Tierra Grande - January 2015

Helping Texans make better real estate decisions since 1971

Judon Fambrough

Senior Lecturer and Attorney at Law Technical Report 570

It’s All About the Big Bucks Another deer season has come and gone. Lucky hunters have a buck in the freezer. For landowners, the bucks are in the bank. But not everyone is happy. More often than not, their problems have something to do with the deer lease. Make sure your lease doesn’t have holes in it.

Download The Texas Deer Lease for free.

recenter.tamu.edu/pdf/570.pdf iii

TIERRA GRANDE

JANUARY 2015

VOLUME 22, NUMBER 1 ™

TIERRA GRANDE

Visit us online at

recenter.tamu.edu

JOURNAL OF THE REAL ESTATE CENTER AT TEXAS A&M UNIVERSITY

14 South Padre Paradox

Director, GARY W. MALER Chief Economist, MARK G. DOTZOUR

Selling Homes on Island Time

Senior Editor, DAVID S. JONES

Relax, y’all. The residential market moves slow on South Padre Island, just as it has for the past 30 years. So until the deal closes, get yourself a margarita, sit out on the deck and watch the waves roll in.

BY HAROLD D. HUNT

Managing Editor, NANCY MCQUISTION Associate Editor, BRYAN POPE Assistant Editor, KAMMY BAUMANN Art Director, ROBERT P. BEALS II Graphic Specialist/Photographer, JP BEATO III Circulation Manager, MARK BAUMANN Lithography, RR DONNELLEY, HOUSTON ADVISORY COMMITTEE: Kimberly Shambley, Dallas, chairman; C. Clark Welder, San Antonio, vice chairman; Mario A. Arriaga, Conroe; Doug Jennings, Fort Worth; Russell Cain, Port Lavaca; Jacquelyn K. Hawkins, Austin; Walter F. “Ted” Nelson, Houston; Doug Roberts, Austin; Ronald C. Wakefield, San Antonio; and Bill Jones, Temple, ex-officio representing the Texas Real Estate Commission.

TIERRA GRANDE ™ (ISSN 1070-0234) is published quarterly by the Real Estate Center at Texas A&M University, College Station, Texas 77843-2115.

Telephone: 979-845-2031.

SUBSCRIPTIONS free to Texas real estate licensees. Other subscribers, $20 per year. Subscribe online at www.recenter.tamu.edu/store VIEWS EXPRESSED are those of the authors and do not imply endorsement by the Real Estate Center, Mays Business School or Texas A&M University. The Texas A&M University System serves people of all ages, regardless of socioeconomic level, race, color, sex, religion, disability or national origin.

PHOTOGRAPHY/ILLUSTRATIONS: Harold Hunt, pp. 1, 14 (left), 16, 17, 18; JP Beato III, pp. 6–7; Kevin Butts, Red Wing Aerial Photography, pp.

14–15; Robert Beals II, p. 19; Kari Rives, p. 26; Real Estate Center files, p. 28. © 2015, Real Estate Center. All rights reserved.

2 Yours, Mine or Ours?

The Rule of Capture

19 The Dating Game

Talk about sticky wickets. With water becoming more scarce and fracking more common, Texas courts are busy with cases involving oil, gas and groundwater production, as well as injection of wastewater created by the fracking process.

BY JUDON FAMBROUGH

Center researchers have identified economic indicators that influence Texas’ residential construction sector. Their goal is to anticipate cycles — that is, ups and downs — in this key segment of the state’s economy.

BY JAMES P. GAINES AND LUIS B. TORRES

and Subterranean Fluids

6

Less is More

Small Parcels Yield Higher Prices While Texas land prices vary by region, type of land and size, generally speaking the smallest properties tend to draw the highest per-acre prices throughout the state.

BY CHARLES E. GILLILAND AND HARRISON HUNT

9 Common Cycles in Metro

ON THE COVER Sunset at South Padre Island

PHOTOGRAPHER Harold D. Hunt

JANUARY 2015

Housing Markets

A Center study looked at common housing market cycles and trends in Texas’ four largest metros — Austin, Dallas-Fort Worth, Houston and San Antonio — over the past nine years.

BY ALI ANARI

Texas Housing Construction Cycles

26 Heart of the Housing Market

For most of us, mortgage interest rates determine how much house we can afford. Why do interest rates vary? Because they generally move in tandem with the ten-year Treasury bond rate.

BY MARK G. DOTZOUR

28 Flipping Houses?

Uncle Sam is Watching

Flippers, beware! If the IRS considers you a real estate dealer rather than an investor, expect to write a bigger check at tax time.

BY JERROLD J. STERN

1

Legal Issues

Y Urs, MINE OR

URS?

THE RULE OF CAPTURE AND SUBTERRANEAN FLUIDS

by Judon Fambrough

In recent litigation, Texas courts focused on applying the rule of capture to oil, gas and groundwater production and injection of wastewater.

The rule of capture, simply put, legalizes the drainage of oil, gas and groundwater under certain conditions. Mineral owners and surface owners own these substances in the ground under their property, but not absolutely. If a neighbor (adjacent landowner) drains them from a legal location on his or her property and reduces them to possession on the surface, the substances then belong to the neighbor without liability for the drainage. This rule is sometimes referred to as the “big-pump theory.� The landowner with the biggest pump eventually owns all the oil, gas and groundwater in the area that it can drain and produce from a legal location.

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The Railroad Commission of Texas (the commission) establishes the legal location for oil and gas production on a statewide basis. Generally speaking, this is a minimum of 467 feet from a property line. Each local groundwater district establishes the legal location for the production of groundwater in its district. No statewide rules exist. If there is no groundwater district, a legal location is anywhere across the property line.

P

erhaps the leading case in groundwater production is Day v. Edwards Aquifer Authority decided by the Texas Supreme Court in 2012. The Edwards Aquifer Authority (EAA) denied Day a pumping permit for the amount of groundwater requested because he could not prove adequate usage (production) from the aquifer during the historical-use period from 1972 to 1993. Day sued for a taking of his groundwater under the Texas Constitution (Article I, Section 17[a]).

This section of the Texas Constitution provides, in part, that a person’s property may not be taken, damaged, destroyed or applied to a public use without adequate compensation being tendered to the owner. The only exception is when the property owner consents. In this case, Day did not consent.

At the time, two principles of law applied to ownership and production of oil and gas: (1) landowners own the oil and gas beneath their property (in place) prior to capture and (2) with certain exceptions, the rule of capture permits drainage by an adjoining landowner without liability as long as the oil and gas are withdrawn from a legal location.

EAA raised the defense that no legal precedents exist in Texas recognizing landowners’ ownership of groundwater prior to capture. EAA did not deprive or take Day’s groundwater after it was captured (produced), but before capture by denying the pumping permit. No Texas cases supported Day’s right to the groundwater in place prior to capture.

The high court responded by ruling, “Whether groundwater can be owned in place is an issue we have not decided. But, we held long ago that oil and gas are owned in place, and we find no reason to treat groundwater differently.”

The rule of capture does not entail ownership of groundwater prior to capture, but neither does it preclude it. Furthermore, the court ruled that Day was entitled to a fair share of the groundwater for beneficial use based on a full development of the records.

The Bragg v. EAA decision, rendered a year later, also focused on the issue of a taking. EAA denied the Braggs permits to irrigate their two commercial pecan orchards. Again, based on historical usage, one permit was partially granted, the other denied entirely. The Braggs asserted that this amounted to a taking of their groundwater.

JANUARY 2015

At the bench trial (trial without jury), the trial court found a taking occurred and awarded the Braggs roughly $725,000. The EAA appealed both the issue of the taking and the amount of the damages.

The appellate court, citing the Day case, reiterated the landowner’s absolute title to the water in place beneath the property subject only to the rule of capture and the state’s right to regulate. The court then structured its decision after Penn Central Transportation v. New York City, decided by the U.S. Supreme Court, regarding the economic impact of an investment-backed expectation on a claim for taking.

The Braggs purchased the land in 1973 before the implementation of the Edwards Aquifer Act with the reasonable expectation of pumping as much groundwater as needed to irrigate their orchards. As the trees matured, which takes five to seven years, more water was needed. The Braggs would not have purchased the property had they known the future limitation on the use of the aquifer’s groundwater.

Mr. Bragg was no amateur farmer. He held a master’s degree in agricultural economics and served as a county extension agent, a position in which he advised other pecan growers.

He was a licensed irrigator. The couple invested time, money (approximately $2 million) and effort in planting, maintaining and operating the orchards. Despite their best efforts to lower the groundwater consumption by trimming and reducing the number of trees, the Braggs still lost money because of the inadequate or expensive supply of irrigation water.

“The purpose of the investment-backed expectation requirement,” the San Antonio appellate court ruled, “is to assess whether the landowner has taken legitimate risks with the reasonable expectation of being able to use the property, which, in fairness and justice, would entitle him or her to compensation.”

In this instance, the court found the expectations were both reasonable and, under the circumstances, compensable.

The court did not agree with the $725,000 in damages, though. It remanded the case to trial to determine the difference between the value of the land as a commercial-grade pecan orchard with unlimited access to water and its value with limited or no access to groundwater under the EAA.

