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Housing Market Slowdown Could Stall Or Change State's Urban Transition

It's undeniable: California is in the worst housing bust since the early 1990s. Sales have dropped by a third compared with last year. Prices are stable for now, but nobody knows what will happen once all those bank repos hit the market. And it's pretty clear that developers all over the state are sitting on their entitlements. Nobody's building anything unless they absolutely have to.

Which means all those condo and mixed-use projects that planners are crowing about will not get built anytime soon. But does that mean they won't get built at all? No. In the long run, the shift toward a more urban California especially in the coastal areas will continue. Land won't get a whole lot cheaper, and construction materials will probably still go up in price. But the urban transition may not happen as fast as we thought, and it might look a little different than we expected.

This is the fourth real estate bust over the last 35 years in California. The other three have all followed a pattern the bust is long, and then it is followed by a boom of slightly shorter duration characterized by huge price increases. Last time, prices bottomed out during 1991 or 1992, then stayed flat until 1997 or '98, then tripled between '98 and '06. (Evened out over the 15-year period, this actually represents about 8% annual appreciation.)

But there are some differences. The last bust occurred mostly as a result of Southern California's aerospace-led recession. Lots of people were losing their jobs in factories and on military bases, or were shifting over to jobs that didn't pay as well or they were just plain nervous about getting laid off. It's fair to say that the early '90s bust was an honest-to-God recession.

This time, the bust can probably be viewed much more as a "correction" an inevitable downturn in an overheated real estate market fueled at least in part by easy credit. Sales are slow partly because those 100%-plus, low-initial-interest-rate mortgages just are not around anymore. (The 65% fixed-rate mortgage is doing just fine.) This will not have much effect on prices unless those subprime mortgage holders default on their loans or have to sell at a bargain-basement price, which is already happening in some market segments. So it is reasonable to assume that prices will drop some. The question is how much. Five percent? 10? 20? No one really knows. A lot depends on the extent to which both the feds and the Fed decide to step in and bail out the subprime mortgage lenders with refinancing opportunities and lower interest rates.

The bottom line question in planning and development goes more or less like this: Will housing continue to be the driving force in the real estate development business, as it has been over the last decade? And, if not, can other sectors of the real estate industry attract enough capital to keep the development business going?

You can't build too slowly during a recession; and you can't build too fast during a boom. Developers downsize during a bust. But they also keep pushing for entitlements, so they can come out of the bust ready to build. What will they try to entitle during this bust?

California's push toward urbanism during the last decade and, more to the point, smart growth and new urbanism is attributable mostly to housing prices. All kinds of high-density, urban-style projects pencil out for developers when condos go for $400,000 instead of $150,000. Demand has been strong enough, especially in the built-out coastal counties, that condo developers willingly delivered retail and lots of other mixed-use components to cities in exchange for permission to lay the golden egg of housing.

The condo egg isn't so golden anymore but wherever prices land, they are still likely to be far higher than they were back at the end of the '90s. That would suggest we shall see more high-density projects entitled in the future. But it's also an article of faith that in bad times, developers stick to the knitting. So maybe we'll see residential developers sticking with residential projects and not venturing so readily into mixed-use projects even when planners push them in that direction.

But the developer is only half of the entitlement equation. The other half is the investor. And whereas developers stick to what they know residential developers like to do residential projects investors are fickle. They'll put their capital wherever they think they'll get a return. They're also lemmings, following the latest fad. This can affect the planning and development business in two ways.

First, it's possible that the overall amount of capital flowing into real estate development will decrease considerably. Investors tend to regard real estate and stocks as "countercyclical" that is, when one goes down, you should invest in the other because it's going to go up. This trend is often a self-fulfilling prophecy, as prices in either sector rise simply because more investment money is being shoveled toward those investments. It's no surprise that real estate went up during the late '80s when the stock market went down. The reverse happened in the early '90s; and the trend reversed again around 2000. Right now both real estate and stocks look fragile, but it may well be that capital flows from real estate into stocks over the next year or two.

The other possibility is that capital will flow to other types of real estate. It's been easy to forget this during the recent housing boom, but the truth of the matter is that investment in different real estate sectors is cyclical and faddish as well. Remember the early 1980s boom in warehouses? The late '80s boom in office buildings? The mid '90s boom in entertainment retail?

All these were capital-driven booms, as investors threw money at a real estate sector that was hot at the time. And with money being thrown at housing over the last decade, we've got a pent-up demand in some of these other sectors, especially office and industrial. It is entirely possible that in the near future, mixed-use condo projects will be remembered as so-o-o-o 2005 compared with those shiny new office condos built in 2010.

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