Tierra Grande - January 2016 by Texas Real Estate Research Center

JANUARY 2016 ™

JOURNAL OF THE REAL ESTATE CENTER AT TEXAS A&M UNIVERSITY

NON-PROFIT ORG. U.S. POSTAGE PAID HOUSTON, TEXAS PERMIT No. 4126 COLLEGE STATION, TEXAS 77843-2115

In This Issue New Real Estate Legislation Construction Forecast Vacation Home Sales Transportation Legislation Home Sales Recovery Commercial Real Estate 2016 Outlooks

Helping Texans make better real estate decisions since 1971

JANUARY 2016 ™

JOURNAL OF THE REAL ESTATE CENTER AT TEXAS A&M UNIVERSITY

iii

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JANUARY 2016

www.recenter.tamu.edu

Director, GARY W. MALER Chief Economist, JAMES P. GAINES Senior Editor, DAVID S. JONES Managing Editor, NANCY MCQUISTION Associate Editor, BRYAN POPE Assistant Editor, KAMMY BAUMANN

VOLUME 23, NUMBER 1 ™

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JOURNAL OF THE REAL ESTATE CENTER AT TEXAS A&M UNIVERSITY

14 Green Light on Transportation Legislation

How important are highways to the real estate industry? Extremely. So it’s good that the governor made transportation issues a priority in last spring’s legislative session. BY HAROLD D. HUNT

Art Director, ROBERT P. BEALS II Graphic Specialist/Photographer, JP BEATO III Circulation Manager, MARK BAUMANN Lithography, RR DONNELLEY, HOUSTON ADVISORY COMMITTEE: C. Clark Welder, San Antonio, chairman; Russell Cain, Port Lavaca, vice chairman; Mario A. Arriaga, Conroe; Jacquelyn K. Hawkins, Austin; Doug Jennings, Fort Worth; Walter F. “Ted” Nelson, Houston; Doug Roberts, Austin; Kimberly Shambley, Dallas; Ronald C. Wakefield, San Antonio; and Bill Jones, Temple, ex-officio repre senting the Texas Real Estate Commission. TIERRA GRANDE ™ (ISSN 1070-0234) is published quarterly by the Real Estate Center at Texas A&M University, College Station, Texas 77843-2115. Telephone: 979-845-2031. SUBSCRIPTIONS free to Texas real estate licen sees. Other subscribers, $20 per year. Subscribe online at www.recenter.tamu.edu/store VIEWS EXPRESSED are those of the authors and do not imply endorsement by the Real Estate Center, Mays Business School or Texas A&M University. The Texas A&M University System serves people of all ages, regardless of socioeconomic level, race, color, sex, religion, disability or national origin. PHOTOGRAPHY/ILLUSTRATIONS: Real Estate Center files, pp. 1, 4, 6, 9, 10–11, 12, 14–15, 16, 24, 28; JP Beato III, pp. 2–3, 18, 21, 22. © 2016, Real Estate Center. All rights reserved.

2016 Economic & Housing Outlook A Q&A with James Gaines The Center’s chief economist answers questions about what this year may hold for the real estate industry. BY JAMES P. GAINES

Trends

Texas Commercial Real Estate Vacancy rates come in two varieties: natural and actual. By comparing both along with historical vacancy trends, Center economists can anticipate commercial real estate rental trends. BY LUIS B. TORRES AND HAROLD D. HUNT

10 Home Construction Ahead Forecasting Ups and Downs ON THE COVER Mexican wolf, southwest Texas

PHOTOGRAPHER Steve Geer

JANUARY 2016

Real Estate Center and Dallas Fed economists teamed up to create an index intended to help them better determine which direction the housing market will go in the near future. BY JESUS CAÑAS, KEITH R. PHILLIPS AND LUIS B. TORRES

18 Regional Contributions

to Home Sales Recovery

While Texas home sales in general have recovered since the Great Recession ended, it’s not surprising that the big metro areas have expanded more than smaller towns and cities. BY ALI ANARI

24 Licensing Act Changes and More

Legislators Pass New Real Estate Laws Do yourself a favor and stay on the right side of the law. Our attorney highlights the changes. BY JUDON FAMBROUGH

28 Tax Rules for Vacation

Home Sales

Some of the IRS’ rules for converting a vacation home to a rental home took center stage in a 2015 tax court case. BY JERROLD J. STERN

Economy

H Economic 2016 JAMES GAINES A Q&A WITH

RECON editor Bryan Pope interviewed James Gaines, the Center’s new chief economist, and shares his insights.

Q: What are your thoughts about the Center as a whole, looking at it from your new vantage point as chief economist? We know the Center has been working with the Texas Association of Realtors (TAR) and Multiple Listing Services (MLSs) to improve the quality and reliability of Texas housing data. A: Yes, we have. Beginning in January, we will be able to

report MLS activity data for a specific geography. If we say the data is for an MSA, it will be for the counties that compose the MSA according to the Census Bureau’s definition of that MSA. We can then drill down and get county, ZIP code and other geographic specifics. This will allow us to tie the housing data to other government-related data and look at census tracts and neighborhoods.

Q: One thing we need to be clear on is that the new data is not owned by the Center; we only have limited access to it for research purposes, correct? A: That’s true. That was our agreement with TAR and the

MLSs. Obviously, these data are proprietary. The data and our access is governed by a rigorous research contract prohibiting public disclosure of the specific raw data.

Q: What else can we look forward to? A: Our researchers agree that the Center needs to report not

only data from the past (for example, sales figures for last month or last year) but also to provide analysis and insight regarding what we think the future will hold. So we are becoming more future oriented, more projection oriented.

Q: About a year ago, you called oil prices “the big unknown.” What do we know now about the impact falling prices have had on the state’s economy? A: It looks like the price has more or less stabilized in the

low 40s per barrel but it could go lower. The question is, at what price does it affect exploration and production, upstream energy and oil production and drilling? We can see effects already because the rig count is down almost 60 percent. Texas peaked at a little over 900 rigs in summer 2014. Since then, it has fallen to fewer than 350. When prices go down, there’s an immediate short-term impact — some people lose their jobs. But the multiplier impact and other ancillary impacts take a while to hit the marketplace. Center researchers have been studying this, and the consensus is that in Texas it takes one to three years before

we start seeing all of those impacts. That’s been true for at least the last three or four cycles in which there was a run-up in prices and upstream activity followed by a falloff. Because drilling of new wells has declined, eventually production numbers are going to start sliding.

