This article discusses the current residential vacancy rates in California and the pressure vacant properties place upon this decade’s real estate recovery.

Rental and homeowner vacancy rates both declined in 2011, falling to their lowest levels since 2006 and 2007, respectively. Vacancy rates remain significantly higher than in the pre-recession years of 1999-2004.

	2011	2010	2009
Homeowner Vacancy Rate	2.1%	2.5%	2.2%
Rental Vacancy Rate	6.1%	7.5%	7.6%

The postman’s beat is getting lonelier

The recession may be over, but the effects of the Great Recession remain visibly etched on the landscape of the California real estate market in the form of vacancies. Residential vacancies, particularly in single family residences (SFRs), can be found in any neighborhood in the state. Dead lawns and the constant presence of “For Sale” signs stand out as vividly as missing front teeth do on the face of a smiling child.

These vacancies blight neighborhoods and provoke crime, destroying the wealth of neighboring homeowners. Neighbors casting wary eyes on increasingly dilapidated vacancies are at the mercy of the extended recovery cycle — like the child with a missing tooth, utterly unable to do anything to hasten the process of healing.

Heavy residential vacancies are an indicator of an improperly functioning local economy — one in which real estate is held hostage by a lack of liquidity (read: cash) and a dearth of users. The length of time it will take for neighborhoods to re-populate properties left vacant as a result of the Millennium Boom depends on the extent of the vacancies both locally and within the state, and the rate at which ready, willing and able homebuyers or tenants become available.

A look at trends driving vacancies during the past recession and recovery periods provide a glimpse into what vacancies can tell us about the direction of the current recovery.

Trends in residential vacancies

Residential vacancies are broken down into two categories by the U.S. Census Bureau:

• homeownership vacancies; and
• rental property vacancies.

Homeownership vacancies represent the number of vacant units present in the total homeownership housing segment of California residential housing. Homeownership housing units consist of residential properties which are:

• owner-occupied;
• sold to a homebuyer and awaiting occupancy (from both builders and multiple listing service (MLS) inventories); or
• unsold and vacant housing inventory held out for sale to an owner-occupant, and not for lease.

California’s equilibrium vacancy rate for homeownership properties is roughly 1.2%, a keystone figure to remember. As the economy strengthens and then weakens, the actual vacancies will run below the equilibrium (as in 2005) and above it (as in 2010).  Presently, homeownership vacancies are extremely high with no recent history of equal distortion.

Likewise, rental property vacancies represent the number of vacant units within California’s rental housing segment. The rental housing segment consists of properties which are:

• renter-occupied;
• rented and awaiting occupancy; or
• unrented and vacant and held out for sale or lease, or just for lease.

The equilibrium vacancy rate for residential rental properties in California is roughly 5.5%, a pivotal figure for property managers and investors, and varies above and below that figure depending on conditions of a full recovery or a recession. Presently, the rental vacancy rate is rising and will not peak out for at least a couple of years, probably in 2013 and at just over 10%.

In previous recent recessions, residential vacancies of both types rose steadily during the recession years and peaked in the ensuing recovery years, as the corrective effects born of a recessionary economy take time to get a foothold on individuals’ ability to pay and stay in their current housing. Corrective effects have a more dramatic impact on the rate of residential rental vacancies due to the more transient nature of rental housing tenants, sometimes rising to nearly double the equilibrium rate before settling down.

The historical movement of homeowner vacancies is relatively tame, ranging from 1% to 2% with the historical equilibrium trend line vacancy rate of around 1.2%. Homeowners are less likely and, in many recessionary real estate markets, simply unable to sell, pack up and move, tethered to their homes by a decrease in property prices, negative equity and a dearth of users.

The relationship between the vacancies in the homeowner housing segment and rental housing segment is one of undulating equilibrium. When housing prices are high and it makes more financial sense to rent, vacancies in rental housing go down and vacancies in homeowner housing go up. Over time, the dominance of one type of housing (homeowner vs. rental) is equalized by a shift in favor the other type of housing, a fact borne out by simple arithematic.

