Phoenix: Today's Market and Tomorrow

Implications: This review is a republication of Belfiore Real Estate Consulting's October 2, 2006 - KnowledgeBase Current and Future Market Conditions Insight Publication.  The article is lengthy with information on the metro area and one of four metro area regions.

Analysis:

Executive Summary

The residential housing market continues to be in great flux. Homebuilders have entered a new phase of discounting- dropping base home prices- and resellers have awakened to the reality that their homes are not worth as much as they had thought. Overall demand is down, yet many homebuilders continue to build unsold homes. And, new communities going through the development pipeline continue to bring additional competition into the marketplace.

While demand levels are disconcerting- closings were down 28% through the 2^nd quarter and were off an additional 7%-12% during the 3rd quarter (data to be released in coming weeks)- supply conditions are to blame for recent heavy discounting. More than 4,500 new homes, complete or nearly complete, sit unsold in Valley subdivisions. Builders are desperate to sell these homes, apparent in recent price drops. New home prices have decreased approximately 13% since January 2006.

East Valley market data highlight submarkets under the most stress: those that are on the far outskirts. The Queen Creek / Hunt Highway and Florence / Coolidge Submarkets have shown the most drastic price decreases- down 15.9% and 18.0%, respectively- while closer-in new home submarkets like South Chandler and Gilbert have had smaller decreases- 10.5% and 10.0%, respectively.

Resale supply has largely stabilized during the last month. Early in the current cycle, price discounting was attributable to resale supply. New home discounting during the 3^rd quarter 2006, though, is being driven by new home supply and homebuilders.

When market data is viewed in its entirety, the basics of Economics 101 become clear. Today’s prices are a direct result of the number of speculative homes in the marketplace. There is significantly more supply on the market today and less demand- and prices, therefore, are declining. Submarkets with the least number of spec homes- particularly those homes complete or within 60 days of completion- have experienced the smallest price declines, while those with the highest number of spec homes have experienced the largest declines.

The bottom of declines has yet to arrive. Belfiore Real Estate Consulting expects demand to remain stagnant until April 2007, when Phoenix MSA buyers return in full force. Strong job and population growth will continue to create opportunities for sales, but current excessive supply conditions must change to reach market stabilization.

A limited number of homebuilders have recognized the current correlation between speculative inventory levels and price decreases. They have cut back on production until inventory within subdivisions declines. Many builders, however, continue to start new homes, even in the midst of current supply conditions and price declines. Therefore, our forecast is for continued price declines, albeit smaller than those that have occurred since January 2006. We anticipate a decline of 4% to 9% between now and mid- 2007, when overall prices will stabilize. Most of this discounting will occur during the next 3 to 4 months, as builders slash prices to move inventory.

Demand

Although complete data has yet to be released, mid- 3^rd quarter reports indicate demand has continued to drop- for both new and resale homes. Demand, evidenced by closing activity, has dropped 35% to 40% from one year ago. The most recent, full quarter, East Valley closing data is highlighted in the table below:

East Valley and MSA Closing Activity
BREC Submarkets	# of Closings
	2Q2006	%Chg
Tempe Town Lake	269	-8.8%
Central Tempe	584	-18.2%
South Tempe	105	-24.5%
West Mesa	900	-36.6%
East Mesa	1,322	-41.9%
NE Mesa	436	-43.0%
Williams Gateway North	503	-19.1%
Central Chandler	801	-33.0%
West Chandler	287	-17.1%
Ocotillo / Sun Lakes	491	-21.3%
South Chandler	582	-58.0%
Gilbert	1,837	-44.5%
Queen Creek / Hunt Hwy	1,744	-28.6%
Gold Canyon	155	-44.4%
Apache Junction	256	-39.3%
Coolidge / Florence	265	21.6%
East Valley Averages	10,537	-35.9%
MSA Averages	37,216	-28.0%

Raw Zip Code Data provided by DataQuick; custom Submarkets by Belfiore Real

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With strong job (88,500 new jobs during last 12 months, 5.0% growth rate) and population (estimated 110,000 new residents in 2006, per Moody’s Economy.com) growth, many are wondering where the buyers have been.