Q: This year, we’ve seen a gradual decline in the job growth rate in Texas. Should we expect this trend to continue in 2016? A: Yes. Three major things

that will impact Texas’ economy in 2016 and probably on into 2017 are energy, the national economy and the value of the dollar. Job losses in the energy sector have not stopped and probably are going to pick up this year. As stated earlier, the real impact takes one to three years to hit the marketplace. The initial wave of job losses, including service companies cutting back, has already occurred. The support jobs are next. So the energy sector is going to have a negative effect on employment for at least the next 12 to 18 months. Number two is the national economy. If the U.S. economy is prospering and doing well in industries other than energy, such as health care, technology or business services, that will help buoy the state’s overall economy. Third — and most Texans don’t think of this one — is the value of the dollar. When the dollar is strong, it hurts our exports. Texas is one of the top states for exporting. A lot of TIERRA GRANDE

Housing Outlook our industrial and investment dollars are based on exports and exporting activity. Those are the big three concerns. But health care is in the mix, too. We’re seeing continued growth in hospitals, emergency centers and independent clinics. And many of the jobs being created are fairly high-paying positions. There is still an inﬂux of technology and technology-related jobs. Businesses that have been headquartered on the two coasts — Silicon Valley in California and Boston on the East Coast — are figuring out that Texas looks good by comparison. The regulatory environment, labor, cost of living and taxes contribute to business development and growth. Our housing market has been strong, and Texas leads the nation in housing construction, both single-family and multifamily. In 2014 and continuing into 2015, both Dallas and Houston built more homes than many other states.

Q: Let’s talk more about housing. Can you give us a recap of how the state’s housing market fared in the past year?

A: Really well. I thought it was going to be a strong market, but I didn’t think it was going to be as strong as it has been. Across the board statewide, in terms of single-family home sales, 2014 was the second best year ever, second only to 2006, and 2015, through the third quarter, is on pace to do just as well and probably a little bit better. I don’t know if the volume will quite make the 2006 number, just short of 300,000 sales, but it’s going to be close. The home building industry will have strong numbers for 2015, well above average and more than last year. Studying the data, what stands out is that new home sales — not condos and townhomes but detached single-family home sales — are up over 9 percent from last year. Home builders in the state say they don’t need to build spec homes, although some are because they can sell what they build before or during construction. Inventory of finished new homes is less than two months, and prices are considerably higher than last year. To give a data point, the average price of an existing home through third quarter 2015 was around $240,000. The average price of a new home was around $340,000. We know that home builders are building more on the high-end side than on the low-end side, and in some of our major metropolitan areas, because of labor costs, material costs and especially land costs, home builders find it almost impossible to build anything much under $200,000 JANUARY 2016

or $225,000. So average and median prices of new homes are going up, but sales volume continues to rise. That supports the notion that the Texas housing market is probably going to continue reasonably strong into 2016.

Q: Will 2016 be a good year to sell my home and buy a new one?

A: It might not be a good year if you expect to choose from

a large number of homes for sale. Because of the shortage of inventory, you’ll probably want to work closely with an agent or someone else close to the market on a day-to-day basis. In many markets, sellers receive an offer or multiple offers the first day properties come on the market. Even so, I think 2016 will be a pretty good year. Sellers likely will be able to sell quickly and for a good price, at least for the first half of the year. I think the housing market will slow down a bit in 2016. It’s not going to fall off a cliff, though. For the past four years there has been a significant imbalance between demand for housing and the supply offered for sale. I think demand is going to slow down. Home builders will continue to build and will find a good market for new homes. Some people will decide to buy or sell before interest rates go up.

Q: How about your commercial outlook for 2016? A: The commercial outlook is generally positive, despite the

fact that we expect the economy to slow down. Office markets in Dallas and in Houston are beginning to show some signs of this. Rates of absorption are declining. In Dallas and in Houston and, to some extent, in San Antonio and Austin, many construction projects that were started two or three years ago are just coming on the market. It’ll be interesting to see how that new space competes with the existing sublet space. The office market typically goes through cycles of heavy construction, followed by a lull to let the market catch up before beginning more construction. This type of supply is called “lumpy” – a good economics term. Retail is still going strong though actual physical space is in short supply because we never had a retail construction boom. Retail supply tends to be tied more directly to demand, that is, population and roof tops. Texas is a leading state for distribution of goods. The industrial warehouse sector in the North Texas area, particularly around Dallas-Fort Worth, is strong. Houston, with its busy international seaport and the high level of import-export that goes on there, is strong,. The same is true in Corpus Christi, San Antonio and Laredo, where a project for a major warehouse distribution center will take advantage of the established transportation facilities and trade with Mexico.

Commercial

Trends Texas Commercial Real Estate

By Luis B. Torres and Harold D. Hunt

hat direction are commercial rents headed? Is the environment ripe for new construction? A region’s industry mix often leads to a wide variety of answers to these questions at the local level. Commercial real estate (CRE) markets within the “Texas Triangle” (see “Texas Triangle”) are no exception. A comparison of actual and natural vacancy rates provides valuable insight for those who put their money in CRE. Three CRE classes — office buildings, retail structures and industrial warehouses — accounted for more than half the value of all private, nonresidential construction occurring between January 1980 and July 2015. Because of their relative size, these three categories within the four major Texas MSAs are assumed to represent the bulk of Texas CRE.

Ofﬁce Markets Austin-Round Rock The Austin MSA’s overall office market has continued to improve since vacancy peaked in fourth quarter 2009 (2009Q4). Vacancy fell steadily from a high of 16.9 percent in 2009Q4 to 10.4 percent by mid-2015 (Figure 1). This level is well below the average 14.3 percent observed between 2000 and mid-2015, the extent of available data.

Texas Triangle Approximately 77 percent of the value of all nonresidential construction is concentrated within the “Texas Triangle,” an area encompassing the state’s four major metropolitan statistical areas (MSAs): Austin-Round Rock (Austin), Dallas-Fort WorthArlington (DFW), Houston-The Woodlands-Sugar Land (Houston) and San Antonio-New Braunfels (San Antonio). This 60,000-square-mile area represents less than one fourth the state’s land mass. TIERRA GRANDE

Changes in demand are measured by net absorption, or the net change in square footage leased during a given period, including space leased in newly delivered buildings. Net absorption since 2011 has remained strong, moving closer to 2006 pre-financial crisis levels as the Austin office market continues to benefit from a resilient high-tech sector. ew relocations and existing firm expansions have steadily increased demand for Austin office space. Employment growth in the combined financial and business services sectors has averaged 4.8 percent annually between 2009Q4 and mid-2015. This is well above the 15-year average of 3.2 percent observed since 2000. The real annual rental rate increased by an average of 3.5 percent in the three years since mid-2012, an impressive growth rate in real terms. On the supply side, new construction has begun to decline in the overall office sector (which includes owner-occupied space) as well as new buildings being constructed solely for lease.