For instance, as more and more individuals favor rental housing, the demand for rental housing causes landlords to increase rents to maximize profits. This, in turn, eventually translates into more lucrative conditions for homeownership (as well as construction opportunities for builders). [For more information on the rent vs. own decision, see the June 2010 first tuesday article, Renting vs. buying: the GRM.]

However, the lush lending conditions of the early and mid-2000s introduced massive inventories of SFR housing units into the market with relatively little demand by true users – homeowners.  By the mid 2000s, the historical trends pulling on both types of vacancies were jolted loose and vacancies became unanchored, to soar as they did.

Easy lending fueled the building rampage

Chart last updated 5/8/12

Data courtesy of U.S. Census Bureau and Construction Industry Research Board

The introduction of new housing units into the homeowner/rental vacancy equilibrium is not in and of itself a disruptive event, since the California population does grow (presently around 1% annually, and at the moment primarily comprised of net births over deaths). However, the sheer volume of real estate introduced into the housing-saturated Millennium Boom real estate market was not only disruptive, but disastrous. [For a more detailed analysis of the construction starts in California, see the first tuesday Market Chart, CA single- and multi-family housing starts.]

In the early 2000s, just as the economy was beginning to slip into a corrective recession, the Federal Reserve stepped on interest rates to stimulate growth in hasty reaction to the September 11, 2001 attacks. [For more information on the economic effects of the Federal Reserve’s actions in the early 2000s, see the April 2009 first tuesday article, Lenders vs. owners in 2000-2010: the real estate interest of each.]

These low interest rates encouraged lenders to lend — which they did in spades.  The Fed later took no steps to withdraw the excess funds they prematurely pumped into the banking system after September 11, 2001( and before the 2001 recession had completed its work to eliminate excessive real estate prices at the time). The money flowed like wine, luring all manner of borrowers to gulp from the proffered cup. Among those who drank most deeply were builders, who borrowed to build since there was money available from local bankers to do so. For, contrary to popular belief, builders do not build in anticipation of current or future housing demand, but rather, they build because there is money available for them to do so.

Editor’s note — Observe that even as the rental vacancy rate (the purple line) rose, builders did not cease their building of multi-family apartment buildings (the red line). The expense and scope of building multi-family units kept that boom from reaching the proportion of the single family residence (SFR) building spree, but it nonetheless illustrates the unrealistic doggedness of builders with money. In the coming months, the first tuesday journal online will debunk the myth of construction as a leading economic indicator.

When the Millennium Boom began in earnest circa 2002, more people began to jump on the homebuying bandwagon and naturally rental vacancies began to rise. However, the homeowner vacancy rate (the teal line) also begins to rise uncharacteristically with the rental vacancies, even during a period of time (2004-2006) when buyers (owners, investors and speculators) were pouring into the market. The concurrent increase in construction of residential units kicks the homeowner vacancies to upwards of an unprecedented 3% level in 2008.

In contrast, the recent previous peak in building permits (the orange line) during the late ‘80s was met with a relatively modest, but extended homeownership vacancy rate of 2%. The overbuilding during the late ‘80s was fended off, then and into the early ‘90s, with a weapon the current real estate market does not have: household formations.

The demographic shift creates an inventory issue

As observed in the vacancy and construction chart, the actual peaks of both SFR and multi-family housing unit starts came in the late ‘80s. Fortuitously, the blind overbuilding of that decade came at the same time the Baby Boomers were forming families and moving into rental housing or buying homes. The massive population of the Boomer generation thus relieved the market of much of its excess inventory in the period immediately following the 1990 recession. [For more information on how demographics drive the real estate market, see the October 2010 first tuesday article, The demographics forging California’s real estate market: a study of forthcoming trends and opportunities — Part I; for more information on the current rate of household formations, see the October 2010 first tuesday article, Low household formations translate to high vacancy rates.]

