Real Estate: "Seven Varieties of Deflation," by Dr. A. Gary Shilling

Segment of Gary Shilling's INSIGHT newsletter:

Nonresidential structures, along with other real estate, were hard hit by the Great Recession and remain weak as capacity remains ample and prices of commercial real estate generally persist well below the 2007 peak. The two obvious exceptions are rental apartments and medical office buildings. Returns on property investments recovered from the 2007-2009 collapse, but are now slipping.

Retail vacancy rates remain high (Chart 9) due to cautious consumers and growing online sales. Rents remain about flat. Ditto for office vacancies due to weak employment and the tendency of employers to move in the partitions to pack more people into smaller office spaces. The office vacancy rate in the second quarter was 17.2%, the same as the first quarter, down slightly from the post-financial crisis peak of 17.6% in the third quarter of 2010 but well above the 2007 boom level of 13.8%. In the second quarter, office space occupancy rose just 0.12% from the previous quarter compared to 0.18% in the first quarter.

Housing Woes

House prices have been deflating for six years, with more to go (Chart 10). The earlier housing boom was driven by ample loans and low interest rates, loose and almost non-existent lending standards, securitization of mortgages which passed seemingly creditworthy but in reality toxic assets on to often unsuspecting buyers, and most of all, by the conviction that house prices never decline.

I expect another 20% decline in single-family median house prices and, consequently, big problems in residential mortgages and related construction loans. In making the case for continuing housing weakness, I've persistently hammered home the ongoing negative effect of excess inventories on house sales, prices, new construction and just about every other aspect of residential real estate.

Spreading Effects

That further drop would have devastating effects. The average homeowner with a mortgage has already seen his equity drop from almost 50% in the early 1980s to 20.5% due to home equity withdrawal and falling prices. Another 20% price decline would push homeowner equity into single digits with few mortgagors having any appreciable equity left. It also would boost the percentage of mortgages that are under water, i.e., with mortgage principals that exceed the house's value, from the current 24% to 40%, according to my calculations. The negative effects on consumer spending would be substantial. So would the negative effects on household net worth, which already, in relation to after-tax income, is lower than in the 1950s.

Gary Shilling's INSIGHT newsletter

Thanks to John Mauldin for bringing us Gary Shilling's insightful and thorough economic overview: A Little Chronic Deflation | Outside the Box Investment Newsletter | Mauldin Economics

Why didn't aggregate price-inflation kick in? It didn't kick in because the Fed, Congress, & White House didn't fight deflation enough to cause such inflation. Overshooting the stimulus without unwinding in time would have resulted in high aggregate price-inflation. It would have over heated the economy. That we had small doses of Fed deflation fighting and small doses of Congress using fiscal stimulus, we had only a lessening in the severity of the recession and then a slow recovery (if one may correctly call it a recovery yet; if one ignores the still looming shadow inventory for instance, which shadow inventory CoreLogic has decided it had been underestimating since the onset of the Great Recession and by a huge percentage, as you will see from our tweet on it).

So, if the Fed runs out of tools (it can start charging interest on bank's excess reserves to force them to lend at low rates) and if the Congress continues down the austerity path, then Gary Shilling's arguments are quite sound in our view.


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