A Commercial Real Estate Dissection of Third Quarter GDP

While the formal dating of the recession’s end is a privilege that resides with the NBER, news of the economy’s expansion has trumped a formal announcement —

The Bureau of Economic Analysis (BEA) released the advance report of third quarter gross domestic product (GDP) on Thursday, October 29. The advance report, which is based on incomplete data and which is subject to revision†, shows that the domestic economy grew at a seasonally-adjusted annual rate of 3.5 percent in the third quarter. The economy contracted by 0.7 percent in the second quarter. While the formal dating of the recession’s end is a privilege that resides with the National Bureau of Economic Research (NBER), news of the economy’s expansion has trumped a formal announcement from Cambridge.

The headline result that prompted yesterday’s 2.05 percent rise in the Dow masks a wealth of detail regarding the underlying drivers of growth. As described below, spending on automobiles – fueled by the Car Allowance Rebate System program (more commonly, the “CARS” or “Cash for Clunkers” program) – was a particularly important contributor to the third quarter’s result. On the other hand, declining investment in non-residential property development was a significant drag.

In spite of robust growth in aggregate output, the advance estimate of GDP should be considered carefully. Automobile sales and improving conditions in the residential market were both important drivers of the result. In both of these areas, however, short-term government interventions have contributed significantly to the positive results. At least in the case of personal consumption expenditures, we can reasonably anticipate a smaller contribution to growth in the fourth quarter.

Drivers of Growth in the Third Quarter

Personal Consumption Expenditures

+3.4 percent | Contribution to GDP: 2.36 percentage points

Consumers loosened their purse strings over the summer, driving the strongest growth in consumption since the first quarter of 2007. According to the advance estimate, personal consumption expenditures (PCE) grew by 3.4 percent in the third quarter, more than reversing the second quarter’s 0.9 percent decline. The benefits did not accrue to retailers, however. Increases in spending on non-durable goods and services were muted. Rather, the total increase in PCE was dominated by a 22.3 percent rise in durable goods spending corresponding with a sharp rise in automobile production and purchases.The increase in auto production, heavily dependent upon the CARS program, contributed 1.66 percentage points to headline GDP growth. Put another way, GDP growth in the third quarter was approximately 1.8 percent (instead of 3.5 percent) when controlling for the total contribution of the auto industry and auto purchases. The summer’s increase in auto activity is not expected to persist into the fourth quarter. Following the expiration of the CARS program, production and sales are expected to fall. As a result, the auto sector’s contribution to GDP growth may turn negative again in the fourth quarter.

Outlook The sharp rise in headline consumer activity is unlikely to persist into the fourth quarter. Consumer sentiment is rising, pushing savings rates lower and spending rates higher. But job losses will continue to weigh on consumers’ aggregate incomes. Absent the CARS program or a similar consumption subsidy, we can expect that spending will grow more slowly in the fourth quarter than in the third. For retailers, discretionary spending increases will remain lackluster until job growth resumes. This is because job losses constrain aggregate income growth. In the third quarter, disposable personal income – income after taxes – fell by 0.7 percent even though the economy expanded. Ultimately, core retail lenders and borrowers will have to wait for measurable improvements in space demand  driven by stronger consumer traffic.

Federal Government Spending

+7.9 percent | Contribution to GDP: 0.62 percentage points

Total government spending increased by 2.3 percent in the third quarter, reflecting a 7.9 percent jump in federal government outlays and a drop in spending by state and local governments. While the common perception is that federal spending on domestic recovery programs has dominated the rise in outlays, spending on national defense has been increasing at a faster rate than non-defense programs. Defense spending increased by 8.4 percent in the third quarter, outpacing growth of 6.8 percent in non-defense programs. In the second quarter, defense spending increased by 14.o percent; non-defense programs, by a more modest 6.1 percent.

Residential Investment

+23.4 percent | Contribution to GDP: 0.53 percentage points

Following 14 consecutive quarters (3 and ¾ years) of declines, residential investment turned positive in the third quarter, rising by 23.4 percent. The increase corresponds with the rise in new residential construction activity reported by the Census, both in terms of construction starts and value put-in-place. Chained (2005) dollar investment in the third quarter was $362.9 billion at a seasonally adjusted annual rate, up from $344.4 billion in the second quarter, but 22.3 percent below the $443.3 billion of investment just a year ago. Overall, residential investment remains well below long-term average levels.

Drags on Growth in the Third Quarter

Non-Residential Structures

–9.0 percent | Subtraction from GDP: 0.32 percentage points

Investment in non-residential structures, including commercial real estate, fell by 9.0 percent in the third quarter. This is the fifth consecutive quarter of declining non-residential activity. The GDP estimate is consistent with data from the Census Bureau which shows that commercial real estate construction spending in August fell to $372.6 billion (SAAR), down from $382.6 billion in June (the final month of the second quarter) and by 10.5 percent from the same time last year.

Outlook Amongst the principle areas of decline in commercial construction value put-in-place, office construction spending has fallen by 30.0 percent over the last year through August; shopping center spending, by 43.0 percent; shopping mall spending, by 37.9 percent; industrial warehouse spending, by 44.2 percent; and, hotel and other lodging spending, by 35.5 percent‡.

Net Exports of Goods and Services

Subtraction from GDP: 0.53 percentage points

In contrast with the recession to date, the shift in the balance of exports and imports was a drag on economic growth in the third quarter.  Real exports increased by 14.7 percent but real imports increased by an even larger 16.4 percent. If savings rates continue to trend lower and consumption activity continues to increase, the net export deficit will persist as a drag in the GDP accounting. For investors in warehouse and distribution space in major port centers, the deficit is less relevant than the overall increase in the movement of goods into and out of the country.

State and Local Government Spending

–1.1 percent | Subtraction from GDP: 0.14 percentage points

While federal government spending has been increasing at a rate without precedent in recent history, state and local governments are constrained in their ability to run deficits. Declining revenues from property taxes, income taxes, and sales taxes have undermined the capacity of some governments to offset declines in private sector activity. California’s state cutbacks have been well-publicized, but adjustments of comparable magnitude have been made or are in the offing in other states, including Arizona, Florida, Michigan, and Nevada. 42 states have cut state payrolls, 25 have cut elementary and secondary education, and 27 have cut public health services. In some metropolitan areas, these cuts have resulted in payroll contractions that have had a material impact on multifamily and commercial space demand.

Outlook In spite of offsets from the American Recovery and Reinvestment Act, projected budget shortfalls will result in further cuts in state and local government spending in a number of states. 27 states are expected to report deficits in FY 2010. In particular, substantial budget deficits are anticipated in Arizona (15.4 percent), Hawaii (10.4 percent), New Mexico (12.0 percent), and Virginia (9.2 percent).

† Between 1983 and 2006, the estimate of real GDP changed by an average of  1.3 percentage points between the advance and final measures. The quarterly estimate of GDP is incorrect in its direction 2 percent of the time, meaning that it is very unlikely that the final report will show that the economy actually contracted in the third quarter.

‡ A complete update on current commercial construction activity by sector appears in Real Estate Econometrics’ October 5 Core Report. Data and statistics on September construction spending will appear in the November 9 Core Report.