With the latest building spate, which began in 1996, the builders charged full-steam ahead — and built housing for a declining market. The Boomers had already settled in to their properties and the generation immediately following them (Generation X) was far less populous and more transient, leaving a glut of housing units on the market vacant. This overbuilding was fully apparent — that is, for anyone who bothered to look.

In an attempt to drum up household formations (and at the expense of more vacant rental housing), the federal government began a campaign to push the homeownership rate above its traditional 64% national threshold (part of this campaign came in the form of allowing seller concessions – no down payment or funds for closing costs needed – on mortgage loans, now a highly-regulated and mostly prohibited practice). The efficacy of the government’s push for homeownership can be seen in the change in California’s rate of homeownership (which is historically much lower than experienced in the rest of the nation) from around 54% in 1990 to 60% at its peak in 2006. Nationally, the respective percentages were 64% and 69%. [For more information about the annual homeownership rate in California, see the first tuesday Market Chart, Rentals: The Future of Real Estate in CA?]

Unfortunately, just like housing construction, the government’s push for homeownership was running on empty: Generation X simply did not have the population to keep the construction engine running. Thus, the SFR construction boom of 2000-2005 was driven by the availability of money, not demographics, let alone user demand. The homeowners lured out of the woodwork to push that homeownership ratio were those who were, by real estate fundamentals, incapable of sustaining long-term ownership — as evidenced by the increase in the ratio of (the unstable) adjustable rate mortgages (ARMs) to the traditional fixed-rate mortgage (FRM), and the rise of the now-infamous subprime mortgage.

These temporary homeowners served to keep the homeowner vacancy rate down through the middle of the 2000s — the rental vacancy rate at the time was trending steadily upwards, since tenants of all types were vacating their rented premises to move into homes — all with government encouragement. In 2006, homeowner and rental vacancies began to rise again — in part because of the lack of homebuyers in the market, and in part because of the rise of the buy-to-let investor and the speculator.

Speculators and investors take their piece

Bus-loads of speculators purchased real estate in the hopes of selling it on a flip and making money on market momentum as prices were driven ever upwards by frenzied buyers. While the Boom lasted, their effect was mainly on the homeowner vacancy rate: as they purchased properties from owner-occupant sellers and placed the properties back on the market, the homeowner vacancy rate went up (at least for those sellers who became renters or otherwise exited California’s homeowner market). [For more information about the speculator’s role in the real estate market, see the August 2010 first tuesday article, Speculations on speculator suppression.]

Buy-to-let investors purchase property with the intention of renting it out for the long-term. On a more limited scale, they also fell victim to the housing frenzy of the mid-2000s and purchased property away from owners (and to a lesser degree, speculators) to become counted in the rental housing units, thus driving the overall rate of vacant homeowner housing units up.  Eventually, as the Boom wound down and prices began to drop, speculators were left with unsellable homeownership properties (i.e., properties they could not sell at a profit), and slowly the speculators’ “For Sale” signs became “For Rent” signs. The then-burgeoning crisis placed both speculators and buy-to-let investors in the unenviable position of inefficient landlords: unable, as individuals, to find tenants as quickly or with the (relative) ease of larger apartment complexes. Thus, the rental vacancies grew.

The warning bells beginning in 2005-2006 (sales volume peaked in August 2005 and sales prices peaked in January 2006) tolled the coming of the Great Recession, as many of the threads holding the real estate market together began to unravel. The other factor driving vacancies emerged like an angry bull after a red flag: foreclosures.

The effect of NODs on vacancies

Chart last updated 5/8/12

Data courtesy of U.S. Census Bureau and Dataquick

During the Boom, buyers of real estate (and their brokers and agents) completely lost track of the fundamentals behind the decision to buy a home versus rent it. The simple cost/benefit analysis multiplier which determines whether it makes financial sense for a tenant to become a buyer, also known as the gross revenue multiplier (GRM), went through the roof. [For more information about the GRM, see the June 2010 first tuesday article, Renting vs. buying: the GRM.]