Industry professionals have estimated 25% to 35% of 2005 demand was the result of investor buyer activity. Investors are no longer homebuyers- thus a majority of the drop in demand is explained.

Macroeconomic factors have contributed to the drop in demand, including inflation, increasing mortgage rates, and fear. Oil prices have now started to retreat but fuel costs have taken money from consumer’s pockets. Although mortgage rate increases have been minimal (despite seventeen Fed Rate increases since June 2004) and rates remaining around 6.5% for a 30-year, fixed mortgage, we live in an “affordable” west metro area where median incomes are relatively (compared with large neighbors) meager. And, fear is also a factor for potential buyers. They fear purchasing a home and losing money; they fear further increases in fuel costs; and, they fear the general direction of the economy.

Some homebuilders and analysts argue that homes are selling strongly today; demand is down, but not down 40%, they argue; the problem with demand in today’s market is cancelations. Buyers are still visiting builder sales offices / model homes and gross absorptions are strong. Average East Valley traffic figures indicate 22 potential buyers are visiting typical subdivision models each week. Traffic for each of the most active submarkets is below:

East Valley Sales Traffic
Submarket	Avg # of Potential Buyers per Subdivision
Ocotillo / Sun Lakes	38
South Chandler	27
Williams Gateway North	20
Gilbert	25
Queen Creek	21
Coolidge / Florence	14

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Cancelations are indeed the major demand hurdle for builders today. Buyers are canceling sales for numerous reasons, including:

• Cannot sell existing homes (#1 Reason)
• Equity decline in current home
• Fear of further drops
• Inflation
• Interest Rates
• There is a better deal down the street
• Distrust (of homebuilder or salesperson)

To counter, builders have adopted several tactics. Existing home sales assistance, low down payments, down payment assistance, price decline protection assurances, and even prepaid gas card incentives with the purchase of a home. Additionally, they’ve upped co-brokerage fees. Late in 2004, many homebuilders stopped paying co-brokerage fees. Prior to then, builders willingly paid licensed real estate agents 3% of the purchase price of the home to bring them buyers. Today, builders are paying up to 12% to sell completed homes and an average of more than 4%. East Valley averages are below:

East Valley Co-Broke Fees
Submarket	Percentage Paid to Outside Agents
Ocotillo / Sun Lakes	3.30%
South Chandler	4.15%
Williams Gateway North	3.70%
Gilbert	4.09%
Queen Creek	4.36%
Coolidge / Florence	4.13%

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The cure for homebuilders’ woes is not likely to be found in demand- altering attempts. Builders are ensuring high enough traffic levels to sell homes. Cancelations, however, still plague them, and will likely continue to be a problem until supply and pricing stabilize.

Supply and Pricing

At the end of September, Phoenix MSA homebuilders were constructing or had completed an estimated total of 6,871 homes that were not sold. Of these homes, the majority- 4,557- were complete or within 60 days of completion. The value of existing homes and pricing of new homes is now being dictated by the desperate need to sell this speculative inventory.

The greatest supply of speculative inventory exists in submarkets on the outskirts of the MSA- in Queen Creek / Hunt Highway, Coolidge / Florence, Maricopa, Goodyear, Buckeye, and Surprise. Therefore, home prices in these areas have declined the most. The table below reflects East Valley new home submarkets’ inventory units per subdivision and price declines:

60-Day Inventory Averages and Price Changes
Submarket	# Homes per Subdivision	Price Change since January 2006
Ocotillo / Sun Lakes	5.0	-13.6%
South Chandler	4.5	-10.5%
Williams Gateway North	3.7	-9.4%
Gilbert	3.4	-10.0%
Queen Creek	5.5	-15.9%
Coolidge / Florence	6.4	-18.0%

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Trying to eliminate costs associated with finished and nearly-finished homes on their books, some homebuilders have started to curb speculative home building. Others continue to start homes without buyers, claiming buyers desire “move-in ready” homes. Regardless of strategy choice, overall market pricing is being driven by builders pushing speculative inventory. The average subdivision now has 7.4 unsold units under construction, 4.9 of which are within 60 days of completion.