L

itigation addressing trespassing subsurface fluids began in 1991with Geo Viking, Inc. v. Tex-Lee Operating Co. The case involved the legality of subterranean trespassing frack fluids used to enhance (stimulate) the migration of hydrocarbons from underneath an adjoining, unleased tract.

The operator hired Geo Viking (Geo) to frack beyond the boundaries of the 80-acre lease. Geo botched the attempt, and the operator sued for the revenue it would have received had the operation been successful.

3

T

he jury held that the rule of capture permits trespassing fluids to enhance the operator’s production (drainage) from beneath the neighbor’s property. The court of civil appeals reversed the jury’s verdict by stating the rule of capture does not allow subterranean trespassing without liability. The Texas Supreme Court supported the appellate court’s opinion by stating “ . . . the rule of capture would not permit the operator to recover for a loss of oil and gas that might have been produced as the result of fracking beyond the boundaries of its tract.”

Six months later, however, the high court withdrew its opinion, saying, “We should not be understood as approving or disapproving the opinions of the court of appeals analyzing the rule of capture or trespass as they apply to hydraulic fracturing.” This left the issue unresolved.

In 2008, the Texas Supreme Court again addressed the issue in Coastal Oil and Gas Corp. v. Garza Energy Trust. In this case, Coastal successfully fracked beneath the plaintiffs’ adjoining tract, depriving them of approximately $1 million in lost royalties caused by the drainage. Unlike Geo, Coastal had both the tracts under lease, but they were not pooled.

The high court found no liability on the part of Coastal for two reasons. First, the rule of capture precludes any claim for injury caused by trespassing frack fluids.

(This is a reversal of its initial opinion in Geo Viking.)

Second, when mineral owners sign an oil and gas lease (which is viewed as a mineral deed in Texas), they convey all possessory rights in the mineral property to the lessee (oil company) for the duration of the lease. This eliminates their right to sue for a subsequent mineral trespass. The only right they retain after signing a lease is the right to receive royalty payments. Because Coastal had both tracts under lease and thus owned the possessory rights in both, it could not be held for trespassing on its own property.

In another case six years later, the high court reflected on this decision. It ruled that because the plaintiffs no longer owned any possessory rights in the minerals, they must prove actual damages (other than drainage) for a recovery. Thus, the rule of capture negates the element of injury from a trespassing claim for fracturing.

The decision leaves open the question of liability when both tracts are not under lease by the same operator or when the tract being drained is not under lease to anyone. The opinion points out that an action for trespass requires the plaintiff to own the right of possession. But, if Coastal did not have both tracts under lease, would the court have ruled differently? Stay tuned.

According to the high court, the only recourse plaintiffs have in situations like this is to seek to pool their interests, drill an offset well with their own funds or force their lessee to drill an offset well under the implied covenant. However, to successfully force a lessee to drill an offset well under the implied covenant, the mineral owner must prove the offset well would recover the lessee’s drilling and completion costs; transportation, marketing and overhead expenses; and result in a reasonable profit. This is a difficult burden of proof.

FPL Farming (FPL) v. Environmental Processing Systems (EPS), 2011, is the most recent case involving trespassing subterranean fluids, specifically trespassing injected wastewater.

The defendant (EPS) began injecting wastewater 8,000 feet below the surface pursuant to a permit issued by the commission. The adjoining rice farmers (FPL) claimed the wastewater trespassed onto their property. They sued for an injunction to stop the project and for damages.

As a defense, EPS cited the 1962 Texas Supreme Court case of Railroad Commission of Texas v. Manziel. The case involved a secondary recovery operation approved by the commission. The project entailed the injection of massive amounts of water into a depleted formation to enhance the recovery of the remaining oil. The injected water migrated beyond the boundaries of the project and polluted Manziel’s domestic water supply.

As did FPL, Manziel sued for an injunction to stop the project and for damages. The court refused to issue an injunction because the project had been approved by the commission, but it allowed recovery of damages. To avoid damages in this case, EPS relied on Manziel.

On appeal, the Beaumont Court of Appeals (citing Manziel) agreed and held that the approval of the project by the commission removed any liability (damages) for trespass when the wastewater migrated across property lines. However, when the Texas Supreme Court heard the case, it responded by stating that the lower court misinterpreted its ruling in Manziel.

The high court explained, “We did not decide whether the Railroad Commission’s authorization of such operations throws a protective cloak around the injecting operator who might otherwise be subjected to the risks of liability (for damages). Instead, we held that the Railroad’s Commission authorizations of secondary recovery operations are not subject to injunctive relief based on trespass claims.”

When the rule of capture applies, landowners may seek to pool their interests, drill an offset well or force their lessee to do it for them.

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TIERRA GRANDE

The high court pointed out that the issues in Manziel and Coastal were factually similar. Both dealt with the subterranean injection of fluids that crossed property lines. Both were authorized by state agencies. Both dealt with the extraction of oil and gas, making the application of the rule of capture critical.

The rule of capture is the cornerstone of the oil and gas industry.

The FPL case, however, did not involve the extraction of oil and gas but the injection of wastewater. For that reason, the rule of capture does not apply and EPS may be liable for the trespassing wastewater.

As mentioned earlier, when the rule of capture applies, landowners may seek to pool their interests, drill an offset well or force their lessee to do it for them. With wastewater, these protective measures are not available because the rule of capture does not apply.

“The mere fact that an administrative agency issues a permit to undertake an activity does not shield the permittee from third-party tort liability stemming from consequences of the permitted activity,” ruled the court.

The issue of damages has not been settled.

This case has been before the Beaumont Court of Appeals three times and the Texas Supreme Court once. Presently, there is a petition before the Texas Supreme Court to review the latest decision rendered by the appellate court in this matter.

purpose of treating the waste for a subsequent beneficial use, the transferred material is considered to be the property of the person who takes possession of it for the purpose of treating the waste for subsequent beneficial use until the person transfers the waste or treated waste to another person for disposal or use. . . .”

The second section allows the transfer of liability under certain circumstances.

If the transfer is with the contractual understanding that the fluids will be treated to make them suitable for the subsequent drilling or production of oil or gas, the party making the transfer is no longer liable in tort for the subsequent use of the treated product.

The issue of a taking arises under the first section where ownership accompanies possession. An oil and gas operator may not always own the wastewater being transferred.

Water for fracking may be obtained two ways: by purchase or under an implied right. Unless limited by the mineral lease, the lessee has the implied right to use (not own) as much of the physical surface and groundwater as is reasonably needed to explore and produce the minerals without asking permission and without having to pay. This right of usage is limited to the leased premises or lands pooled with it.

Consequently, if the frack water is initially acquired under this implied right, it still belongs to the landowner (surface owner) when it returns to the surface as wastewater. Any subsequent transfer of “ownership” by the lessee without the landowners’ consent may constitute a taking even though authorized by the statute.

Unless limited by the mineral lease, the lessee has the implied right to use (not own) as much of the physical surface and groundwater as reasonably needed to explore and produce the minerals without asking permission and without having to pay.

An interesting development occurred during the 83rd Texas Legislative Session that may trigger another round of taking claims for groundwater under the Texas Constitution (Article I, Section 17[a]). The statute, effective Sept. 1, 2013, found in Chapter 122 of the Texas Natural Resources Code, attempts to encourage the treatment and recycling of oilfield wastewater. These fluids include salt or other mineralized substances, brine, hydraulic fracturing fluid, flowback water, produced water, or other fluids that arise out of or are incidental to the drilling for or production of oil or gas.

The new law lessens, to some degree, the liability for the possession and transfer of wastewater. The statute does so in two sections. The first section provides that with possession of the fluids (wastewater) comes ownership. “ . . . when fluid oil and gas waste is transferred to a person who takes possession of that waste for the JANUARY 2015

Fambrough (judon@tamu.edu) is a member of the State Bar of Texas and a lawyer with the Real Estate Center at Texas A&M University.

THE TAKEAWAY Several recent cases in Texas have been key to oil, gas and groundwater production and wastewater injection in the state. Landowners will benefit from understanding the rule of capture, which governs who owns those substances before and after they are drained from property.

5

Land Markets

Less is More Small Parcels Yield Higher Prices

By Charles E. Gilliland and Harrison Hunt

T

exas land prices vary widely across the state, reflecting the type of land (farm, timber, grazing) as well as population density. In virtually all regions of Texas (Figure 1), small properties command higher per-acre prices than larger properties. And the differences between prices in the smallest market segments and larger property prices are increasing (Figure 2).

Figures 3 through 8 illustrate price trends for transactions in different market segments in Texas. The highest price per acre occurs in the small property end of the market. Examining trends in these size-segmented price categories hints at conditions developing in local markets. For example, the trend in small and large property prices in the Gulf Coast–Brazos

Annual Price Per Acre

10,000

Figure 2.