This impracticality came home to roost when the ARMs began resetting and homebuyers suddenly realized they could not pay more than the initial teaser rate payment on their mortgages. By December of 2007, the Great Recession had officially set in, brought on by an unprecedented number of mortgage delinquencies (a precursor to lost jobs, which were yet to come).

In California, recording a notice of default (NOD) is the first step in the foreclosure process, which ends when the property is sold at a trustee’s sale. In most cases, these trustee’s sales result in the property being sold back to the lender and becoming real estate owned (REO) property. Since lenders are typically unwilling to play landlord on an REO, most of these properties are placed back into the market for sale, increasing the homeowner vacancy rate in tandem with the oversupply of newly constructed homes. [For more information about how NODs affect the real estate market, see the first tuesday Market Chart, NODs and Trustee’s Deeds: Grim signs of real estate’s present condition.]

These REOs are considered homeowner vacancies while they are on the market for sale. The disposition of REO properties on resale goes both ways:

• to owner occupants who will decrease the homeowner vacancy rate; and
• to buy-to-let investors or speculators who will both end up attempting to rent them, and whose inefficient collective attempts to do so will result in an increase in the rental vacancy rate.

From 2008 to 2009, the sheer number of NODs and subsequent foreclosure sales eventually drove real estate prices back closer to their 1999 pre-Boom levels (and below inflation adjusted levels for 2001), creating a pocket of relatively cheap real estate prices in the low-tier and (to a more limited extent) mid-tier properties. High-tier property owners were able to carry the mortgage payments on their devalued properties, which they could not sell for lack of mortgage lending (the so-called “jumbo” mortgages). But by 2010, defaults, foreclosures and resales at must lesser prices began to appear in these wealthy caged in neighborhoods with a vengeance: the magic performed by recessions after a decade of rising prices and diminishing sales volume in this high-tier property category. [For more information on the recession’s effect on California’s high-tier property, see the February 2010 first tuesday article, The “frugal aesthetic” pulls down sales of million-dollar homes.]

The shock of the housing crash and the flood of vacant inventory prompted both state and federal governments to attempt to stimulate tenants into becoming first-time homebuyers and purchasing newly-constructed and existing homes using tax subsidies to supplement the down payment. Thus, homeowner vacancies broke the upward trend in 2009 and decreased. This reversal did not persist beyond the end of the subsidies in 2010; however, the NODs and foreclosures remain and will continue to rise throughout 2011 to push the direction of vacancies as long as they end up being sold by lenders as REOs, priced right on their resale for the remaining buy-to-let investors and speculators, but increasingly more accessible to homebuyers.

The pace at which NODs become foreclosures (and foreclosures become vacant REOs for sale), and thus become cleared from the market are at the mercy of the standoff between the Federal Reserve (the Fed)/Federal Deposit Insurance Corporation (FDIC) and the lender-banks. Thus, NODs and foreclosures will continue to tug on the vacancy rates until:

• the foreclosures are cleared from the market at the current pace, which could take several years; or
• the Fed and the FDIC force the banks to declare their losses on their books with mark-to-market property values, basically demolishing mortgage-heavy banks as insolvent. [For more information on the interplay between the Fed and the banks, see the October 2010 first tuesday article, Deflation’s push on the real estate recovery.]

Thus, expect the rise in vacancy rates to continue and reflect the unfinished business of the Great Recession to correct the real estate market — never quite able to lower to their natural rates until after the coming tsunami of the so-called shadow inventory is addressed.

Jobs move real estate

 

Chart last updated 5/8/12

Data courtesy of U.S. Census Bureau and California Employment Development Department

In the recovery period following the 1990-1991 recession, jobs increased as both rental and homeowner vacancies decreased. This makes sense: when people have jobs, they are able to form households and move out on their own to occupy housing.