Until the 3^rd quarter, builders were discounting homes only through the use incentives- most keeping base prices stable. During the latter half of the 3^rd quarter, though, market dynamics began to change. In addition to increasing incentives, builders began discounting base home prices. In the East Valley Region, 29.6% of homebuilders decreased base home prices during the 3^rd quarter.

Base price discounting is considered by many a last resort because existing home devaluation becomes more transparent to those following home prices. Many analysts wonder why they have not read a lot about the price decreases they are now just starting to see. The reason: most data providers have not collected incentive data consistently throughout U.S. metro areas; they’ve tracked only base price data.

New home price decreases will be reflected in Phoenix MSA data with future data releases, partially due to decreasing base prices and partially due to new subdivisions coming to market at lower prices. The 60-day inventory price change figures above, of course, are inclusive of base home price and incentive data.

The Outlook

The driving factor behind today’s market conditions is speculative new home supply. Builders continue to push home prices downward in a desperate attempt to keep these units off of their balance sheets. The market will not stabilize until speculative inventory begins to decline.

Recently conducted Belfiore Real Estate Consulting surveys indicate many builders continue to start homes without homebuyers. These builders are dependent upon volume; some have signed trade-contractor agreements to provide a steady flow of work; and, others are simply trying to exit exceptionally slow submarkets / subdivisions.

Most builders will recognize the correlation between speculative inventories and sales prices during the next 3 to 4 months. Speculative inventory does indeed satisfy the needs of a buyer profile- just not all buyers. Therefore, builders will start to limit the number of spec units to 3 to 4 homes, each within a different stage of construction. The discount on these homes will be reduced, and these homes will eventually sell at a similar price to non-speculative homes.

Resale supply has peaked, and as listing agreements from the summer months expire, buyers whom had anticipated moving prior to school starting are not re-listing. They are removing their homes from the market.

Belfiore Real Estate Consulting is forecasting market stabilization- in overall supply and home prices- to occur late 2^nd quarter / early 3^rd quarter 2007. Buyers are active in the marketplace today, as demonstrated in gross sales figures. And a steady flow of potential buyers is apparent in employment and population growth figures. As we enter 2^nd quarter 2007, demand should surge with the summer school break.

Sales prices will continue to decline through mid- summer 2007. By this time, new home prices will have dropped 17% to 22% (since January 2006). Once stabilized, prices will remain stagnant through 2007 and the first quarter 2008.

Key Risks

Outside of macroeconomic factors, which residents and local homebuilders have no control over, there are risks that pose a threat to our forecast coming to fruition. We believe the greatest risks are builder “over-optimism” and 2^nd quarter 2007 resale supply conditions.

Builders have always been known as an optimistic bunch. When asked about market conditions earlier this year, many responded that the slowdown started in the middle of November 2005 and that the “holiday season” was responsible. When home sales data was finally released, though, it was obvious the slowdown occurred during the 3^rd quarter, months before.

Homebuilders know home sales are greatest in the MSA from April to August, when school is out. This knowledge, and a general optimistic nature, may push them to continue building speculative homes beyond the next 3 to 4 months and beyond the 3 to 4 units we consider healthy. As mentioned multiple times, speculative inventory is driving current overall market conditions; further building would likely delay market stabilization, even if demand levels improve in April.

Unsuccessful resellers from the summer of 2006 may push a glut of existing homes in the 2nd quarter. From the 1^st quarter to the 2^nd quarter 2006, resellers added 55% more inventory to the local multiple listing service. These buyers anticipated moving to new homes. Since many were unable to sell their homes during the summer months, they have started allowing their listing contracts to expire. These sellers may consider re-listing their homes during the 2^nd Quarter 2007. A significant jump in resale listings could drive overall market conditions down further, forcing homebuilders to continue price cuts through the 2^nd and 3^rd quarters of next year.