2005 Real Estate Market Forecast

The combination of low interest rates, strong home price appreciation, and moderate job growth that drove record-setting home sales in 2004 should continue to fuel the sale of homes in 2005, say economists from around the nation. Meanwhile, the commercial real estate market should expect a revival.

"Home sales will ease but will remain extremely high by historic standards, so 2005 promises to be yet another extraordinary year," said David Lereah, chief economist for the National Association of Realtors®.

Last year's record sales performance was due in large part to mortgage interest rates that averaged a low 5.9 percent. For this year, NAR is forecasting sales of 6.3 million existing homes, 1.1 million new homes, and 930,000 condominiums and co-ops. NAR's forecast calls for the mortgage interest rate to average 6.5 percent in 2005.

It was low mortgage rates, supported by an accommodating Federal Reserve that dropped its benchmark interest rates to an historically low 1 percent in 2003, that made move-up buying attractive to existing homeowners and encouraged new, immigrant, and renter households to jump into the market. More than 69 percent of households in this country now own their own homes, according to data from the U.S. Census Bureau.

The interest in buying came even as household income growth remained modest, about 3 percent, and home prices posted a healthy average 7 percent gain. NAR projects income growth near 4 percent in 2005.

"Because many people are buying with little downpayment, you're going to see sales volume go up whenever interest rates stay low and price appreciation goes up, even if people's income isn't rising much," says Mark Dotzour, chief economist at the Real Estate Center at Texas A&M University. "That's what we saw in 2004. Buyers were using the leveraging value of low rates to take advantage of those gains in appreciation."

Strong home sales kept inventories at a tight 4.3-month supply nationwide. That's one of the reasons price appreciation has been so strong, says NAR. But that should change somewhat in 2005.

With mortgage rates rising as the Federal Reserve Board attempts to avoid over-stimulating the economy, sales will slow, inventories will soften, and appreciation will ease. The Realtors® association is forecasting an average five- to six-month supply of housing for 2005. That would put inventories at a level NAR considers well balanced between supply and demand and would cool appreciation to an historically stable rate of 5 percent.

At the same time, in super-hot coastal markets such as Boston and Los Angeles, where annual price appreciation reached double digits over the last few years, increases are expected to ease to more sustainable, one-digit gains.

Midwestern cities such as Indianapolis and Cleveland, hard hit by manufacturing and other job losses, will see some gains as the jobs picture improves. The economy posted a modest but psychologically significant net gain of about 50,000 manufacturing jobs in the second quarter of 2004, the first net gain in manufacturing jobs in seven years, NAR analysts say. As the economy begins to add those jobs more evenly across the country, "we could see better home price growth in some Midwestern markets," Lereah said.

More broadly, job growth is finally picking up steam after a halting performance in 2003. The economy added about 1.5 million jobs last year and is set to add at least 2 million in 2005. And those aren't expected to be just modest service-sector jobs.

"It's true many of the people who lost high-paying jobs in the economic downturn several years ago have been taking lower-paying jobs, but the data doesn't support the idea widely talked about in the media that most new jobs are low paying," said Frank Nothaft, chief economist at Freddie Mac. "Over time, the quality of jobs created tends to increase, and that would certainly be the case here."

The Fed Board's tightening of the money supply by raising its benchmark interest rates, which started in mid-2004, is expected to continue in 2005 and to help keep inflation in check as the country's economic fortunes improve. The economy posted growth of 4.4 percent in its gross domestic product last year and is projected to post growth of 4.1 percent this year.

"If the Fed can maintain a low but positive rate of inflation, within a narrow band of about 1.5 percent of the Consumer Price Index, as it's been doing, inflation will be a non-issue in economic decisions in 2005," said Doug Duncan, chief economist at the Mortgage Bankers Association.

NAR is forecasting inflation at 2.1 percent this year, well below the 2.5 percent to 3 percent rate the Fed has historically considered to be the cut-off point for price stability, and down from 2.5 percent in 2004. The Fed will raise its bank rate to 3 percent by the end of this year, NAR predicts.

The wild card, though, is energy prices. Thanks in large part to geopolitical instability in several of the world's key oil-producing countries--including Iraq, Nigeria, Russia, and Venezuela--the price of a barrel of oil has jumped 67 percent since January 2004, to above $50 in late 2004. The price stood at $29 at the end of 2003, and at about $25 at the end of 2002. But prices will likely come down in 2005, NAR predicts. The association is forecasting the price to drop to $40 by year's end, similar to what other analysts are projecting.

"Right now the price includes a risk premium because of the fear of disruption to supplies," said NAR's Lereah. "You can think of all sorts of scary scenarios that would keep prices high, but no one expects these scenarios to happen."