The opposite occurred during the Millennium Boom. Vacancies rose in both homeownership and rental segments, sure signs the real estate market was oversaturated with property and thus could not sustain its breakneck pace forever, climbed steadily even as the number of jobs increased. Why? The economy, spurred by the false success of the housing market, over-hired. With the scads of money being thrown at housing during the Millennium Boom, the number of jobs in construction, real estate and real-estate related financial services (lenders, mortgage brokers, sales agents, insurance, etc.), skyrocketed. The money being earned by these industries seeped into other industries through consumerism, fueling more jobs growth in other economic sectors, and more construction, and so on – the virtuous cycle. [For more information on the population trends of Department of Real Estate (DRE) licensees, see the first tuesday Market Chart, The rise and fall of real estate brokers and agents.]

When the recession hit in 2007 and the false expectations of perpetual growth were dashed, the number of jobs fell off precipitously, rippling from the real estate market on outwards. As jobs return in sufficient numbers (300,000 – 400,000 annually) around 2013, individuals will begin to cultivate the economic and social confidence needed to form households and deplete some of the excess and shadow inventory in, and coming into, the market.

These future users of real estate will arrive in the form of the Baby Boomers’ children — Generation Y — peaking in numbers around 2018-2021. Their function as the impetus behind the housing recovery will be, as always, contingent on the creation of jobs supporting their household formation – renting and buying homes.

Without jobs befitting their college educations, Gen Y-ers will be unable to leave their parental nests and move out on their own. They are shadow households — the users for the real estate which will, even after they come of age, need financial stability in the form of jobs before they can proceed to claim their households, and in the process reduce all types of residential vacancies.

When they do succeed in finding jobs that will support households, most all of them will initially rent until they have settled into their jobs and communities, thus driving the rental vacancy rate down after the midpoint in this decade. In a few years, after they have built up sufficient credit and wealth to qualify to purchase a home, many will do so and drive down the homeowner vacancy rate. Thus, similar to the injection of housing units which created the current distressed real estate market, the injection of Gen-Y households will serve to balance and return equilibrium to residential vacancies. [For more information on the coming of the Gen-Y households, see the November 2010 first tuesday article, Generation Y is still chasing their dream of homeownership.]

Agents and brokers, looking forward

Rental vacancies historically have taken roughly ten years to go from trough to peak. Thus, we have another couple of years to go – into 2013 – before rental vacancies reach peak levels. The rental market will recover first since new households and new job holders typically rent prior to entering into homeownership. Also, look for a shift in the equilibrium of vacancies in rentals vs. homeowner housing units — many or most of those burned by this latest real estate recession may not return to homeownership once the dust has settled. Similarly, Boomers who are successful in selling their empty nest properties may look to rent instead of own, depending on a comparison of the out-of-pocket costs of owning or renting.

Thus, household vacancies will follow the line of the abortive checkmark recovery for this recession before equalizing, remaining flat at best and rising slightly at worst while the Fed wields its economic tools in lieu of the FDIC pushing the big, bad banks over. [For more information on the shape of the real estate recovery, see the November 2009 first tuesday article, Divining the future: the letters game.]

Further, any significant recovery of the market is contingent on the cessation of building in the short-term. Any excess inventory at this point in the recovery due to subdivision or condo construction would simple further extend the time it takes for Gen Y to absorb the inventory in and on its way into market.

Brokers and agents can keep an eye on vacancy rates in certain niches of the market — cities, as centers of culture, commerce and government, will work through their inventory more quickly than will their suburban bedroom community counterparts. Watch for rentals in urban markets to pick up first and direct employment and investment efforts in that direction to reap profits in the future.

Orange County is leading the way to recovery, and soon other areas west of the 5 Freeway will follow.  It is then that the tide of recovery will eventually ripple and flow into the inland valleys – and hopefully be more stable the next time around the real estate cycle, when the economic tide recedes. [For more information on the direction of the rate of ownership vs. renting, see the July 2010 first tuesday article, Rentals: The Future of Real Estate in CA?]

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Tagged as: Baby Boomers, Generation Y (Gen Y), population, shadow inventory, vacancy rate