Small and Large Rural Land Sales Gulf Coast–Brazos Bottom

8,000 6,000 4,000 2,000 0 1966

1978

1990

2002

2014

Source: Real Estate Center at Texas A&M University

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TIERRA GRANDE

Figure 1. Land Market Regions

1

Panhandle and South Plains

3

4

West Texas

2

Far West Texas

Northeast Texas

7

Austin-WacoHill Country

5

Gulf CoastBrazos Bottom

6

Bottom region (Figure 3) registered no price change for largest market segments posting price South Texas either the small property market segment or the comincreases. bined large market segments in 2014.

Price trends traced out in the Gulf Coast– Some who monitor these developments might interpret Brazos Bottom region (Figure 3) reveal that them as a pullback from the 2013 market exuberance that small property prices were flat, and there was a drove prices sharply higher. However, information from sizable drop in prices in the 43- to 66-acre market professionals in that region suggests an alternative explanasegment. Prices increased in the other three larger tion. Buyers in 2013 flocked to a market with an abundance market segments. These dynamics appear to conof top-quality properties commanding premium prices, while firm that overall flat price performance results from changes in 2014 buyers found fewer top-quality options. Thus, the apparmarket composition rather than a general cooling of demand. ent price weakness actually results from buyers settling for Another interesting dynamic has emerged in the Panhandle lesser quality land. This phenomenon was largely confined and South Plains market segments (Figure 4). That region to the two smallest market segments (Figure 3) with the two reveals a curious phenomenon in the trends for the largest

8,000 6,000

Small < 43 Acres 43–66 Acres 67–99 Acres 100–180 Acres 181+ Acres

4,000 2,000 0 2000

2004

2008

2012 2014

Source: Real Estate Center at Texas A&M University JANUARY 2015

2,500 Annual Price Per Acre

Annual Price Per Acre

10,000

Figure 3.

Rural Land Prices Gulf Coast–Brazos Bottom

2,000 1,500

Figure 4.

Rural Land Prices Panhandle–South Plains Small < 160 Acres 161–180 Acres 181–320 Acres 321–550 Acres 551+ Acres

1,000 500 0 2000

2004

2008

2012 2014

Source: Real Estate Center at Texas A&M University

7

Figure 5.

Rural Land Prices West Texas

8,000

Small < 95 Acres 95–159 Acres 160–239 Acres 240–499 Acres 500+ Acres

2,500 2,000

Annual Price Per Acre

Annual Price Per Acre

3,000

1,500 1,000 500 0 2000

2004

2008

Annual Price Per Acre

4,000

2,000

2004

2008

2012 2014

Source: Real Estate Center at Texas A&M University

Annual Price Per Acre

8,000

6,000

Figure 7.

Rural Land Prices South Texas Small < 45 Acres 45–89 Acres 90–164 Acres 165–364 Acres 365+ Acres

4,000

2,000

0 2000

2004

2008

2012 2014

properties in this area. Before 2006, per-acre prices in the 551acre and larger market segment, the largest sales in the region, ranged lower than those in all of the other market segments.

As expected, small property per-acre prices were highest in the region. eginning in 2006, however, large-sized property prices began to equal or exceed prices in the three 161- to 550acre market segments. Price growth in large-sized markets even substantially closed the gap with the small property per-acre prices at times. Large property per-acre prices in 2014 continued to exceed prices in the intermediate markets.

From 2006 to 2014, strong demand for cropland produced numerous large transactions. In addition, investors recently have vied for large operating livestock properties. Owing to the scarcity of such large properties on the market, prevailing buyers must compete for available farms and ranches, driving up prices.

No other region in the state had such upward pressures on large-tract prices until 2013–14 in the Austin-Waco-Hill Country region (Figure 8). Large property prices, never far below the intermediate-sized markets, have begun to surpass the 155- to 279-acre market price and close in on prices in the 95- to 154acre market segment. This development suggests that sizeable investments in larger Hill Country properties, perhaps fueled by newly wealthy Eagle Ford shale participants, may be bidding up prices for larger tracts.

Generally, the four largest land market segment trends track each other well within each region. The smallest market category tends to post much higher per-acre prices. Digging into the details can reveal market developments not readily seen in overall market indicators.

B

Small < 34 Acres 34–53 Acres 54–87 Acres 88–156 Acres 157+ Acres

0 2000

2,000

Source: Real Estate Center at Texas A&M University

Figure 6.

Rural Land Prices Northeast Texas

6,000

Small < 50 Acres 50–94 Acres 95–154 Acres 155–279 Acres 280+ Acres

4,000

0 2000

2012 2014

Source: Real Estate Center at Texas A&M University

8,000

6,000

Figure 8.

Rural Land Prices Austin-Waco-Hill Country

Dr. Gilliland (c-gilliland@tamu.edu) is a research economist and Hunt is a research assistant with the Real Estate Center at Texas A&M University.

2004

2008

2012 2014

Source: Real Estate Center at Texas A&M University

THE TAKEAWAY Land prices vary across the state, but small tracts generally have higher per-acre prices than large properties.

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Housing Markets

COMMON CYCLES IN METRO HOUSING MARKETS

JANUARY 2015

Home sales, home prices, listings and other housing market indicators are partly driven by local market conditions (such as local supply and demand forces) and partly by macroeconomic conditions affecting all local markets (such as interest rates, the unemployment rate and national economic cycles). By comparing housing market indicators across local markets, it is possible to identify common trends and cycles among local housing markets; ďŹ nd leadlag relationships between local housing market indicators; and use information from one local market for forecasting housing market conditions in other markets.

AUSTIN HOUSTON SAN ANTONIO

DALLAS FORT WORTH ARLINGTON

BY ALI ANARI

This article reports the ďŹ ndings of a research study at the Real Estate Center at Texas A&M University to discover and analyze common cycles and trends in four Texas metropolitan areas: Austin-Round Rock-San Marcos (Austin), Dallas-Fort Worth-Arlington (Dallas), HoustonSugar Land-Baytown (Houston) and San Antonio-New Braunfels (San Antonio). These metros represent more than 70 percent of the total home sales in Texas.

9

W W-Shaped Housing Demand Cycle

10

Moving Average Home Listingss per Month

Moving Average Home Sales per Month

and output, and any positive impact of monetary policy is The four Texas metro housing markets experienced a W-shaped short-lived. common cycle, or a two-trough cycle, from January 2006 to From early 2011, the four metro housing markets embarked July 2014. This cycle was shaped by the Great Recession (GR) on a strong economic recovery that is still ongoing. However, of 2007–09, the U.S. government attempts to help housing the pace of the recovery has slowed in recent months (Figure 1). markets and the eventual recovery of the economy Figure 1. Housing Demand Cycles, 2006–14 Figure 2. Housing Supply Cycles, 2006–14 from the GR (Figure 1).

Austin Housing demand in the Austin 2,400 12,000 metros, measured in the moving averages of the 10,000 2,000 number of homes sold, reached its prerecession 8,000 maximums in early 2007 1,600 before sliding into the GR. 6,000 Dallas housing demand was first to slide in February, 1,200 4,000 2006 2008 2010 2012 2014 2006 2008 2010 2012 2014 followed by Houston and Dallas Dallas San Antonio in March and, 8,000 50,000 finally, by Austin in May. The W-shaped housing 7,000 40,000 demand cycles could have been U-shaped cycles but for a number of govern6,000 30,000 ment initiatives to help housing markets recover 5,000 from the recession, such as 20,000 2006 2008 2010 2012 2014 2006 2008 2010 2012 2014 the Housing and Economic Houston Houston Recovery Act of 2008 and 7,000 40,000 the American Recovery and 35,000 Reinvestment Act of 2009.

6,000 As Figure 1 shows, the 30,000 beneficial effects of the gov25,000 ernment intervention was 5,000 temporary. The housing 20,000 markets of the four metros 4,000 15,000 had a recovery in 2010 that 2006 2008 2010 2012 2014 2006 2008 2010 2012 2014 turned out to be fragile and San Antonio San Antonio 2,200 short-lived.

14,000 The W-shaped cycle pro2,000 12,000 vides support for the new classical theory of policy 1,800 10,000 ineffectiveness proposed by Thomas Sargent and Neil 1,600 8,000 Wallace in 1975. According to policy ineffectiveness 1,400 6,000 theory, government cannot 2006 2008 2010 2012 2014 2006 2008 2010 2012 2014 systematically manipulate Source: Real Estate Center at Texas A&M University Source: Real Estate Center at Texas A&M University the levels of employment TIERRA GRANDE

M M-Shaped Housing Supply Cycle

Home Prices Continue Long-Term Upward Trend Texas did not experience a home price bubble like some parts of the United States because home builders responded to growing demand by supplying more homes.

Consequently, there was not a rapid run-up in JANUARY 2015

Moving Average List Price, Dollars

Moving Average Sales Price, Dollars

home prices before the GR. Home prices in the Texas metros On the supply side, the housing markets of the four metros suffered a mild setback during the GR, with a decline of less experienced M-shaped common cycles, or two-peak cycles, than 8 percent (see table). Even so, home prices continued their from January 2006 to July 2014, again due to the GR of 2007– long-term upward trend. Since early 2012, sales prices in met09, the U.S. government attempt to help the housing market ros have been on a steep upward trend, not only recovering lost and the eventual recovery of the economy from the GR (Figure ground but also posting new highs (Figure 3).

