Chicago: Lessons from the Most Beat-Up Market in the Country

October 29, 2015

For years, our thesis has been that the national downturn and recovery (in blue below) will play out similarly to the mid-1980s downturn in Houston (in orange below) and the early-1990s downturn in Southern California (in green below) because both the job losses and bank/savings and loan destructions were similar. That theory has worked well nationally, but certain markets have fared much better or much worse. No major market has fared worse than the Chicago metro area (in purple below).

Two Factors Are Unique to Chicago, but One May Be Coming to You Soon

Instead of construction volumes falling 75%+/-, Chicago’s single-family market fell 90%! Now, while US construction remains 60% below peak, Chicago remains 80% below! One reason is that Chicago had a higher percentage of highly leveraged private builders who were unable to weather the recession (17 of the top 28 builders in 2005 no longer exist or left the market). But we believe there is another reason too: property tax fear.

Property Tax Fear

As our team travels around the country, we rarely hear that fear of rising property taxes contributes to home buying hesitation. In Illinois, however, where property tax rates are eclipsed only by New Jersey, and where there are so many taxing authorities that our property tax bills look like a grocery receipt, potential home buyers have heard so much about the likelihood of additional property tax hikes to fund pension obligations, that most of our home builder clients regularly hear this “excuse” in their sales offices. Our CEO John Burns believes that home buyer confidence is lower in Chicago than anywhere in the country. If your local government has unfunded liabilities that are only getting worse, keep an eye on Chicago as a precursor to what could happen to your market as well.

Room for Optimism

Chicago’s housing market will continue to improve. Single-family construction has doubled from the bottom, and we believe current levels are not even enough to keep up with the need to replace homes that need to be torn down. Chicago housing is on the mend, and numerous builders have realized that parts of Indiana and Wisconsin are commutable to employment centers and don’t have the same issues. Here are the fundamentals:

  • 1.0% annual job growth
  • Steady household formations
  • Solid resale market. Notwithstanding the property tax fears, 106,500 resale sales transacted over the past year in the Chicago metro area, up 6% YOY. Resale home prices rose 4% over the same period and remain far below peak pricing.
  • Median new home price: $343,500, up 9% YOY

What Needs to Occur to Get Chicago Back on Track?

  • Price appreciation. The new vs. resale price gap has pushed consumers to seek alternatives to new homes, such as resale housing closer to employment centers, different product solutions altogether, or simply staying put. Resale price recovery in the fringe, the traditional growth submarkets, is necessary for builders to compete in these areas. Resale prices need to appreciate roughly 10–20% in these areas to make new home development viable and competitive.
  • Location, location, location. Location continues to be the primary consideration for consumers. There has been a change in consumer preference for location, especially as younger buyers have expressed their willingness to live in smaller homes to spend less time commuting. The key is taking into consideration where buyers want to live versus where new home construction is viable.
  • Cost considerations. Land prices need to better align with consumer expectations; the days of simply taking price increases to cover increased house costs are over. Chicago continues to be very competitive with respect to raw and developed land, but builders, developers, and investors cannot afford to pay top dollar for land and pass those costs along to future home buyers.
  • Taxation challenges. Taxation continues to challenge builders, developers, investors, and homeowners, which is an issue we are monitoring closely. Our friend John Mauldin wrote an excellent educational piece on the subject.

If elected officials can devise a plan to appease the fear of rising taxes, we expect Chicago housing to rebound strongly. If officials are able to continue kicking the can down the road, we expect the slow recovery to continue. With this level of uncertainty, our clients continue to invest aggressively in short-term projects in great locations or in adjacent states and cautiously in long-term projects, including paying agricultural value for long-term land.

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