doing without certain activities

Since September 11, Americans have discovered they can get along without many activities they formerly carried out regularly. The most obvious is air travel, especially abroad and on vacations, but also for business. Related to that is patronizing hotels and resorts instead of spending vacation and leisure times close to home. This discovery was initially inspired by fear of terrorism, but has since become motivated by other factors too.

The result has been an economically devastating slump in air travel and hotel and resort bookings, both here and abroad. Even local restaurants and theaters have suffered. That slump has been aggravated by the worldwide economic slowdown since 2000. Recently, these industries have been further depressed by the SARS epidemic in Asia, especially in Hong Kong and China, and by war in the Middle East.

On the other hand, businesses that cater to home and family activities have been booming. Home furnishings, gardening, outdoor recreation, home entertainment systems, appliances, and even cooking programs on television are doing well. People are “nesting”: focusing on their close-to-home lives rather than on other uses of disposable incomes. That is one reason why home sales have soared – also aided by low interest rates and a flight of capital from the stock market. This new focus on one’s personal life also helps explain why so many hotels and resorts have opened health, beauty, and fitness spas to attract new business in this environment.

When the U.S. economy starts recovering strongly, airlines, travel businesses, meeting planners, and hotels and resorts are hoping their usual activities will return to something like pre-9-11 levels. But I seriously doubt this will happen. The truth is that Americans previously were preoccupied with activities that are in reality easily dispensed with. Vacation travel to exotic destinations is the most obvious example. After all, there are plenty of interesting places to visit within the United States, and many can be reached by car at less expense than by air. In the same way, foreign tourists can just as easily stay in their own countries as visit America. Tourism is the single largest industry in the world; so when it suffers a major decline, economies the world over are hurt. Some regions like Hawaii and the Caribbean are heavily dependent on tourism, and thus especially vulnerable. This is one way in which terrorism has already seriously injured myriad economies all over the world.

Lots of other “normal” activities are also dispensable. Many business trips can be replaced by phone calls, e-mails, or video conferences. Whole industries are dominated by the sale of goods and services that can hardly be considered necessities. A lot of goods, gadgets, fashion items, and trinkets that people buy during periods of prosperity can easily be done without. People can also hold onto their existing cars, clothes, computers, televisions, and appliances a little longer than they have in the past, thereby reducing annual sales levels in those industries. Billions of dollars are spent each year in advertising aimed at persuading people they ought to buy something new right now that they could easily postpone indefinitely, or just forget about.

As a result, the world economy is vulnerable to prolonged slumps in specific activities that are highly dispensable. Moreover, once people have discovered that they can do without certain activities, there is a strong chance that many will not resume the former levels of spending, even when prosperity returns. I believe that is the situation facing airlines and the hospitality business, and many producers of luxury goods and services. Hence investors contemplating putting money into those businesses should be extremely cautious. They surely do not want to become additional victims of the huge negative impact that terrorism has already had on the world’s prosperity.

stock market standing 2002

First, the stock market took another nose dive. From the start of 2002 until Nov. 27, the NASDAQ composite index was down 25 percent, in spite of a recent rally. The S & P 500 fell 19 percent in that same period. Millions of owners of stock thus suffered large equity losses. Second, job formation was very weak. Unemployment rose to 6 percent in April and again in November, and total job growth was less than one-half of one percent – compared to an average of 1.7 percent from 1992 through 2000.

Third, certain key sectors of the economy were in the tank economically. These include the airlines, hotels and resorts, the telecom and internet industries, and state governments – which are suffering from enormous fiscal deficits. Fourth, commercial real estate markets deteriorated greatly and are experiencing a true recession, even though the overall economy is not. Office and industrial vacancy rates shot upward because of an unprecedented withdrawal of demands for space, plus huge surpluses in sub-leasing and rented-but-not-used space. Rents fell, but property values for well-occupied buildings and for most real estate investment trust shares were held up by strong demands from investors fleeing out of stocks.

Finally, there was – and still is – a tremendous amount of general uncertainty and insecurity because of the war on terrorism in general, and the possibility of war in Iraq in particular. The resulting malaise was intensified by the episode of the Washington-area snipers, who showed that any part of the nation could easily be terrified and upset for weeks by just two renegades.

As we look ahead into 2003, several of these factors will continue to make many Americans feel bad, but others probably will not. We hope the stock market has bottomed out and therefore will not take another nosedive – though no one can be certain. The heavily depressed sectors are likely to stay depressed, unfortunately, and job growth will probably be low again too. Commercial property markets are not going to get much better, but perhaps they will not get much worse either. Uncertainty caused by terrorism and Iraq are still with us as 2003 begins, and surely the former type will remain even if war either is accomplished or becomes less likely. So we will probably feel slightly better in 2003 than in 2002 – but not a whole lot better – even if real GDP again grows in the three percent range, which seems likely.

The balance of supply and demand in early 2002

U.S. commercial office, industrial, and research property markets are experiencing paradoxical conditions. The balance of supply and demand for space is extremely unfavorable. Especially in high-tech markets like Silicon Valley, vacancy rates have soared to 15 percent or more in early 2002. Few leases are being signed because almost no firms need more space, and thousands that need less are flooding markets with sublease space. Yet for properties fully leased at good rents, market demand has been strong and property prices rising. The stock prices of real estate investment trusts (REITs) have also been driven upward while the rest of the stock market stagnated.

The main reason for this paradox is that investment yields have recently been so low on stocks and bonds. Therefore, the steady positive yields on real properties that are well occupied or on well-run REITs look very attractive to yield-hungry investors. So they have shifted a lot of money from stocks and bonds into commercial real estate, which often produces yields of 8 to 9 percent. This has stabilized or raised prices on many well-occupied properties in spite of adverse conditions in space markets.

This paradoxical situation only applies to properties well enough occupied to produce steady net incomes, not those with high vacancy rates. This situation is occurring within property markets experiencing unusually low levels of both leasing and sales transactions. Leasing activity is low because so few firms want additional space. Some sales are occurring, but many fewer than in a normally sound market. Buyers are deterred from making offers because of uncertainty about the true value of properties in a market where few leasing transactions establish likely future rent levels. Property owners are deterred from selling by similar uncertainty, and by the fact that many are large corporations that own commercial properties they have been using themselves. Also, institutional owners like pension funds have been reluctant to sell because they don’t know what they would do with the money.

How long will this paradoxical situation last? One way it could end is by the return of strong general prosperity. Yet vacancy rates are now high enough so that even expanding space demand will not create much upward pressure on rents and prices for at least two years, and perhaps longer. This means entrepreneurial owners of older, relatively obsolete buildings with strong occupancy and yields should consider selling them now, before a return of general prosperity sucks yield-hungry money back into stocks and bonds.