2). Housing supplies, Figure 3. Sales Price Trends, 2006–14 Figure 4. List Price Trends, 2006–14 which were measured in the moving averages Austin Austin 320,000 300,000 of the number of active listings, embarked on an 275,000 upward trend in Dallas 280,000 from early 2006 followed 250,000

by Houston and San 240,000 Antonio from late 2006, 225,000 and Austin from mid2007.

200,000 200,000 2006 2008 2010 2012 2014 2006 2008 2010 2012 2014 The M-shaped housing Dallas Dallas supply cycle could have 240,000 260,000 been an upside down U-shaped cycle if not 240,000 220,000 for the U.S. government housing policy initia220,000 tives mentioned earlier.

200,000 However, as in the case of 200,000 housing demand recovery, the beneficial effects 180,000 180,000 2006 2008 2010 2012 2014 2006 2008 2010 2012 2014 of government initiatives Houston Houston were temporary (Figure 2).

280,000 280,000 The four metros’ hous260,000 ing supplies are currently 240,000 in a downward trend that 240,000 began in January 2011 in 220,000 Austin and San Antonio 200,000 and in March 2011 in 200,000 Dallas and Houston.

160,000 2006

2008

2010

2012

2014

San Antonio

220,000

180,000 2006

220,000

180,000

200,000

160,000

180,000 2008

2010

2012

2014

Source: Real Estate Center at Texas A&M University

2010

2012

2014

2012

2014

San Antonio

240,000

200,000

140,000 2006

2008

160,000 2006

2008

2010

Source: Real Estate Center at Texas A&M University

11

List price moving averages in the four Texas metro housing markets also continued their long-term trends despite mild softening during the GR (Figure 4). Since early 2012, list prices have shown an upward trend but not as steep as sales price trends.

M-Shaped Days-on-Market Cycles

M-Shaped Price Concession Cycles

The Culprits The mortgage interest rate, unemployment rate and government housing policies were the forces driving and shaping the M-shaped and W-shaped housing cycles discussed in this article. The GR was preceded by a period of growing demand for houses fueled mainly by low mortgage interest rates and loose credit standards. Low interest rates ended in 2006 when the Federal Reserve increased the Fed Funds rate to control expected inflation. Although the fear of inflation was exaggerated, all interest rates, including the 30-year conventional mortgage rate, went up and cooled real estate markets (Figure 7).

Then Lehman Brothers went bankrupt and the Fed allowed it to be liquidated. But the shock of the Lehman Brothers’ bankruptcy

12

Moving Average Days-on-Market

Reducing asking prices to strike deals with homebuyers is common in U.S. housing markets. Home price concession is defined here as the percentage of reduction of list prices (list price minus sales price divided 100 by list price, and multiplied by 100). When they waited longer 80 to strike a deal, home sellers had to reduce asking prices by more than 4 percent in the Texas metros 60 (Figure 6). Metro housing markets posted common M-shaped home 40 price concession cycles in the GR 2006 (Figure 6). As in the case of supply 90 and demand cycles, the positive impacts of government housing 80 policies were short-lived, changing upside down U-shaped cycles to 70 M-shaped cycles.

Moving Averages of Homes Sold Prices in Texas Metropolitan Markets During the Great Recession

Austin

Peak Price

Date

Trough Price

Date

Decline Rate, Percent

$249,685.4

Feb. 2008

$241,254.1

Oct. 2009

3.4

Dallas

199,616.9

Nov. 2007

184,461.0

Nov. 2009

7.6

Houston

209,640.3

Sept. 2008

197,398.4

Sept. 2009

5.8

San Antonio

184,804.1

Feb. 2009

177,251.2

June 2010

4.1

Source: Real Estate Center at Texas A&M University

Figure 6. Home Price Concession Cycles, 2006–14

Figure 5. Days-on-Market Cycles, 2006–14 Austin

4

3

2008

2010

2012

Dallas

2008

2010

2012

2014

2012

2014

2012

2014

2012

2014

Dallas

4.5 4.0 3.5 3.0

2008

2010

2012

2014

Houston

90 80 70 60 50 2006

2 2006

2014

60 50 2006

Austin

5

Moving Average of Price Concessions (Percent)

As the economies of the metros fell into the GR, home sellers had to wait longer to strike deals with homebuyers. Waiting time, measured by the moving averages of number of days on the market, increased to more than 80 days (Figure 5). The impacts of the government housing policies were shortlived and the metros experienced M-shaped days-on-market cycles (Figure 5).

2008

2010

2012

2014

San Antonio

100

2.5 2006

2008

5

4

3

2 2006

2008

2010 San Antonio

5

90

2010 Houston

4

80 3

70 60 2006

2008

2010

2012

2014

Source: Real Estate Center at Texas A&M University

2 2006

2008

2010

Source: Real Estate Center at Texas A&M University TIERRA GRANDE

Figure 7. Mortgage Rate Trend, 2006–14

Moving Average Unemployment Rate, Percent

Moving Average Mortgage Rate, Percent

7

Figure 8. Unemployment Rate Trends, 2006–14

6

5

4

3 2006

2008

2010

2012

2014

Source: Real Estate Center at Texas A&M University

forced many businesses to postpone capital expenditures, throwing the U.S. economy into the GR. While higher interest rates triggered the cooling of housing markets initially, growing unemployment rates in the GR in all metropolitan areas, including Texas’ metros (Figure 8), led to increasing foreclosures, decreasing housing demand and a growing inventory of homes for sale. U.S. government attempts to speed the recovery resulted in nothing more than a temporary respite from the down cycle.

Dr. Anari (m-anari@tamu.edu) is a research economist with the Real Estate Center at Texas A&M University.

9 8 7 6 Austin Dallas Houston San Antonio

5 4 3 2006

2008

2010

2012

2014

Source: Real Estate Center at Texas A&M University

THE TAKEAWAY A Center study of the housing markets of Texas’ four major metros revealed that government intervention during the Great Recession had only temporary beneficial effects.

These findings support the theory of policy-ineffectiveness, which maintains that government cannot systematically manipulate employment and output levels, and any positive impact of monetary policy is short-lived.

D

Data and Method of Analysis The datasets used consist of homes sold in the four Texas metropolitan areas from January 2006 to July 2014. Each of these time series contains four components: secular trends, seasonal variations, business cycles, and irregular or random changes.

Secular trends are long-run trends owing to changes in population and economic fundamentals. Seasonal variations are fluctuations depending on the months or quarters of the year. Cycles are fluctuations around the secular trends that are not seasonal. Then there are irregular changes or shocks. Seasonal variation is an important component of housing market indicators. All the selected time series exhibit seasonal variations. So, the first step in cycle analysis is to remove seasonality in the data. This is done by computing 12-month moving averages for each time series. This article compares moving averages of the number of homes sold, listings, sales prices, list prices and days-on-market for the metro areas to discover common housing cycles among the local Texas markets.

JANUARY 2015

13

Housing Markets

South Padre Paradox Selling Homes on Island Time

By Harold D. Hunt

South Padre Island is a city with small-town feel and â&#x20AC;&#x153;big-townâ&#x20AC;? buildings. It is also host to a rather eclectic group of people. Depending on the day, the mix may be any combination of short-term visitors, long-term residents, Mexican nationals or Americans coming from anywhere.

The result is a residential niche located on a tiny sliver of Texas that moves to many different beats.

Primarily driven by second-home demand and tourism, the market dynamics behind this coastal city offer a number of interesting insights for Texas real estate professionals.

14

TIERRA GRANDE

Days of Easy Money In 2006 and 2007, easy financing drove an unusually high level of investment, including out-of-state and international money, into South Padre’s residential property market. Real estate brokers were in dire need of additional agents, sometimes recruiting from local restaurants and retail shops.

At its peak, the city of about 2,500 permanent residents was home to 265 real estate agents and brokers. Several hundred new condos were built and added to the market from 2005 to 2008.

In 2006, 610 residential sales transactions worth $160 million were closed. In contrast, 2014 is expected to see just $65 million in sales. Although most Texas housing markets have rebounded well since the last recession, South Padre is a notable exception.

“It’s not unusual to see 1,000 to 1,200 days on market for residential properties on the island,” says Julie Hyland of Hyland Appraisals. “However, if you look back over the past 20 or 30 years, slow sales on the island are really nothing new.”

Current property owners who are not full-time residents, especially those from the state’s major metropolitan areas, are JANUARY 2015

often puzzled by the sluggishness of the South Padre market.

The extended marketing period has made it difficult for investors to implement a successful buy-and-flip strategy.

Island Demographics The 2012 American Community Survey (ACS) published by the U.S. Census Bureau provides an estimate of the island’s inhabitants and housing makeup based on actual surveys.

According to the ACS, South Padre has a full-time population of 2,837. On a busy summer weekend, the island’s population, including visitors, may exceed 30,000.

The median age of full-time residents is 57. About threefourths of locals are older than 45 while almost a third are 65 or older.

