California Economy in the Doldrums Cynthia Kroll

California Economy in the Doldrums
Cynthia Kroll, Regional Economist
Fisher Center for Real Estate and Urban Economics
University of California Berkeley

Presentation to the First American Commercial/Industrial Advisory Counsel

(Summary of Remarks)

Oakland, October 8, 2002

In 2001, in many parts of the country, it seemed US was barely in recession, yet now it seems the country is barely having a recovery. While GDP growth shot up in the first part of the year, and stock prices seemed to be moving towards recovery in the early months of 2002, by the 3^rd quarter of the year, GDP growth had dropped to much more modest levels, revised numbers showed that GDP declined for three quarters in 2001, and stock values plummeted below their 1998 levels.

Consumer confidence, a major factor in the mildness of the recession, began to sag in July 2002. Interest rates, at a 30 year low, are one promising area of the economy.

Statewide, California employment held up surprisingly well during the economic downturn. Despite being the center of the dot-com collapse, employment losses in California were more mild than in the US as a whole.

Unemployment in the state has exceeded nationwide levels since 1990, but the gap narrowed sharply in the current slowdown. Overall, unemployment rates have been mild compared to the two previous recessions.

The statewide picture masks some important differences among industries and among regions within the state. The manufacturing sector has experienced the biggest losses, with an employment drop of over 5% and earnings loss of over 10% in the past year.

Even the services sector has lost employment in this slowdown. Government, retail and finance sectors are supplying a small level of job growth to counterbalance losses in other sectors.

The poor showing of the services sector is largely due to job losses in dot-com related occupations such as computer programming and personnel supply, which combined have lost over 120,000 jobs since late 2000.

Much of the employment loss has been centered in the San Francisco Bay Area. The region’s metropolitan areas led employment growth in 2000 and now lead employment losses statewide. These metropolitan areas had the lowest unemployment rates in the state as recently as 4^th quarter 2001. Now the San Jose metropolitan area leads the state’s large regions, with an unemployment rate of 7.7%.

California building activity in 2002 has been characterized by slumping nonresidential and multifamily housing sectors and a thriving single-family housing sector. The value of total building permits has dropped by 3.9% from a year ago, with the loss primarily in office permits (down 55%), industrial (-30%), nonresidential alterations and additions (-19%), and multifamily housing (-15%). In contrast, single-family building permits are up by 8.5% in value and make up more than half of the value of California permits in the first half of the year.

Building activity in the San Francisco Bay Area has dropped by two thirds in office space, by 44% in industrial, and by 42% in multifamily. However, even in the San Francisco Bay Area, the level of single-family construction has grown.

The continued strength of single-family residential construction is a response to short supply, strong home sales and prices. Residential building activity lagged in the expansion period of 1995-2000, compared to other periods of economic strength in California.

California home prices are growing faster than nationwide. In Los Angeles, price gains outpaced the state. In the San Francisco Bay Area, prices gains slowed briefly in 2001, rose sharply in the first half of 2002, and only showed signs of dipping in August 2002.

Unlike the single-family sector, the multifamily sector has weakened as the economy has slowed. With fewer workers in the high-tech and dot-com sectors, there is reduced overall demand for housing in the San Francisco and Silicon Valley areas, and low interest rates have made home ownership an attractive alternative for renters who are still employed in high wage occupations. Rental vacancy rates have climbed throughout the state, reaching a peak in the first quarter of 2002.

Rents have dropped primarily in areas that experienced the most rapid rent increases in the previous two years and where vacancies have risen the highest. Rents have dropped by 18.4% for the San Francisco Bay Area, by 19.5% in the City of San Francisco, and by

The changes to the rental housing market are modest compared to the impacts of the economic slowdown on the office market, especially in Northern California. In most parts of the Bay Area, vacancies reached their lowest levels, in many places below 2%, in 2000. In less than two years, vacancies had increased by 5 to 10 fold, going from the lowest in the state to the highest.

Rents have also taken a sharp downturn. In 2000, Bay Area office rents had become among the most expensive in the world. Silicon Valley was number 3 worldwide, surpassed only by Tokyo and London, while 3 of the top 5 office markets in the US were in Silicon Valley.

As vacancies have dropped, so have California rents, although San Jose and San Francisco remain in the top 5 nationwide. The decline has been much greater for Bay Area markets than for the rest of the state. Office rents in San Jose and San Francisco are down by more than 50% from their peaks in 2000. In Southern California, the greatest adjustment has been in Orange County, where rents are down 20%.

With declining rents, vacancies have stabilized in the last quarter, and some markets are beginning to see small levels of positive net absorption. However, the overhang remains very large. At absorption rates equivalent to the average for the 1990s, many markets have at least a 10-year overhang. Even at the more robust absorption levels of the 1980s, the overhang is close to 5 years for many markets. The overhang affects both Northern and Southern California.

Industrial markets are also showing signs of weakness, with rising vacancies, negative net absorption, and declining rents. As with the office and apartment markets, problems appear most severe in the San Francisco Bay Area markets, while markets elsewhere in the state show signs of stabilization or improvement.

The outlook for the rest of the year and for 2003 is uncertain. There are negative factors likely to keep growth slow, especially for the last quarter of the year, including:

None of these factors alone would lead to a double dip recession, but the combination of all of these factors could lead to continued slowness in the economy for a few more quarters.

In this slowdown, a diverse economy has been an advantage for the state, with Southern California and central parts of the state counterbalancing the more severe slowdown in the San Francisco Bay Area.

For real estate, a continuation of the slowdown in Northern California may eventually dampen the pace of price increases in the for-sale housing market and could lead to a drop in home prices back to levels of a year or two ago in some markets. In nonresidential segments of the market, even with an economic recovery, it will be several years, before rents rise and new building becomes attractive once again.

Dr. Cynthia Kroll is the regional economist for the Fisher Center for Real Estate and Urban Economics, a research center on the U.C. Berkeley Campus. She holds masters and doctoral degrees from U.C. Berkeley's Department of City and Regional Planning. She is well known for her research on California economic trends and their implications for real estate development opportunities and land development issues. Her recent and ongoing research includes the global position of California’s economy in general and of the computer cluster, California’s economic outlook after the dot-com bubble, the role of the World Wide Web and other new technologies in the real estate industry, and the effects of construction defect litigation on multifamily and condominium construction. Earlier topics include: an evaluation of the CEDAR (economic recovery) web site, the Bay Area housing market, the role of tourism in California’s economy, the effects of defense cuts on California employment and economic structure, the future of the Southern California economy, the effects of high housing prices on job growth, the effects of the Loma Prieta earthquake on the Bay Area economy, trends in California's Central Valley, housing cap proposals in San Diego, and the role of high tech industries in the Silicon Valley industrial market. Dr. Kroll conducts ongoing evaluations of California's residential, office and industrial markets. In addition to her nineteen years at the Center, Dr. Kroll has also worked for the State of California's Office of Economic Research, for the Association of Bay Area Governments, for SRI International, and as an independent consultant.