If high prices were to stick, GDP growth would slow, but home sales probably wouldn't be too affected, at least in the short term. That's because the Fed would likely loosen the money supply, keeping rates low. "We wouldn't see home sales at past record levels, but housing should still do OK," said Duncan..

Beyond energy prices, many economists agree that there's little on the horizon that could derail the solid home sales forecast. The economy should continue with positive but measured growth, creating jobs and supporting income gains at a modest rate. Interest rates will climb slowly but remain low relative to historical trends. And inflation will remain subdued.

Those factors also pave the way for improved prospects in the commercial real estate arena, economists say.

Commercial poised for growth

Investors poured some $100 billion into commercial properties in the country's 57 biggest metropolitan areas in the first two quarters of 2004, up from just over half that in the same period in 2003, signaling the start of a bullish investment climate that NAR forecasts will get stronger in 2005.

"This optimism by investors says more about the future of the commercial real estate sector than anything else could," said NAR's Lereah.

"The slump in commercial is finally ending," said Paul Merski, chief economist at the Independent Community Bankers of America.

Industrial markets could see the hottest activity among all commercial sectors in the months ahead. Driven in part by booming global trade, particularly with China, industrial port areas led by Los Angeles and Long Beach, Calif., are absorbing an influx of warehouse and distribution facilities.

"We're seeing some really big numbers out there," said Steven Dunn, chief economist at CB Richard Ellis/Information Management. "There's a lot of demand for big-box industrial product, something that can be built and put into operation quickly."

The downside to the new inventory becoming available is stubbornly high vacancies and flat rental rates, even though absorption is showing marked improvement. Net absorption in the country's top markets quadrupled to 97.4 million square feet in 2004 from 16.5 million square feet in 2003, according to preliminary NAR year-end figures, yet the national vacancy rate barely budged. Vacancies averaged 11.7 percent last year, up just a hair above 11.6 percent in 2003. And rental rates have been flat. NAR is forecasting vacancies to improve marginally to 11.4 percent and rental rates to decline 0.2 percent this year.

These figures mask wide differences in markets, though, with distribution hubs such as Los Angeles, Las Vegas, and northern New Jersey maintaining low vacancies (6 to 8 percent) and solid rental growth (1 to 2 percent), while many older industrial areas are still struggling to fill space.

But with manufacturing jobs picking up, look for improvement in overlooked markets such as Indianapolis and Cleveland, both of which are seeing small but positive rent growth, Dunn said.

"There are some good pockets outside of coastal markets," he said. "It might turn out to be a better picture than we think it is."

The picture for the residential rental market is brightening, with multi-family rental rates expected to improve. Multifamily markets have been in a weak patch over the last three years as renters took advantage of historically low interest rates to move into home ownership. But markets are poised to see improvement as the number of home sales cools somewhat.

"The economy is now generating jobs, and the rise in (mortgage) rates in 2004 makes renting more attractive," said Nothaft, of Freddie Mac.

This sector saw a net absorption of 260,000 units last year, up from 159,400 units the year before. Vacancies dropped to 5.9 percent from 6.4 percent in 2003, and are forecast to ease more, to 5.8 percent, this year. Average rent is forecast to rise 2.2 percent, from 1.2 percent in 2004.

Office markets should continue to mount a comeback, after falling the hardest of all the sectors in the aftermath of the tech debacle in 2001. Vacancies in the sector jumped from 14.2 percent in 2001 to 16.5 percent in 2002 as absorption plummeted and rental rates flattened out or declined. But the picture's been steadying since mid-2003. Vacancies last year eased a bit, to just above 16 percent, and are forecast by NAR to drop to 15 percent this year.

Behind the easing are renewed business spending; job growth, particularly in suburban markets; and the restraint that developers showed in the 1990s growth years not to overbuild markets. With only modest amounts of new inventory becoming available in many areas, net absorption was a solid 45.3 million square feet last year, more than double the absorption of 20 million square feet the year before. Rents rose 1.4 percent last year, based on preliminary NAR year-end figures. NAR is forecasting further improvement of 1.9 percent this year.

Retail markets have been the most stable sector since 2001--powered by strong consumer spending while spending on the business side was waning--and will continue to see slow but steady growth this year.

"We won't see retail back off from growth now," said Dunn.

The sector posted net absorption of 22.1 million square feet in 2004, based on preliminary NAR year-end figures, compared with 11.8 million the year before. The vacancy rate stood at 8.2 percent, virtually unchanged from 2003, and should improve to 8.1 percent this year. Retail rents rose 3.6 percent last year and are forecast to rise another 4.2 percent in 2005.