The city’s 2014 comprehensive plan notes that an out-migration of younger people and in-migration of older folks has been occurring in the permanent population since 2000. The city is attempting to attract the optimal blend of permanent residents and seasonal visitors for maximum year-round economic activity. Knowing exactly who to target is difficult. The permanent population has remained basically flat since 2010.

15

SALES DON’T HAPPEN fast on South Padre. Time on market may stretch to 1,200 days.

Typical residential buyers on the island today can be broken down into several groups: • Americans who purchase properties as second homes and Housing Makeup either rent them infrequently or not at all; • Americans who purchase properties, live on the island outh Padre’s total residential stock of 7,053 units is heavfull-time and don’t rent to others; ily weighted toward large multifamily properties, with • American investors who purchase properties strictly for the ACS reporting 1,125 single-family detached homes or short-term rental to tourists; and townhomes, 1,737 units in properties two to nine units in size • Mexican nationals who purchase properties as second and 4,191 units in properties that contain ten or more units. homes and rarely, if ever, rent to others.

Of the 7,053 total units, only 1,586 (22.5 percent) are occuAnother category more prevalent in the past is families pied full time (Table 1). Of these, about two-thirds (1,066 units) with children who purchase properties for limited vacation are owner occupied (Table 2). Most full-time locals choose to use, maybe only a few weeks a year. The property would then live on the bay side of the island, finding it generally quieter be leased out to others, either through the owner or a vacathan the more “touristy” beach side. tion rental management company, to help reduce the cost of Surprisingly, the timeshare model has had little success on ownership.

South Padre. “Part of the reason is limited developable beachThis group has been severely marginalized since the recession front,” says Wally Jones. “We only have about three miles of it, according to Wally Jones, which helps keep the values CEO and co-owner of Padre up but works against timeTable 1. South Padre Island, All Housing Units Getaways. share models.

Housing Occupancy Estimate Percent “Before the recession hit, “Also, access to the island young families with chilis not as easy as other areas Total Housing Units 7,053 100.0 dren were a high percentage with successful timeshare Occupied Housing Units 1,586 22.5 of the buyers,” says Jones. properties. Air service is limVacant Housing Units 5,467 77.5 “But current lending terms, ited and fairly distant. Those including the need for much Source: U.S. Census Bureau 2012 American Community Survey wanting to jet around to higher down payments, have multiple timeshares wouldn’t virtually eliminated that segment from the market.” consider South Padre a workable location.”

Greg Jones, mortgage banker for Island Mortgage, agrees that The ACS data also indicate a well-defined separation more rigorous lending standards for second homes have had an between the type of housing chosen by full-time owner effect. occupants and full-time renter occupants (Table 2). More than “Before the economic downturn, there were viable options 87 percent of owner occupants either live in single-family, to Fannie Mae and Freddie Mac loans on the island. Today the detached homes or townhomes (50.5 percent) or condo propermortgage alternatives we once had are virtually gone.” Greg ties with ten or more units (37.1 percent). Alternatively, almost Jones notes that most residential condo loans made on South 80 percent of full-time renter occupants live in the island’s Padre have never conformed to Fannie or Freddie guidelines. middle-sized structures of two to nine units.

One result of this has been a shift in the demographic About 42 percent of full-time owner-occupied units are makeup of potential buyers to a more affluent group. “Young valued at $300,000 or more. The median value according to the families can still buy on the island,” says Hyland. “They just ACS is $276,300. need a much better job than those who bought properties in For ownership costs, the ACS looks only at properties that the past.” are occupied by the owner full time. Looking at the subset of

S

16

TIERRA GRANDE

Table 2. South Padre Island, Occupied Housing Units

Number of Units in Structure 1 unit (detached) 1 unit (attached) 2 units 3 or 4 units 5 to 9 units 10 or more units

Total Occupied Housing Units

Owner-Occupied Housing Units

Renter-Occupied Housing Units

1,586

1,066

520

Percentage Estimate

Percentage Estimate

Percentage Estimate

34.7 45.0 10.5 14.3 9.6 26.4

43.8 6.7 6.4 6.1 0.0 37.1

16.0 0.0 19.0 31.2 29.2 4.6

Source: U.S. Census Bureau 2012 American Community Survey

owners who carry no mortgage, the median monthly cost of ownership is a fairly significant $943. This number is made up of real estate taxes, insurance, utilities and homeowners association (HOA) or condo fees.

“HOA dues alone will run from the mid-$300 range per month on the low side to $900 on the high side,” says Wally Jones. “And that’s not considering any special assessments. So the cost of owning these properties can be quite high.”

Mexican nationals have a reputation for keeping their properties on the island well maintained, even though they may seldom use the property. They often choose to congregate in the same development, with most floor plans including accommodations for maids or nannies. They also tend to prefer beachfront properties.

Seasonal Tourism Variations The timing of visits by tourists and part-time residents has become well established. Winter Texans, mainly from the Central United States and Canada, favor the months of January and

JANUARY 2015

February. The group that frequents South Padre favors condo rentals over recreational vehicle (RV) parks, partly because of the high cost and tight availability of RV spaces on the island and the cost of driving an RV such long distances.

“The demand is high from Winter Texans, but revenue is low,” says Elana Jones, broker and co-owner of Padre Getaways. “Rents for one month in the winter are about equal to rents for one week during the peak season weeks of summer or spring break.” here it used to be a whole month, spring breakers now only inhabit the island about ten days. Locals are often divided, with some appreciating the shorter duration and others whose businesses depend on tourism wishing for longer stays.

It can take as long as two hours to travel the 2.5-mile distance across the island’s only bridge during spring break and other peak times. A second bridge that would connect the north side of South Padre’s city limits to the mainland has been in the planning stages for a number of years.

The three or four days around Easter are a popuUPSCALE CONDOS lar time for visits from are popular with Mexican nationals. The Mexican nationals summer break is continwho visit the island a few times a year. ually busy, with families The building in the bringing their children foreground provides to the island after school accommodations for is out. nannies and maids.

“Compared with three or four years ago, I’ve noticed a change in the families who show up during summer,” says Wally Jones. “Before, five to seven days was a typical stay for them. Now it’s more like two to four days.”

He has also noticed that the new group tends to be more budgetconscious, spending less money than those who used to stay a week.

W

17

W

hen school begins in the fall, tourism slows except for a bit of activity over Labor Day. After that, the wait for the Winter Texans begins.

The hope is that SpaceX, a private space transport services company that plans to locate a launch site on nearby Boca Chica Island, will spark additional economic opportunities for the island based on rocket launches. Shuttle launches in Florida generated an average of $5 million in economic activity for surrounding local economies.

South Padre is only 4.5 miles from the future launch site.

If there should be clear views of a launch from the island, it could become a major tourist attraction. Although some have speculated that SpaceX employees might also choose to live on the island, the 40-minute circuitous commute to get from South Padre to Boca Chica Island could hinder that possibility.

New Development Hurdles

While current lending regulations have impaired the recovery of the real estate market on the island, mid- and long-term prospects look quite positive.

The City of South Padre Island has run out of easily developable land. Although ample land exists north of the city, the fear is that protracted battles over such things as endangered species could occur. Also, wetland remediation could further slow the development process, possibly reducing the amount of developable land by as much as two-thirds.

The city has extended electricity several miles to the north.

However, no water or sewer infrastructure exists, nor are there any immediate plans for any. As a result, it may be some time before the footprint of the city increases in any meaningful way.

Obstacles to Clearing the Market South Padre is not a primary housing market. “As a rule, no one is getting a job transfer here,” says Wally Jones. “We are really a second-home market.”

18

The result has been a demand pool consisting of people who are often in no hurry to buy. Until the lending environment improves, making it easier to finance condos and second homes, this is not likely to change.

Alternately, sellers on the island have been in no hurry to sell. “I would describe this as a market of patient sellers who can afford to hold,” says Elana Jones. “Instead of prices adjusting and the market clearing as you would expect, properties simply don’t sell.”

The island has about 800 residential properties on the market today. “That sounds like a lot for such a small market, but it’s actually about typical,” says Wally Jones.

While current lending regulations have impaired the recovery of the real estate market on the island, mid- and long-term prospects look quite positive.

“Many of the properties for sale are great values as selling prices haven’t increased significantly for the last several years,” says Wally Jones. “We are also optimistic that the lending requirements will be relaxed. But it’s really critical that effective marketing programs get put in place to increase the demand for properties here on the island going forward.”

Dr. Hunt (hhunt@tamu.edu) is a research economist with the Real Estate Center at Texas A&M University.

THE TAKEAWAY In a period when most Texas residential properties are turning over quickly, South Padre Island’s market is an outlier. Here, longer marketing time is the norm due to very different buyer and seller attitudes and expectations.

TIERRA GRANDE

Housing Markets

J

ust as the health of the U.S. housing market influences the national economy, Texasâ&#x20AC;&#x2122; housing sector plays a significant role in the stateâ&#x20AC;&#x2122;s economic expansions and recessions.

Measuring the relationships between key economic performance measures and housing cycle changes provides a method of anticipating the direction and magnitude of future changes.