Vacancy Rate Descriptions Natural vacancy rate is defined as the point at which zero real (inflation-adjusted) rent growth will occur. Natural vacancy is generally stable over time. Actual vacancy rates quoted are raw quarterly vacancy numbers that have been seasonally adjusted and detrended. These modifications smooth the raw data by removing fluctuations created by seasonal and time trends. Natural vacancies for the possibility of new construction are calculated separately using historical construction data. The calculated natural vacancies, compared with the actual vacancies (Table 2) were used to estimate whether new development should be expected in the various CRE markets as well. A comparison of natural vacancy and actual vacancy (Table 1) along with historical vacancy trends (Figures 1 through 3) allows researchers to anticipate the future direction of CRE rental rates in real terms.

Dallas-Fort Worth-Arlington

Percent

the result of growth in Houston’s energy sector as oil prices DFW MSA office market vacancy most recently peaked in topped $100 per barrel. mid-2010 and was primarily hampered by the Great Recession A steep fall in crude prices since the end of 2014 has begun (Figure 1). The DFW economy remains heavily tied to U.S. to negatively impact the overall office market, with vacancy economic performance. As the U.S. economy picked up steam increasing to 15.2 percent by mid-2015. Long-term vacancy post-recession, DFW also began to experience stronger economic growth. The result was a fall in office vacancy from 19.7 between 2000 and mid-2015 averaged 14.4 percent. Houston’s net absorption has largely trended negative since percent in mid-2010 to 15.8 percent by mid-2015. Longer-term 2015Q1, also attributable to falling oil prices. Expectations vacancy between 2000Q1 and mid-2015 averaged 17.4 percent. for any significant near-term Net absorption has sustained improvement in the oil and its positive growth trend since Figure 1. Office Vacancy Rates gas sector are low. However, the recession’s end, increasing Major Texas MSAs 22.5 history has shown that crude to levels not seen since the early markets can be extremely 2000s. Corporate relocations 20.0 unpredictable. and strong job growth conDFW 17.5 Energy producers continue to tinue to benefit the DFW office AUSTIN downsize and consolidate opermarket. Significant corporate 15.0 ations. Although financial and relocations include Toyota and HOUSTON 12.5 business services employment Liberty Mutual Insurance. grew at an average annual rate DFW’s financial and business 10.0 SAN ANTONIO of 4.3 percent from 2010Q3 to services employment grew at 7.5 mid-2014, it rapidly sank to 2.6 an average annual rate of 4.2 5.0 percent between 2014Q3 and percent in the last five years to mid-2015. Annual employment mid-2015, double the long-term 2.5 average of 2.1 percent since 2000 2003 2006 2009 2012 2015 growth at mid-2015 remained Note: Seasonally adjusted and detrended above the 2000-to-mid-2015 2000. Rents began to rise in real Sources: CoStar and Real Estate Center at Texas A&M University average of 2.1 percent. Lower terms after 2013Q1, registeremployment growth and office ing average annual growth of space demand should still be expected. 3.5 percent from mid-2013 to mid-2015. New office construcInﬂation-adjusted rents descended from an average annual tion overall has declined while rental space construction has growth rate of 5.7 percent between 2013Q3 and mid-2014 remained quite strong since 2013. to 4 percent in the year since. New overall office construcHouston-The Woodlands-Sugar Land tion in Houston has fallen, as has construction of new buildThe Houston MSA’s office market registered significant growth ings for lease. Although the upstream energy sector remains weak, a reduction in new office construction combined with following its vacancy peak of 15.5 percent in mid-2010 (Figure a strengthening U.S. economy should mitigate any significant 1). Vacancy fell steadily through the second half of 2014 when market breakdown. it bottomed at 12.7 percent. The strong showing was primarily JANUARY 2016

IMPRESSIVE NET absorption in DFW’s retail sector led to growing retail employment after the Great Recession. From 2014 through mid2015, it rose by 3 percent.

he San Antonio MSA office market has displayed more volatility than other major Texas MSAs. This should be expected in smaller markets. However, such volatility makes accurately anticipating future changes in the San Antonio market more difficult. Vacancy increased fairly rapidly, reaching a peak by mid2009 in the midst of the Great Recession, improving the following year but weakening again through 2012 (Figure 1). The San Antonio MSA has been heavily impacted, both negatively and positively, by the federal government. Changes in military budgets during the past decade have been a major factor. The office market has shown progress as the U.S. economy has improved. Luckily, San Antonio only took a glancing blow from the energy sector slowdown, as the Eagle Ford Shale’s inﬂuence in local CRE markets was late in coming. By mid-2015, San Antonio’s vacancy rate had reached 11.9 percent, slightly higher than the ten-year average of 11.6 percent from mid-2005 to mid-2015. CoStar’s office data for San Antonio only extends back ten years. Net absorption, although still positive, slowed after mid-2014. Employment in financial and business services has been robust, registering a healthy average annual growth rate of 5.4 percent by mid-2015. This is well above the historical average of 2.5 percent observed between mid-2005 and mid-2015. Annual office rent growth in real terms measured 1.5 percent in mid-2015. Office space supply in the MSA is increasing slowly, both overall and in lease space.

Retail Markets Austin The Austin MSA’s retail vacancy peaked in 2007Q3, steadily improving since then, reﬂecting the dynamism of the Austin economy (Figure 2). Vacancy fell to a low of 4.5 percent by mid2015, well below the average of 6.2 percent between 2006Q1 and mid-2015. CoStar’s retail data is not as historically deep as its office data. Net absorption has remained positive since the second half of 2011 and continues to grow. Retailers continue to expand in the region, increasing the demand for retail space.

The average annual growth rate of retail sales increased 5.2 percent in real terms in 2014, higher than the historical average of 3.5 percent registered between 2006 and mid-2015. Alternatively, retail employment has slowed since 2014Q1, registering a 2.1 percent annual growth rate by mid-2015 compared with a historical average growth rate of 3 percent between 2007 and mid-2015. The Austin retail CRE market remains strong, registering average annual real rent growth of 4.2 percent quarterly in mid-2015. On the supply side, new retail construction overall is declining as are rentable buildings under construction.

DFW The DFW MSA’s retail vacancy has steadily declined after reaching a peak in 2010Q3, and continuing to tighten through mid-2015 (Figure 2). Similar to the office market, the strong retail showing is heavily tied to the MSA’s solid economic growth post-recession. Vacancy rates had fallen to a historically low level of 7.6 percent by mid-2015, lower than the average of 9.4 percent between 2006 and mid-2015. Net absorption in DFW is impressive, continuing to show strong positive gains since the depths of the Great Recession in 2010. Positive growth in the retail sector has led to solid retail employment gains that reﬂect an increased demand for retail space.

