Changes afoot in the broader real estate market

Summary: With consumer debt, fueled by mortgage refinance, coming to a head, the ripple effect will be felt throughout the residential real estate market, and subsequently the commercial market. Investors would do well to heed the warning signs.

It's finally happening. The recent repeated warnings of economists and industry watchers predicted the housing boom of the 2000s is winding down. The recent news is full of reports about slowing existing home sales, rising inventories, longer selling cycles and lower asking prices. So if the housing market finally appears to be cooling down, commercial real estate investors should take notice. Here's why: There's a strong connection between the residential boom and the health of the four key commercial sectors - retail, multifamily, office and industrial. Soaring home prices and low interest rates have enabled millions of homeowners to take out home equity loans and cash-out refinancing and the resulting wealth effect has percolated through the economy. The big beneficiary was retail real estate, where owners of malls and shopping centers have seen valuations skyrocket, along with retail receipts. The boom also has helped drive growth in industrial construction, particularly on the West Coast, to handle incoming Chinese goods. It has also bolstered office occupancies in hot residential markets as the mortgage business expanded. Finally, the housing boom has whipsawed multifamily properties, first crushing occupancy rates as renters became owners and more recently boosting occupancy rates as the condo craze cull units from the rental inventory. Changes are afoot. Existing home sales plummeted 2.7% last month - more than double the 1.1% that analysts predicted in September - and 2.87 million unsold homes are now on the market (which represents the largest unsold inventory since 1986, reports the National Association of Realtors). Even David Lereah, the chief economist at the National Association of Realtors (NAR), stated recently that the housing sector "has passed its peak." With home-equity cash running dry, homeowners will reign in retail spending next year. This could materially impact retail REITs, particularly those with large holdings in pricey markets such as Southern California and the Northeastern cities. According to PricewaterhouseCoopers' most recent Emerging Trends In Real Estate 2006 report, the only factor that will keep consumer spending afloat are wage increases. However, energy costs and rising mortgage rates could zip pocketbooks. Retail has all the risk. After retail, multifamily is the most directly affected sector in the housing slowdown. And, in this case, the news could be good. With apartments dropping out of the rental pool and more renters priced out of the purchase market, national apartment vacancies dropped from 6.4% to 5.8% between midyear and the end of September, the largest quarterly drop that Manhattan-based Reis Inc. has measured since it began tracking the apartment market in 1999. There is one caveat, however: Overhanging the rental market is a potential glut of condos. If converters fail to sell recently converted condominium units and throw them back into the rental market, occupancy rates could fall again. A housing slowdown could also ripple through pockets of the office market, especially those where residential mortgage firms have aggressively staffed up in recent years. No market exemplifies this trend better than Orange County, Calif., where heated demand to buy homes and refinance existing loans has fueled a leasing binge on behalf of these firms. This won't help, either. Roughly 37% of all recent homebuyers in Orange County are using interest-only mortgages (requiring the first few years of the mortgage to be just interest payments). Orange County is the third most expensive housing market in the country after Los Angeles and San Diego, so it's obvious why so many new owners are resorting to creative financing methods. Much like the office market, the industrial market is also exposed to ripple effects from a housing slowdown. The difference here is that any negative effects will be delayed for several months because the industrial market tends to move at a much slower pace than its peers. To Bob Bach, national director of research at Grubb & Ellis, the industrial market is possibly the least exposed property class for one simple reason - imports. Of course, the biggest threat to commercial real estate would be a national recession, sparked by a slowdown in retail sales (consumer spending now accounts for roughly 72% of GDP). The gloom scenario is a downward spiral. Consumer spending falters because the cash-out boom ends and the situation is made worse by rising fuel prices and higher interest rates on all consumer debt. That triggers falling profits, layoffs, deeper cutbacks in consumer spending