The National Bureau of Economic Research (NBER) Business Cycle Dating Committee has been dating U.S. expansions and recessions for the past 85 years. The committee identifies business cycle turning points from a selected list of economic variables that represent aggregate economic activity.

The reason for using multiple economic series is that no single proven and accepted indicator of an observed business cycle exists. No single series can completely capture all upturns and downturns in economic activity. Given that recessions can be caused by different factors and no two recessions are totally JANUARY 2015

alike, the probability is low that any one data series, by itself, will perform best over all the peaks and troughs. To increase the probability of getting true signals and reduce the chances of false ones, an array of indicators representing a cross section of economic activities or sectors were chosen from a wide range of economic sectors and processes to estimate the date a business cycle turns.

Similarly, business cycles in different regions and economic sectors are not necessarily the same. For example, the U.S. economy did not register a downturn in 1985, while the Texas economy suffered one of its worst as a consequence of falling oil prices (Table 1). The recent boom and bust in the housing market, especially in residential construction, and its impact on overall economic growth at the national and state level highlights the need for identification of economic indicators that most influence the residential construction sector. The

19

housing market’s size and volatility make it an important sector in the overall economy’s growth at the national and regional level.

Until now, there have been no attempts to determine turning points in local residential construction economic activity and date the Texas residential construction business cycle.

This is especially critical in the absence of a timely measure of state output in the residential construction sector. The Real

Expansions and contractions can last from a few months to more than a year. Typically, expansions last longer and are considered the normal state of the economy because most recessions are much briefer. During either a contraction or an expansion, brief, minor reversals in construction activity may occur. Thus, a recession may include a period of much slower decline or even a short expansion followed by further decline.

Similarly, an expansion may include a period of much slower gain or even a short period of contraction followed by further growth.

Table 1. Chronology of U.S. and Texas Business Cycles One of the defining characteristics of Months Contraction, Months Expansion, a business cycle is how economic variPeak Date Trough Date Peak to Trough Trough to Peak ables move together over the cycle. This U.S. Economy is referred to as “co-movement.” A series December 1969 November 1970 11 106 can be classified based on the timing of November 1973 March 1975 16 36 these movements. If they are coincident January 1980 July 1980 6 58 (move together with the cycle), some lead July 1981 November 1982 16 12 the overall cycle (leading indicators) and July 1990 March 1991 8 92 some variables lag the overall cycle (lagMarch 2001 November 2001 8 120 ging indicators).

December 2007 June 2009 18 73 Coincident series, such as output and Texas Economy employment, reflect current economic February 1982 March 1983 14 conditions and generally move in tandem October 1985 January 1987 16 32 with the overall business cycle. Leading March 2001 June 2003 28 171 June 2008 November 2009 18 61 indicators reflect future activity and move ahead of the construction cycle, such as The coincident index from the Dallas Federal Reserve does not identify an economic downturn for Texas during the 1970s. building permits and new orders. Finally, Source: National Bureau of Economic Research (NBER) and Dallas Federal Reserve lagging indicators move behind the cycle.

A cycle is detected and described by Estate Center has launched a program to determine a conisolating and identifying the timing of major turning points in sistent and reliable procedure to monitor and date the Texas overall activity, after which those dates are used to mark off residential construction cycle. Center researchers chose from expansions and contractions. Market cycle fluctuations occur the available measures of residential construction and the varialong the overall, long-term trend of the economic activity. ables that represent the most comprehensive measures of the Over a 40- or 50-year period of overall growth in the volume of direction of this important sector. Based on the data, Center residential construction, there may be several contractions and research economists will determine turning points in a manner expansions in the residential construction cycle. similar to the NBER procedure.

Cycle Concepts The objective is to establish a chronology of the residential (single and multifamily) construction business cycle in Texas based on key economic performance measures such as employment, housing starts and home sales. The chronology comprises alternating dates of economic high points (peaks) and economic low points (troughs). A contraction is the period between a peak and a trough.

20

Texas Residential Construction Cycles

Acting as the residential cycle dating committee, Real Estate Center research staff applied their judgment based on the above definitions of contractions and expansions and their knowledge of and expertise within the residential market in Texas. There is no fixed rule to determine whether a given decline in activity is only a short interruption of an expansion or a true contraction or, conversely, if a sudden increase in activity is only a brief interruption of a contraction or a true expansion.

TIERRA GRANDE

Table 2. Chronology Coincident Housing Market Variables Business Cycles Trough Date

Months Contraction, Peak to Trough

Months Expansion, Trough to Peak

Nonfarm Employment February 1982 November 1985 March 2001 August 2008

April 1983 December 1986 July 2003 November 2009

15 14 29 16

32 172 62

GDP IV-Quarter 1981 III-Quarter 1985 III-Quarter 2000 II-Quarter 2008

IV-Quarter 1982 I-Quarter 1987 III-Quarter 2001 II-Quarter 2009

15 21 15 15

36 165 84

Construction Wages IV-Quarter 1981 II-Quarter 2001 III-Quarter 2008

II-Quarter 1989 I-Quarter 2003 I-Quarter 2011

93 36 33

House Price Index II-Quarter 1986 I-Quarter 2009

I-Quarter 1989 II-Quarter 2011

36 30

Peak Date

Residential Construction Employment February 2008

April 2011

39

Residential Construction Wages I-Quarter 2007

II-Quarter 2011

54

Existing Home Sales September 1979 May 1984 April 1994 December 2006

August 1982 April 1986 February 1995 September 2010

36 24 11 46

All Mortgage Loans Past Due IV-Quarter 1981 II-Quarter 2000 I-Quarter 2007

I-Quarter 1987 III-Quarter 2001 I-Quarter 2010

66 18 21

Source: Real Estate Center at Texas A&M University

T

he procedure for determining turning points consists of identifying economic activity based on a range of indicators, placing considerable emphasis on monthly indicators. The duration and amount of a change in activity typically determines a significant change in activity that warrants it being identified as a true turning point.

Five key economic variables emerged as leading indicators to estimate the Texas residential construction cycle: • housing starts; • residential contract values; • residential building permits; • the 30-year home mortgage fixed rate; and • West Texas intermediate (WTI) crude oil price.

The residential construction process, which typically takes from four to six months, starts when a building permit is issued. Building permits provide an early, direct indicator of the level of housing starts in the coming months. Permit information also includes the contract value of the proposed residence.

Residential building permits and contract values are broad measures of the housing sector that signal the timing of economic activity, whether up or down. Permits and starts exhibit a strong, positive correlation over time; however, at a downturn JANUARY 2015

they can move apart as permitted structures fail to be started. nother leading series is the conventional 30-year fixed mortgage 147 interest rate, which represents 57 the financing cost of purchasing a home by a homebuyer.

243 Although mortgage rates play an important role in demand for housing, relatively less weight is given to this residential construction cycle leading indicator as its influence is somewhat less direct. Moreover, the mortgage interest rate 22 at any given time is influenced 97 by other factors external to 143 housing market conditions.

Most recently in the past several years, monetary policies 162 39 by the Federal Reserve have been directed at keeping the mortgage interest rate low to influence overall housing activity.

In a similar manner, the price for WTI crude oil, the third leading indicator, is influenced by numerous global factors that do not tie directly to housing activity. However, WTI oil prices are another key measure because the energy sector is such an important influence on the overall Texas economy, employment, incomes and housing demand.

The chronology of peaks and troughs and the durations of the expansions and contractions for the leading series indices are depicted in Table 2.

Several coincident series reflect when activity took place, making them better indicators of housing sector peaks and troughs. For this analysis, eight Texas economic series were included as coincident indicators. They were: • total nonfarm employment, • gross state product, • construction wages, • residential construction wages, • FHFA house price index, • residential construction employment, • existing home sales and • mortgage loans past due.

A

21

Figure 1. Residential Construction Business Cycles

A financial and stock panic is sparked when the Federal Reserve Board announced a raise in its discount rate from 11 to 12 percent.

Fixed exchange rate system became a floating exchange rate system.

Decline in economy associated with Arab oil embargo begins.

General price and wage controls end.

A record 43,000 farms go bankrupt as land prices fall and interest rates soar. Many banks and savings-and-loan institutions go bankrupt in OPEC freezes oil Texas, Oklahoma, and other prices at $32 per oil states that are pressured barrel and by collapsing world oil prices. announced plans to cut production The stock market crashes, by 10 percent. with the Dow Jones plummeting a record 508 points. Computerized program trading as well as economic factors are blamed for the crash.

Residential Construction Cycles

1970

1975

1980

Oil embargo is lifted by OPEC. The U.S. prime interest Arab oil-producing states substantially raise posted price of crude oil and begin oil embargo on Oct. 17.

rate reaches an all-time high of 21.5 percent.

1985

1990 Low interest rates and low oil prices combine with a weak dollar to boost corporate profits.

The economy continues to falter as inflation hits 14 percent and unemployment reaches 7.4 percent.

Unemployment hits 10.8 percent, the highest since 1940.

Sources: Bekaert, Geert; Engstrom, Eric; Harvey. Campbell R., “The U.S. Risk Premium,” http://people.duke.edu/~charvey/country_risk/chronology/us-events.htm; and Federal Bank of St. Louis, “The Financial Crisis: a Timeline of Events and Policy Action,” http://timeline.stlouisfed.org/index.cfm?p=home.