12.50

Figure 2. Retail Vacancy Rates Major Texas MSAs

11.25

HOUSTON

10.00 Percent

San Antonio-New Braunfels

8.75

DFW

7.50

SAN ANTONIO

6.25 5.00

AUSTIN

3.75 2.50 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Note: Seasonally adjusted and detrended Sources: CoStar and Real Estate Center at Texas A&M University TIERRA GRANDE

Houston The Houston MSA’s retail market continues to show signs of staying power. Retail vacancy peaked in mid-2011 but began to decline as the energy sector blossomed (Figure 2). The relationship between Houston retail activity and the energy sector has been asymmetrical during the recent contraction. The fall in oil prices has not yet deteriorated the retail market. acancy fell consistently from 11.1 percent in mid-2011 to 8 percent by mid-2015, below the historical average vacancy rate of 9.7 percent registered between 2006 and mid-2015. Net absorption is still positive but began to trend downward in mid-2014. Positive conditions in the retail market are partly driven by continued population growth. As a result, retail employment growth and retail sales have been strong. Retail employment registered average annual growth of 2.9 percent from the beginning of 2014 to mid-2015. This is above the historical rate of 2 percent between 2006 and mid-2015. Retail sales have started to slow. Rent growth registered an average annual quarterly real increase of 2.8 percent in mid2015. New retail construction overall remains positive while rentable buildings under construction have started to decline. The decline may be due more to a lack of desirable sites than the recent fall in energy prices.

San Antonio

Employment in transportation and warehousing continues to grow, recording an annual increase of 3.4 percent by mid-2015. This is above the historical average of 2.7 percent between 2001 and mid-2015. The average annualized real rent increase had reached 13.3 percent in mid-2015. New warehouse construction overall has continued to register positive growth, while rentable square footage under construction remains positive as well. Both have shown a slight slowdown in momentum since the beginning of 2015.

DFW The DFW warehouse market continued to perform well even though global demand for goods dropped as the U.S. dollar appreciated. A stronger dollar makes U.S. (and Texas) goods more expensive in other countries. Vacancy has recently begun to increase after reaching a historical low of 7.2 percent at the end of 2013 (Figure 3). However, its rate of 8.7 percent by mid-2015 is still below the historical annual average rate of 10.9 percent calculated between 2000 and mid-2015.

Figure 3. Warehouse Vacancy Rates Major Texas MSAs

17.5

DFW

15.0

AUSTIN

SAN ANTONIO

12.5 Percent

Retail employment registered a 3 percent annual growth rate between 2014 and mid-2015. This is significantly higher than the historical average of 1.1 percent growth from 2007Q1 through mid-2015. Retail sales averaged 6.4 percent in real terms during 2014. This is in sharp contrast to the mere 0.8 percent average increase between 2006 and year-end 2014. Real annual rent growth averaged 1.9 percent from the beginning of 2014 to mid-2015. Retail space is increasing overall as new construction continues, although rentable buildings under construction are slightly decreasing. This bodes well for continued strength in the DFW retail sector.

10.0 7.5 HOUSTON

5.0 2.5 0.0 2000

2003

2006

2009

2012

Note: Seasonally adjusted and detrended Sources: CoStar and Real Estate Center at Texas A&M University

2015

Warehouse Markets

et absorption continues positive, achieving historically high levels of late. This is reﬂected in strong employment growth in the transportation and warehousing sector. The average annual increase of 6.1 percent between 2014Q3 and mid-2015 is much higher than the historical average of 0.8 registered between 2001 and mid-2015. Even though demand for warehousing space remains strong in the DFW MSA, inﬂation-adjusted rents have started to decline. In a sign that the market may be slowing, a negative real annual growth rate of –0.1 percent was calculated for mid2015. The supply of new industrial space in both new construction overall and rentable buildings under construction has begun to trend downward in 2015, a positive sign for long-term market stability.

Austin

Houston

The Austin warehouse market continues to improve. Vacancy has steadily declined from 14.4 percent in 2009Q3 to 7 percent by mid-2015 (Figure 3). Net absorption has remained positive since 2009Q3 as well, further strengthening since 2014Q3.

Despite the fall in energy prices, the Houston MSA’s warehouse market continues to perform well. Vacancy fell to a significantly low 5.5 percent by mid-2015, well below the historical average of 7.7 percent from 2000 to mid-2015 (Figure 3).

Results from the San Antonio retail market are mixed. Vacancy showed upward momentum after its peak in mid-2009 (Figure 2). The vacancy rate fell from 7.7 percent in mid-2009 to 5.8 percent by mid-2015. That is below the historical vacancy rate of 6.7 percent between 2006 and mid-2015. In contrast, net absorption had showed good gains since the end of 2011 but turned negative by mid-2015. Retail sales registered annual growth of 5.7 percent at the end of 2014. However, retail employment has begun to trend downward, recording an annual growth rate of 1.4 percent in mid-2015. New retail construction and rentable buildings under construction have both begun to decline since mid-2014.

JANUARY 2016

The strength of Houston’s warehouse market is also revealed in its real rent growth, posting an annual increase of 9.3 percent in mid-2015. This is much higher than the historical average of 0.8 percent between 2001 and mid-2015. Net absorption continues positive, nearing pre-Great Recession levels. However, low energy prices have started to weigh on Houston’s transportation and warehousing employment, registering a mere 1.1 percent annual rate of growth in mid2015. This rate is still above the historical annual average of 0.8 percent between 2001 and mid-2015. Construction of warehouse space overall continues, while rentable buildings under construction registered a positive growth rate as well.

San Antonio The San Antonio MSA’s warehouse vacancy began to increase after mid-2014, rising to 12.1 percent by mid-2015 (Figure 3). This is above the historical average of 11.8 percent from 2005 to mid-2015. Even though vacancy had trended up, net absorption actually turned positive for the first half of 2015. Employment in transportation and warehousing continues to expand, registering an average annual growth rate of 4.3 percent in mid-2015. This is significantly better than the historical average of 1.8 percent from 2006 to mid-2015. Employment growth has remained positive since San Antonio began to emerge from the Great Recession in 2010. Supply of new warehouse space is declining. New warehouse construction began to decline in 2015 while rentable square footage under construction remained basically ﬂat since the beginning of 2014.

