjes: Right. What is the office-rent environment like these days?

Hudson: Well, rents are increasing, because Atlanta has been adding jobs—around 60,000 jobs over the last year. Not all those people require office space, but some do, so there's going to be some increased demand for office space. Prior to the recession, we actually probably built more than we needed, so a lot of this has been absorbing excess inventory that we'd built earlier. But, the rents are going up, which is an indication that we're getting to the point where the readily available stock of office space is dwindling. At some point this is going to spur new development. What I've heard developers say is, the rents need to be around $35 to $40 a square foot, and they are just now breaching the $30 a square foot level and going up.

So right now, there's not the great impetus to be building a lot of new office space just given the costs of construction, which can be on the order of $350 to $400 a square foot. That's pretty high. The developers we talk to all complain about the increasing costs of construction. Interestingly enough for the Atlanta area, these stadiums that I mentioned, they are going to wind down eventually by 2017. One of the things that will do is release a lot of labor that is dedicated to building those stadiums, and it will be available to other types of projects. I don't know if someone wants to move from a different part of the country to Atlanta just to build a building. If these workers that are already here are looking for another project, they're going to be available. So there is some talk that I've heard that once these stadiums are completed, that's going to free up some resources to build other products.

Heintjes: Ten years from now we'll be knocking down those new stadiums and building newer ones, so we have that to look forward to. Well, this has been a great conversation, and I think it would be fun, or at least interesting, to come back with you guys in a year or so and revisit all this to see where we stand.

Hudson: The one thing I'd like to end with is this whole talk was bubbles. As we started with, bubbles are very difficult to identify. We usually see a lot of price increases with bubbles, and there's less pricing for risk. We also see higher levels of leverage associated with these bubbles. Third—probably most importantly—is this large pipeline of supply and, just to reiterate, demand for real estate can change much more quickly than supply. Really, the good news is, despite the higher CRE prices, and despite some signs of higher leverage, that pipeline of new supply really isn't there compared to 10–15 years ago.

Heintjes: You're right, that's a great point to keep in mind, and I appreciate your emphasizing it.

Hudson: And the one thing is, just because it's not happening at a regional or national level doesn't mean there couldn't be pockets that are boiling over. Really, the dangerous thing for the economy would be if the whole country was experiencing it. It seems to be more regional hotspots, though, which is typical.

Heintjes: The frothiness we talked about.

Hudson: Frothiness—it's not the whole country frothing at once. There will be little hot spots. That's something we've dealt with throughout history.

Heintjes: Great takeaway, I appreciate you making that point, and I want to thank you both for talking with us today.

Hudson and Dill: Thanks, Tom!

Heintjes: Again, I'm Tom Heintjes, managing editor of the of the Atlanta Fed's Economy Matters magazine. Thanks for spending some time with us today. I encourage you to visit Economy Matters at frbatlanta.org/economymatters and read the many interesting features we have for you there, including the Center for Real Estate Analytics web page, which has lots of interesting information about regional real estate. Let's get together again next month, and thanks for listening!