D

uring the construction process, labor and capital are employed in various degrees until the house is completed. While capital is difficult to measure directly, the Bureau of Labor Statistics (BLS) provides different measures of labor.

Residential construction employment and wages can be used to measure the intensity and timing of residential construction activity. Because employment data do not differentiate between full-time and part-time workers, they can be more misleading than total wages. Real wages paid fluctuate with hours worked and worker productivity. These data are not available on a monthly basis. Nevertheless, both series give a better picture of the timing and magnitude of construction activity than other

22

coincident series available and are relied on more heavily to define turning points in housing market activity.

Of the other coincident variables considered, the Federal Housing Finance Agency (FHFA) Texas house price index is directly tied to the regional single-family existing housing market. But the index is considered “sticky” to downward movements, only registering declines during deeper contractions, and not falling during milder recessions. The price index also lags the labor coincident series of employment and wages. In addition, current house prices have embedded in them future price expectations that affect the price index’s ability to measure turning points in the construction cycle. With the exception of all mortgage loans past due, the remaining variables are broader measures of the Texas economy — TIERRA GRANDE

Standard & Poor’s places 612 securities backed by subprime residential mortgages on a credit watch.

The Federal Reserve Bank of New York begins purchasing fixed-rate mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae under a program first announced on November 25, 2008.

The Federal Reserve Board authorizes the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac, should such lending prove necessary.

Standard & Poor’s and Moody’s Investor Services downgrade over 100 bonds backed by second-lien subprime mortgages.

Freddie Mac announces that it will no longer buy the most risky subprime mortgages and mortgage-related securities.

1995

The Federal Open Market Committee (FOMC) votes to maintain the target range for the effective federal funds at 0 to 0.25 percent.

In addition, the FOMC decides to increase the size of the Federal Reserve's balance sheet by purchasing up to an additional $750 billion of agency mortgagebacked securities, bringing its total purchases of these securities to up to $1.25 trillion this year.

The Federal Housing Finance Agency (FHFA) places Fannie Mae and Freddie Mac in government conservatorship.

2000

2005

2010

2015

Lehman Brothers Holdings Incorporated files for Chapter 11 bankruptcy protection.

U.S. Treasury Department announces the Troubled Asset Relief Program (TARP) that Financial market will purchase capital in financial institutions pressures intensify, reflected in diminished under the authority of the Emergency Economic Stabilization Act of 2008. liquidity in interbank funding markets.

The Federal Reserve Board announces President Obama announces the Homeowner Affordability and Stability Plan. The a new program to purchase direct plan includes a program to permit the obligations of housing related refinancing of conforming home government-sponsored enterprises (GSEs)—Fannie Mae, Freddie Mac and mortgages owned or guaranteed by Fannie Mae or Freddie Mac that currently exceed Federal Home Loan Banks—and MBS 80 percent of the value of the underlying backed by the GSEs. home.

construction wages, GDP and nonfarm employment — and do not necessarily reflect specific housing sector activity. They may be increasing (decreasing) when housing activity is decreasing (increasing). The final coincident series, all mortgage loans past due, represents regional credit conditions and does not necessarily measure direct activity in the residential housing market.

The chronology of peaks and troughs and the durations of expansions and contractions for the coincident series indices are depicted in Table 3.

Dating Residential Construction Cycles Because of limited data series availability, the evaluation period of this report is from January 1970 to May 2014. All JANUARY 2015

data series were seasonally adjusted and dollar amounts were measured in real terms deflated by an estimate of the Texas Consumer Price Index (CPI). The Texas CPI is estimated from an interpolation procedure of the CPI data for Dallas-Fort Worth and the Houston-Galveston-Brazoria areas for all urban consumers, with a base period of 1982–84.

Each series was plotted to identify turning points and thereby define specific cycles for each series. Subsequently, the specific information was distilled into a single set of turning points that constitute the chronology of the aggregate cycle for residential construction in Texas (Figure 1).

Identifying the specific dates of the cycle troughs required weighing the behavior of the chosen coincident and leading

23

Table 3. Chronology Leading Housing Market Variables Business Cycles Trough Date

Months Contraction, Peak to Trough

Months Expansion, Trough to Peak

Housing Starts November 1972 April 1978 September 1983 March 2006

November 1974 April 1980 May 1989 November 2010

25 25 55 57

42 69 203

Residential Contract Values November 1972 April 1978 November 1983 February 1994 January 2006

January 1975 October 1981 April 1988 March 1995 September 2010

27 43 54 14 57

40 26 71 131

Residential Weighted Building Permits October 1972 July 1979 September 1983 December 2005

December 1974 October 1981 February 1988 October 2010

27 27 54 59

56 25 215

30-Year Home Mortgage Fixed-Rate May 1980 May 1986 October 1998 January 2007

August 1983 February 1989 November 1999 March 2010

40 34 14 39

34 117 87

Oil Price West Texas Intermediate April 1980 October 1990 May 2008

June 1986 November 1998 July 2010

75 98 27

53 115

Peak Date

Source: Real Estate Center at Texas A&M University

variables. Some data series were available only quarterly and others were subject to regular revisions and measurement errors. For these reasons, it was preferable to refer to a variety of monthly indicators to determine the months of peaks and troughs. Greater emphasis was placed on measures that directly represented residential construction activity than to more general indicators of the Texas economy.

The direct variables included residential construction employment and wages, weighted residential permits, residential contract values and housing starts. Unfortunately, the first two coincident variables were available only since 1990, which affected the researchersâ&#x20AC;&#x2122; ability to identify peaks and troughs during the 1970s and 1980s. However, the other series provided information to help identify turning points during both of the earlier decades. There were no fixed rules about the weights assigned to the various indicators or about other measures that contributed to the process of dating the business cycle.

In addition, a timeline of historic economic events for the past 40 years was used as a reference to complement the identification of turning points.

A contraction in residential construction was defined as a period of significantly falling economic activity spread across

24

the construction sector and lasting more than a few months.

The turning points were normally visible in the following leading and coincident variables: housing permits, residential contract values, housing starts, residential construction employment and residential construction wages. The trough (peak) marked the end of the declining (increasing) stage and the start (end) of the rising (falling) stage of the business cycle.

Economic activity is typically below normal in the early stages of an expansion and may remain so well into the expansion. ased on the behavior of the coincident and leading indicators included here, three peaks and troughs in the Texas residential construction business cycle were identified (Table 4).

The three residential market-leading indicators were found to lead a peak approximately 12 months ahead and a trough about eight months ahead. The dates of these peaks and troughs were consistent with declines (increases) in existing home sales and the house price index.

The first major contraction, from September 1979 to August 1982, was due to the rise in interest rates in the United States as the Fed raised the fed funds rate to subdue rising inflation (Figure 2). This led to a fall in international oil prices as international

B

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Figure 2. Chronology of Coincident and Leading Variables Contractions (Peak to Trough)

0 –1 –2 –3 –4 –5 –6 –7 –8 –9 –10 –11 –12 –13 January 1970

July 1974

January 1979

July 1983

January 1988

July 1992

January 1997

July 2001

January 2006

July 2010

Nonfarm Employment

Construction Wages

Residential Construction employment

Existing Sales

Housing Starts

Residential Weighted Building Permits

Oil Price

House Price Index

GDP

All Mortgage Loans Past Due

Residential Construction Wages

30-Year Home Mortgage Rate

April 2014

Residential Contract Values Source: Real Estate Center at Texas A&M University

and contractions interest rates rose, Table 4. Chronology of Texas Residential Construction Cycles of Texas’ residencausing a slowMonths Contraction, Months Expansion, tial construction down in U.S. and Peak Date Trough Date Peak to Trough Trough to Peak cycle were typically world economic September 1979 August 1982 36 longer than national activity and resultMay 1984 March 1989 59 22 or Texas business ing in a drop in January 2007 June 2011 54 215 cycles. world demand for Source: Real Estate Center at Texas A&M University For an expanded oil. The contracreport, see Dating tion from May the Business Cycle for Texas Residential Housing Construc1984 to March 1989 was the deepest and longest lasting. The tion at recenter.tamu.edu/pdf/2086.pdf. downturn in oil prices from the global excess supply of oil caused a major recession in the Texas economy, reflecting the Dr. Gaines (jpgaines@tamu.edu) and Dr. Torres (ltorres@mays.tamu. fortunes of the energy sector. The latest contraction (January edu) are research economists with the Real Estate Center at Texas A&M 2007–June 2011) reflected the bursting of the national housing University. bubble and its effect on the overall economy and the financial sector, which led to the largest downturn in economic activity THE TAKEAWAY in the United States and the world since the Great Depression of the 1930s.