Natural Vacancy Rates The natural vacancy rate can affect numerous CRE market participants. When actual vacancy in a local market falls below (rises above) natural vacancy, building managers begin to consider increasing (decreasing) rents. The same logic can be used by developers to estimate the relationship between changes in vacancy rates and the construction of new lease space. For tenants, actual vacancy falling below natural vacancy is a signal that rents should begin to increase in the near future. Natural vacancies were calculated for the major Texas MSAs. Aggregate natural vacancy in an overall market may not reﬂect the trigger vacancy rate an individual CRE professional uses to make decisions affecting a specific property or project.

However, they are a good indicator of the direction rents and new construction activity are headed overall.

Office Sector Natural Vacancies versus Actual Vacancies

alculations for the Austin office market reveal a natural vacancy rate of 13 percent while actual vacancy as of mid-2015 is significantly lower at 10.4 percent (Table 1). Based on that difference, along with the downward vacancy trend exhibited in Figure 1, future increases in Austin office rental rates should be expected. The potential for new office development in Austin is even higher, as exhibited by the even larger difference between natural and actual vacancy displayed (Table 2). The DFW office market registers a 17 percent natural vacancy rate compared to 15.8 percent actual vacancy (Table 1). When combined with the downward vacancy trend observed in Figure 1, DFW remains a good candidate for future rent increases. A possibility for additional DFW office construction remains as well (Table 2). Houston’s office market registered a 15 percent natural vacancy rate against 15.2 percent actual vacancy in Table 1. While these two values are almost equal, the upward trend in historical vacancy displayed in Figure 1 leads to the assumption that rental rates should be facing future downward pressure. The same conclusion can be drawn for the possibility of new office construction in Houston because Table 1 and Table 2 values are identical. San Antonio posted a 12 percent natural office vacancy rate compared to an 11.9 percent actual rate. These rates are also identical to those in Table 2. When combined with the relatively ﬂat historical vacancy trend (Figure 2), little change in future office rents should be expected. Expectations should also be low for any new office construction.

Retail Sector Natural Vacancies versus Actual Vacancies The Austin retail market’s natural vacancy rate was calculated at 6 percent compared with 4.5 percent actual vacancy (Table 1). When combined with the downward trend in vacancy (Figure 2), future increases in retail rents should be expected. The potential for new retail development in Austin is somewhat less favorable, although still positive. Table 2 reveals a narrower difference between natural vacancy (5 percent) and actual vacancy (4.5 percent).

Table 1. Natural Vacancy Rates Affecting Real Rents Region/MSA Austin DFW Houston San Antonio

Natural Ofﬁce Vacancy Rate

Actual Ofﬁce Vacancy 2015Q2

Natural Retail Vacancy Rate

Actual Retail Vacancy 2015Q2

Natural Warehouse Vacancy Rate

Actual Warehouse Vacancy 2015Q2

13.0 17.0 15.0 12.0

10.4 15.8 15.2 11.9

6.0 9.0 9.0 6.0

4.5 7.6 8.0 5.8

11.0 12.0 8.0 12.0

7.0 9.5 5.5 12.1

Note: Raw data was seasonally adjusted and detrended by Real Estate Center at Texas A&M University. Source of raw data: CoStar

TIERRA GRANDE

DEMAND FOR WAREHOUSE space in Dallas has been strong but is showing signs of slowing.

vacancy. Both Table 1 and Table 2 have identical values. When Figure 3 is factored in, mixed signals in the DFW warehouse market result. Historical vacancy has begun to increase of late, with the latest trend showing a leveling out. As a result, expectations for both rent increases and new development should be lower than a year ago. San Antonio’s natural vacancy rate (12 percent) and actual vacancy (12.1 percent) are extremely close. Values in Table 1 and 2 are the same. When the upturn in historical vacancy displayed is added in, a possibility for future rental rate decreases seems plausible (Figure 3). Conditions are not favorable for future new construction.

atural and actual vacancy rates for the DFW retail market (Tables 1 and 2) are identical. Actual vacancy (7.6 percent) is below natural vacancy (9 percent). There is a strong downward trend in historical retail vacancy (Figure 2). As a result, the environment for future rent increases and new construction is quite positive. For Houston, there is a slight difference between natural Demand for new commercial space requires an economy that vacancy (9 percent) and the actual rate (8 percent) (Table 1). leads to business expansion and generates more jobs in the Historical vacancy continues to trend down. Future increases process. As shown in this article, the performance of CRE in retail rents should be expected (Figure 2). markets in the state’s major MSAs should be expected to vary Natural and actual vacancy rates (Table 2) are identical for widely. the Houston market at 8 percent. With the strong downward trend in historical Table 2. Natural vs Actual Vacancy Rates Affecting New Real Construction vacancy, future new developActual Actual Retail Natural Actual Warement should be Natural Office Office Vacan- Natural Retail Vacancy Warehouse house Vacancy Region/MSA Vacancy Rate cy 2015Q2 Vacancy Rate 2015Q2 Vacancy Rate 2015Q2 expected. However, Houston’s Austin 15.0 10.4 5.0 4.5 11.0 7.0 dearth of availDFW 17.0 15.8 9.0 7.6 12.0 9.5 able retail sites Houston 15.0 15.2 8.0 8.0 8.0 5.5 remains a limiting San Antonio 12.0 11.9 6.0 5.8 12.0 12.1 factor. Note: Raw data was seasonally adjusted and detrended by Real Estate Center at Texas A&M University. San Antonio’s Source of raw data: CoStar and Dodge Data & Analytics difference in Although the future seems brightest in regions least natural vacancy (6 percent) and actual vacancy (5.8 percent) affected by the downturn in the oil and gas sector, it should is the same in both Table 1 and 2. When combined with the not be considered a determining factor in all cases going relatively flat trend in historical vacancy, the possibility for forward. significant rent increases and new construction should be For more detailed, in-depth graphs, see publication number quite low. 2118 at www.recenter.tamu.edu and download the pdf.

Overall Market Trends

Warehouse Sector Natural Vacancies

The Austin warehouse market’s natural vacancy rate of 11 percent varies widely from its 7 percent actual vacancy. The disparity is also identical in Table 1 and 2. When combined with the strong downward trend in historical vacancy (Figure 3), an increase in warehouse rents and new warehouse development should be expected. A similar trend is observed in the DFW warehouse market, with natural vacancy at 12 percent versus 9.5 percent actual JANUARY 2016

Dr. Torres (ltorres@mays.tamu.edu) and Dr. Hunt (hhunt@tamu.edu) are research economists with the Real Estate Center at Texas A&M University.

THE TAKEAWAY Natural vacancy rates can be useful in the quest to understand where future commercial rents and construction in Texas are headed.

Residential

TIERRA GRANDE

he 2004–07 boom and bust in home prices and residential construction and the accompanying global financial crisis created a need for up-to-date economic indicators to help forecast changes in the residential construction sector. The Real Estate Center at Texas A&M University and the Federal Reserve Bank of Dallas collaborated to construct an economic index that estimates the timing and length of future upswings and downturns in Texas residential construction.