The Real Estate Center, as part of its ongoing research The Texas residential cycle was not totally coincident with efforts, will continue to monitor the coincident and leadthe U.S. or Texas business cycles. For example, the Texas ing indicator series to estimate future residential market residential construction sector did not register a contraction cycles. in 2001 as did the U.S. and Texas economies. Expansions JANUARY 2015

25

Mortgage Markets

By Mark G. Dotzour

OF THE

EART OUSING MARKET Residential mortgages are a vital part of the housing market. While there have been large numbers of cash sales in recent years, most homebuyers in America do not have enough funds to pay cash for a home. In fact, many face a diďŹ&#x192;cult time coming up with a modest down payment.

26

When mortgage rates are low, homeowners can buy larger, more expensive homes. Higher rates preclude them from buying larger homes because the monthly payments increase beyond their ability to pay. Consequently, changes in mortgage rates have a profound impact on sales of single-family houses.

What causes mortgage interest rates to change? Understanding the factors influencing these rates enables real estate professionals and potential buyers to better understand mortgage rate trends. A potential homebuyer may defer purchasing if they think mortgage rates are likely to fall from current levels.

Conversely, if they think rates could rise in the near future, they may buy before rates increase.

The 30-year, fixed-rate mortgage rate moves closely in tandem with the ten-year U.S. Treasury bond rate. Bond investors have numerous choices for investments, including residential mortgages, Fannie Mae and Freddie Mac bonds, corporate bonds and U.S. Treasury bonds. When the interest rate on the ten-year Treasury bond goes up 1 percent, itâ&#x20AC;&#x2122;s highly likely that the interest rate on all the other bonds will increase by nearly the same amount.

Figure 1 shows the relationship between the 30-year conventional mortgage rate as reported by Freddie Mac and the rate on the ten-year Treasury bond reported by the Board of Governors of the Federal Reserve for the past 14 years. When the ten-year Treasury rate moves up, mortgage rates almost immediately move up as well. Conversely, if the ten-year drops, mortgage rates fall. Busy real estate professionals can stay abreast of changes and current trends in mortgage rates by following the

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30-Year Mortgages 10-Year Treasury

Interest Rates

8 6 4 2 0 2000

2003

2006

2009

2012

Source: Federal Reserve Board

2014

OCTOBER

ten-year Treasury rate through the Federal Reserve Bank of St. Louis (http://research.stlouisfed.org/fred2/series/GS10).

Notice that the mortgage rate is always higher than the Treasury rate. That’s because investors perceive mortgages to be a riskier investment than U.S government debt. Over the 14-year period, the average mortgage rate was 5.62 percent, and the average Treasury rate was 3.84 percent. The difference between the two rates is known as the risk premium on mortgages or “the spread.” Over the period, the spread averaged 1.78 percent. So the 30-year mortgage rate is likely to be about 1.8 percent higher than the current ten-year Treasury rate.

While it’s clear the two interest rates move closely in tandem, they are not perfectly correlated. In other words, the spread can vary. Sometimes the risk premium is higher than average. Since 2000, the mortgage rate has usually been between 1.5 and 2.0 percent higher than the current Treasury rate (Figure 2). Notice the big spike in 2008, when the spread

3.0

Figure 2. The Spread (Risk Premium) for Mortgage Loans, 30-Year Mortgage Rate, 10-Year Treasury Rate

Interest Rate

2.5

Figure 3. Ten-Year Treasury Rate and Consumer Inflation

20

10-Year Treasury Rate Consumer Price Index

15 Interest Rates

Figure 1. Mortgage Rates and Treasuries 10

exploded to almost 3 percent. That’s what happens when bond investors lose faith in the American housing market.

What causes the ten-year Treasury rate to go down or up?

The answer is the expected rate of inflation. How much inflation do investors expect to see over the next ten years? If investors anticipate high inflation in the future, interest rates on Treasury bonds will be high. Inflation was high in the late 1970s and early 1980s. So were interest rates.

Figure 3 shows how the ten-year Treasury rate and the Consumer Price Index (CPI) have moved together since 1953. Inflation peaked at an annual rate of 14.6 percent in March 1980.

The ten-year Treasury rate peaked at 15.32 percent in September 1981. Aggressive Fed policies were successful in taming the runaway inflation of the late 1970s. Since then, inflation has

10 5 0

–5 1953 APRIL

1965

1977

1989

2001

2014

OCTOBER

Source: Federal Reserve Board

fallen and the ten-year rate has dropped with it. Inflation has been above 5 percent for only three months since 2000, and above 4 percent in only 13 months. Conversely, the CPI inflation rate has been less than 2 percent for 59 months.

Mortgage rates are largely determined by the interest rate on the ten-year U.S. Treasury bond. The rates are, on average, about 1.8 percent higher than the prevailing Treasury rate. The Treasury rate is influenced largely by the expected rate of inflation. The United States had low rates of inflation for the first 14 years of the 2000s. Real estate professionals who want to follow mortgage rate trends should keep an eye on the ten-year bond rate and the outlook for future inflation.

Dr. Dotzour (dotzour@tamu.edu) is chief economist with the Real Estate Center at Texas A&M University.

2.0

THE TAKEAWAY

1.5

1.0 2000

2003

2006

Source: Federal Reserve Board JANUARY 2015

2009

2012

2014

OCTOBER

Residential mortgage rates have a strong relationship with the current interest rate on the ten-year U.S. Treasury bond.

The mortgage rates are likely to be somewhere between 1.5 percent and 2 percent more than the current Treasury rate.

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Income Taxes

W

hile the heyday for flipping houses has passed, there was a substantial increase in flipping through the second quarter of 2014 in certain areas of the country. During first quarter 2014, Dallas and Houston flips were up 28 percent and 29 percent, respectively, according to RealtyTrac. Flipping is typically assumed to have taken place when houses are sold less than a year after they are purchased.

In August 2014, RealtyTrac reported that flippers earned an average 21 percent gross return ($46,000 average profit), down from a peak of 31 percent in 2011. But as one might expect, where there are profits there is an uninvited partner — the IRS. To a large extent, the tax treatment of flipping depends on whether the IRS considers the flipper to be a real estate dealer or a real estate investor. Investor status is generally preferred by flippers. A list of the key factors the IRS uses to determine dealer/investor status for flippers follows. However, keep in mind that no single factor is determinative. The IRS makes each dealer/investor determination based on the “facts and circumstances” surrounding the sale(s).

The most important factor may be the number of flips per year. Clearly, one flip does not normally indicate dealer status.

But as the number rises, so does the possibility of dealer status.

Other factors considered in determining dealer status are: • Did the sale of the property occur shortly after the property was renovated?

• Is the flipper a real estate professional (broker/salesperson)?

• Is the flipper a part-timer or full-timer?

• What percentage of the seller’s annual income is earned from flipping?

• What business behaviors are exhibited by the flipper? For instance, does the flipper have a sales office? Employees?

Business cards?

Tax Consequences for Investor (Non-Dealer) Investor net income from properties held one year or less is considered short-term capital gain income, generally taxed at ordinary income tax rates ranging from 10 to 39.6 percent.

Such gains may be subject to an additional 3.8 percent investment income surtax depending on the level of the investor’s other taxable income.

For example, assume an investor earns $30,000 from a flip, is married and files a joint tax return, and the couple has

28

$250,000 of taxable income before the $30,000 gain.

The gain would be taxed at 36.8 percent (33 percent marginal ordinary income tax rate plus 3.8 percent).

Thus, the tax would be $11,040.

Conversely, the tax would be only $5,640 ($30,000 × 18.8 percent) if the property were held more than one year, making the gain a long-term capital gain.

Investors (but not dealers) are also eligible to benefit from installment sales as well as Section 1031 exchanges.

Tax Consequences for Dealer In sharp contrast, dealer net income is subject to the regular income tax plus the 15.3 percent self-employment tax (but not the 3.8 percent investment income surtax).

The holding period is not relevant. The 15.3 percent tax rate is applied to the first $118,500 of adjusted net self-employment income. For instance, assume the same facts as in the example, except the seller is a dealer. The tax would be $14,139 ($30,000 x 33 percent; plus $30,000 × .9235 adjustment factor × 15.3 percent). The dealer’s $14,139 tax is substantially higher than the $11,040 and $5,460 tax amounts noted above for the investor. Investors and dealers may be able to avoid all taxes on their gains if they make the house their principal residence for two of the previous five years and the gain is under $250,000 for single taxpayers and $500,000 for married couples. ne tax benefit available only for dealers is that they can deduct losses in full in the year of sale. In contrast, an investor’s short-term and long-term capital losses may be limited to $3,000 per year (depending on the investor’s other capital gain income/loss).

Also important are the anti-flipping rules imposed by the Department of Housing and Urban Development (HUD). These rules can affect transactions with FHA mortgages.

As with all tax matters, dealers and investors must document all aspects of transactions including costs of repairs and capital improvements/renovations. Consultation with a tax accountant or tax attorney with real estate experience is critical.

O

Dr. Stern (stern@indiana.edu) is a research fellow with the Real Estate Center at Texas A&M University and a professor of accounting in the Kelley School of Business at Indiana University.

THE TAKEAWAY Profits from flipping houses may be taxed an additional 15.3 percent if the seller is considered a dealer for tax purposes, rather than an investor. The IRS might treat the seller as a dealer if there are multiple flips per year or if the seller is a real estate professional.

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JANUARY 2015

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