Leading Economic Indicators

underlying indicators are subject to revision, and while errors often cancel out across indicators, one must still be aware of how revisions impact the index and thus the future monitoring of the business cycle. In addition, although leading indicators often indicate the direction of a business cycle, they do not measure the magnitude of the change. Even with these caveats, leading indicators have served a useful function in measuring business cycles.

Table 1. Chronology of Texas Residential Construction Business Cycle

Leading economic indicators frequently rely Months Contraction, Months Expansion, on future economic commitments, such Peak Date Trough Date Peak to Trough Trough to Peak as new orders for capital goods, or buildSeptember 1979 August 1982 36 ing permits. Some indicators, such as help May 1984 March 1989 59 22 wanted advertising, stock price indices and January 2007 June 2011 54 215 consumer confidence surveys, reveal expecSource: Real Estate Center at Texas A&M University tations about future activity. Leading indicators are analyzed to identify turning points in the business cycle. A good leading index will Using the same methodology as the National Bureau of signal an impending upturn or downturn Economic Research (NBER), the Center identified previous months before it actually happens. Leading business cycle turning points in Texas residential construcindicators have the advantage of greater tion (Table 1). The Center’s designation of peaks and troughs in stability over time and across conjunction with the residential construction coincident index regions and sectors to predict indicator will be used to measure the business cycle. This changes. makes it possible to construct a series that predicts changes Some weaknesses in housing construction. The differences in the business cycle exist in the estimabetween residential construction and the overall Texas econtion of leading omy were apparent during the Great Recession and the ensuing indices. The recovery. The Texas economy rebounded faster than the state’s housing market, likely a consequence of the boom in shale oil exploration. To construct the leading indicators for Texas residential construction, economic data from 1990 through 2015 were evaluated with respect to the following: • economic significance, • statistical adequacy (in describing the economic process in question), • timing at expansion and recessions, • conformity to historical business cycles, • smoothness and • currency or timeliness (how promptly the statistics are available).

JANUARY 2016

A common rule used by the Conference Board with the leading index is that three months of consecutive declines signal an upcoming recession and three months of consecutive increases signal an upcoming recovery. It is useful to examine variables specific to the dynamics and multifamily housing market. Four other Texas variables — of the residential housing market, such as changes in buildnonfarm employment, construction employment, help wanted ing permits and interest rates. These are important factors in advertising for construction and maintenance positions and determining the level of housing activity. employment in architecture, engineering and related services hen creating a leading indicator, the measures of — are tied to state and industry related employment. conformity and cyclical timing are given more Three of the Texas variables — loan performance, negaweight. The Center used the same methodology as tive equity, loan to value — represent regional credit condithe Conference Board Leading Economic Index to measure con- tions, while the housing opportunity index is tied to housing formity of a given series by studying the relationship between affordability based on income and financial costs to purchase movements in the series and Table 2. Leading Series NBER peaks and troughs. The dates of the turning points Series Name Source Availability Notes are called reference dates, and Single and multifamily the collection of reference permits weighted based Weighted Building Third/fourth week dates is called the business on annual permit values Permits WBP U.S. Census Bureau following month cycle. This chronology identiBank of Tokyo-Mitsubishi Third week of the folfies the peaks and troughs as Housing Starts HSTAR UFJ lowing eight months expansions turn into recesNote: All series are seasonally adjusted and detrended. sions and vice versa. Source: Real Estate Center at Texas A&M University The cyclical timing of potential leading indicators is judged by simply recording how a house. Rents and apartment vacancy rates are related to mulmany months prior to a peak (trough) the coincident index tifamily housing, a substitute for single-family housing. Texas reaches a maximum (minimum). To do so, each series is plotleading indicators measure the outlook for economic growth ted against the Texas residential construction coincident index based on the Texas business cycle. Real oil prices, well permits to see if they match previous and rig count represent the peaks and troughs in the Texas energy sector, a key compoFigure 1. Texas Residential Construction Coincident residential housing market nent of the Texas economy. and Leading Indexes (Index 1990: 10 = 100) 450 600 business cycle. A good leading Of the four national vari400 candidate series is expected ables two — senior loan 500 350 to rise during expansions and officer survey and lending 300 400 fall throughout contractions. conditions for acquisition, 250 300 If the candidate series does development and construc200 not demonstrate a statistically tion loans — represent credit 150 200 significant relationship to the market conditions. The hous100 100 business cycle, that series is ing market index, also avail50 not useful. able for the south region that 0 0 1991 1995 1999 2003 2007 2011 2015 Approximately 22 candidate includes Texas, is associated Notes: Shaded area represents a recession in Texas residential variables were evaluated in with builder confidence of construction. Retrended with real contract values. the selection process. Eighthose who build single-family Sources: Dallas Fed and Real Estate Center at Texas A&M University teen are related to the Texas houses. The last national economy and four to the national economy. Four of the Texas series is the conventional conforming 30-year fixed mortgage variables — weighted building permits (weighted by average rate, which represents the financing cost of purchasing a home. per unit housing values) for single and multifamily housing, Based on statistically reliable criteria, two variables were housing starts, months of single-family inventory and median selected as Texas residential construction leading indicators: single-family household prices — are tied to the regional single weighted building permits and housing starts (Table 2). These

Coincident Index

Leading Index

TIERRA GRANDE

600 500 400

Figure 2. Components, Texas Residential Leading and Coincident Indexes (Index 1990: IV = 100) Leading Index Building Permits Housing Starts Coincident Index

300 200 100 0 1991

1995

1999

2003

2007

2011

2015

Notes: Shaded area represents a recession in Texas residential construction defined by research economists at the Real Estate Center at Texas A&M University and the Residential Construction Coincident index. Coincident and leading indexes retrended with real contract values. Sources: Dallas Fed, Real Estate Center at Texas A&M University and Mitsubishi Bank

variables demonstrated a significant leading relationship with the residential construction market in Texas. All other variables were found not to be statistically valuable for the leading index.

Results and Evaluation

he Texas leading index for residential construction precedes the movements of the coincident index (Figure 1). The peak of the leading index for the housing bust led the September 2006 peak in the coincident index by eight months, achieving a maximum value in January 2006. A trough in the leading index led the April 2011 trough in the coincident index by 25 months, falling to its minimum value in March 2009 (Figure 2). Although the historical data include a major downturn, it is fairly easy to note the occurrence of peaks and troughs in the leading index. It may be difficult on a month-to-month basis to detect turning points as a result of the volatility in the leading index (Figure 3). A common rule used by the Conference Board with the leading index is that three months of consecutive declines signal an upcoming recession and three months of consecutive increases signal an upcoming recovery. Overall, the leading index is seen to be a good indicator to predict changes in the Texas residential construction business cycle as measured by the coincident index. One major problem in evaluating the index in this study was the short duration of the period. To evaluate business cycle relationships, it is best to study the relationships over a long period and many business cycles. Because the coincident index

Figure 3. Texas Residential Construction Coincident and Leading Index (m/m%) 6 4 2 0 –2 –4 –6 –8 1991

1999

2003

2007

2011

2015

Note: Shaded area represents Texas recessions defined by research economists at the Real Estate Center at Texas A&M University and the Residential Construction Coincident index. Sources: Dallas Fed, Real Estate Center at Texas A&M University and Mitsubishi Bank JANUARY 2016

Figure 4. Texas Residential Construction Leading Index (January 1980 = 100) 250 200 150 100 50 0 1980

1985

1990

1995

2000

2005 2010

2015

Note: Shaded areas represent Texas recessions defined by research economists at the Real Estate Center at Texas A&M University and the Residential Construction Coincident index. Sources: Dallas Fed and Real Estate Center at Texas A&M University

The leading residential construction index was able to signal a directional change in 2006 that became the prolonged downturn that started in 2007. It also signaled a downturn in 1983 in advance of the strong recession that hit the Texas economy as a consequence of declining oil prices. Even though the index has performed well, it is based on a relatively short period. The usefulness of this indicator will continue to be tested in the future to see if it signals directional changes in Texas residential construction. Currently, with data up to September 2015, the leading index is signaling a slowdown in residential construction activity caused by a deceleration in weighted building permits, contrasting with housing starts that register strong growth. Drs. Cañas and Phillips are with the Dallas Federal Reserve and Dr. Torres (ltorres@mays.tamu.edu) is a research economist with the Real Estate Center at Texas A&M University.

Leading Index Coincident Index

1995

starts in October 1990, the period for this series to be evaluated was restricted (Figure 4). As each individual series was tested for its ability to lead the coincident index to the earliest possible date, no series could be tested prior to 1990. Because the predictive ability of the leading index was evaluated over a short time, the possibility always exists that the relationship might not hold in the future. Thus, the performance of the leading index for residential construction in Texas will be best evaluated based on its ability to lead the coincident index in the future. Even though the coincident index for residential construction starts in October 1990, the research economists at the Center have identified the turning points of Texas residential business construction since 1980. These turning points serve as a benchmark to evaluate the performance of the leading index back to the 1980s (Figure 4). For the peak date (May 1984) identified for Texas residential construction, the leading index achieved its peak eight months earlier (September 1983). A trough in the leading index was registered in February 1988, 13 months before the identified trough in March 1989. This demonstrates the usefulness of the leading index in predicting future movements in residential construction in Texas. Going forward, the Texas residential construction leading index should provide a reliable signal of weakness in residential construction, whether the growth declines or actually becomes negative.

THE TAKEAWAY The Federal Reserve Bank of Dallas and the Real Estate Center collaborated to estimate a leading index to help determine the future direction of residential construction in Texas.

Legal Issues

TIERRA GRANDE

n adequate highway transportation system is critical to the success of Texas real estate markets. The primary funding mechanism for decades has been revenue from state and federal fuel taxes. Currently set at 20 cents and 18.4 cents per gallon, respectively, neither has been increased since the early 1990s. Furthermore, federal transportation funds remitted to the states from the Federal Highway Trust Fund have remained “iffy” because of persistent shortterm extensions to previous transportation bills. A new long-term federal highway bill known as Fixing America’s Surface Transportation Act (the FAST Act) was signed into law on December 4th, just before the latest extension was set to expire. Governor Greg Abbott made increased transportation funding a priority during the most recent legislative session, including it as one of his five emergency items for the legislature to address. The result was passage of several new laws that focus on increasing the revenue available for Texas roads in the years ahead. A summary of the pertinent legislation follows.

JANUARY 2016

Moving Away from Toll Roads One important thrust of new transportation legislation involved reducing the state’s future use of toll roads. “The legislature got more public pushback on toll roads this past session than ever before,” says Steven Polunsky, research scientist at the Texas A&M Transportation Institute. “The main concerns were that toll roads be self funding and that their cost is accurately calculated up front.” ouse Bill (HB) 2612 requires the Texas Department of Transportation (TxDOT) to provide a report to Senate and House Transportation Committee members no later than September 1, 2016, concerning the removal of tolls on most toll projects in the state. The toll report must: 1. list the amount of debt on bonds issued for each toll project in the state; 2. identify bonds appropriate for accelerated or complete lump-sum payment of their debt service; and 3. propose a plan to eliminate all state toll roads, which does not include toll roads constructed, operated or maintained solely through funds from bonds issued by other tolling entities such as counties, regional mobility authorities (RMAs) and regional transportation authorities (RTAs).

TxDOT’s network of toll roads includes the Central Texas Turnpike System (CTTS) around Austin, the Camino Colombia Toll Road (SH255) near Laredo and several segments of the Grand Parkway (SH99) in Harris, Montgomery and Chambers Counties. “HB 2612 was meant to provide a reckoning of tolls and toll debt,” says Polunsky. “Exact figures have been difficult to come by in the past.” Another toll-related bill, HB 122, prohibits the issuance of any new debt out of the Texas Mobility Fund (TMF) for toll

roads. Authorized by Texas voters in 2001, the TMF allowed TxDOT to participate in the payment of construction costs for publicly owned toll roads and other public transportation projects through the funding of bonds. TMF revenues are now restricted to retiring toll-related debt and renewing or replacing any existing credit agreements that involve variable rate obligations. In FY 2014, the state spent more than $359 million from the TMF on debt service alone, nearly half the $730 million it spent on transportation projects and maintenance. These two bills focused on increasing direct payments for roads. The intent was to facilitate an eventual return to traditional pay-as-you-go highway funding in Texas.

Raising Transportation Revenue without Raising Taxes In 2013, the 83rd Legislature passed Senate Joint Resolution 1 (SJR1) that led to the passage of Proposition 1 by Texas voters in November 2014. This constitutional amendment diverts half the money that would be deposited into the state’s Rainy Day Fund to the State Highway Fund (SHF). The objective was to increase state highway funding without creating any additional tax burden. The expectation was that Proposition 1 would increase transportation funding by about $1.2 billion per year. The SHF actually received about $1.7 billion in the 2015 fiscal year from significantly higher oil and gas severance taxes. In the most recent session, the Legislature again chose to increase transportation funding without implementing any new tax burden by passing SJR5. The joint resolution put Proposition 7 up for a vote on the November 3rd ballot. Proposition 7 passed handily with 83.9 percent of the votes cast. TxDOT has stated it will be the largest annually recurring infusion of transportation funding in the state’s history. TIERRA GRANDE

FORECAST: STATE TAX COLLECTIONS

$4.6

BILLION

The bill also ends a $1.3 billion diversion of transportation funds that had been going to state agencies other than TxDOT. Affected agencies include the Department of Public Safety, the Department of Motor Vehicles, the Office of the Attorney General and several others.

PROPOSITION 7

“The jewel in the crown for future transportation funding is Proposition 7,” says Polunsky. “Starting in fiscal 2018 and 2019, TxDOT could receive an additional $2.5 billion a year from the state sales tax. By fiscal years 2020 and 2021, revenue added in from the motor vehicle sales Uncertainty from Decreased Oil tax could increase the amount to about $3 billion a year.” and Gas Activity Specifically, Proposition 7 will require the comptroller The comptroller recently lowered his forecast to deposit into the SHF up to $2.5 billion of net revenue of state tax collections by about $4.6 exceeding the first $28 billion collected from the state sales tax each fiscal year. The funds will go “The jewel in the crown for billion with the recent downturn in the state’s oil and gas drilling activity. The to TxDOT through 2032. future transportation latest projection is expected to reduce Proposition 7 will also require the comptrolfunding is Proposition 7.” the Proposition 1 allocation from the ler to deposit into the SHF 35 percent of the net Rainy Day Fund to transportation by revenue collected from the sale, use or rental of motor vehicles that exceeds the first $5 billion coming into the about $685 million. Proposition 1 should add about $1.1 billion to the SHF durstate treasury in that fiscal year. TxDOT will receive the funds ing the 2016 fiscal year, an amount not significantly different through 2029. from the comptroller’s original estimate. However, funding is The legislature, by a majority of members in each chamber, now being forecast to drop to about $600 million in the 2017 may extend either of the expiration dates of these two provifiscal year. sions for ten-year increments. These funds are not insignifiThe $1.7 billion collected in 2015 from Proposition 1, about cant, considering TxDOT’s total funding for the fiscal 2016–17 $500 million more than expected, will temper the effects of the biennium is about $23 billion. predicted lower payout in 2017.

Increasing Efﬁciency, Decreasing Diversions

HB 20 was passed to bring more transparency and accountability to the funding process. The bill requires the creation of a scoring system for prioritizing transportation funding. It also establishes House and Senate Select Committees on Transportation Planning to review, study and evaluate transportation funding, project selection, prioritization and performance. “HB20 is a major retooling of how transportation projects are chosen and carried out,” says Polunsky. “It calls for using performance-based measures in decision making, pulling in local planners and decision makers into the development of those criteria.” JANUARY 2016

Dr. Hunt (hhunt@tamu.edu) is a research economist with the Real Estate Center at Texas A&M University.

THE TAKEAWAY Texas transportation funding is transitioning from borrowing money for highway construction back to a pay-as-yougo model. The recent election provided another source of highway funding that does not raise taxes. Texas real estate markets should benefit from this transition.

Residential

Figure 1. Major Texas Housing Markets’ Share of Homes Sold in Texas, 1979–2014

Percent

70 65 60 55 1979

1984

1989

1994

1999

2004

2009

2014

Source: Real Estate Center at Texas A&M University

exas had a sharp fall in home sales in the 2007–09 Great Recession (GR). Since 2011, the recovery of the state’s economy from the GR has boosted the number of homes sold in Texas. Researchers at the Real Estate Center at Texas A&M University studied the contributions of Texas’ regions to the state’s home sales recovery. They found that the Houston and Dallas metro areas made the largest contributions to Texas’ total home sales recovery in 2012 and 2013 followed by Austin, San Antonio and smaller metro areas. The research also found that after two years of exceptionally strong home sales expansion in 2012 and 2013, the state’s home sales market recorded much slower and more moderate growth rate in 2014.

Regional Housing Markets The Texas housing market comprises regional housing markets in 26 metropolitan areas and 43 micropolitan areas. Not surprisingly, the state’s housing market is concentrated in the five major metro areas of Austin, Dallas, Fort Worth, Houston and San Antonio. The market share of homes sold in Texas accounted for by these major metros increased from 57.8 percent in 1979 to more than 70 percent in 1997, and since then has remained relatively stable at around 73 percent (Figure 1). Houston is the largest regional housing market in Texas with a relatively stable share of around 27 percent of total Texas homes sold since 1997 (Figure 2). Dallas’ share of Texas homes

TIERRA GRANDE

Figure 5. San Antonio’s Share of Homes Sold in Texas, 1979–2014

11 10

Percent

Figure 2. Houston’s Share of Homes Sold in Texas, 1979–2014

Percent

5 1979

1984

1989

1994

1999

2004

2009

2014

Source: Real Estate Center at Texas A&M University

15 1979

1984

1989

1994

1999

2004

2009

Figure 3. Dallas’ Share of Homes Sold in Texas, 1979–2014

7 Percent

Figure 6. Fort Worth’s Share of Homes Sold in Texas, 1979–2014

2014

Source: Real Estate Center at Texas A&M University

24 Percent

8 7

6 5

2 1979

1984

1989

1994

1999

2004

2009

2014

Source: Real Estate Center at Texas A&M University

14 1979

1984

1989

1994

1999

2004

Source: Real Estate Center at Texas A&M University

2009

Figure 7. Texas Smaller Metros’ Share of Homes Sold in Texas, 1979–2014

2014

Figure 4. Austin’s Share of Homes Sold in Texas, 1979–2014

40 Percent

12 10 Percent

35 30

25 1979

6 4 1979

1984

1989

1994

1999

2004

2009

2014

Source: Real Estate Center at Texas A&M University

sold has trended downward since hitting an all-time high of 24.1 percent in 2000. It was the second largest housing market in the state, accounting for 21.1 percent of homes sold in 2014 (Figure 3). Austin’s share of homes sold has trended upward from 5.8 percent in 1979 to 10.8 percent in 2014, making it the state’s third largest housing market (Figure 4). San Antonio is the JANUARY 2016

1984

1989

1994

1999

2004

2009

2014

Source: Real Estate Center at Texas A&M University

fourth largest, with its share of homes sold trending upward since 1997 and reaching 9 percent in 2014 (Figure 5). Fort Worth’s share has slowly trended upward from 3.2 percent in 1998 to 4.2 percent in 2014 (Figure 6). The expansion of housing market shares of the state’s larger metro areas has been at the expense of the smaller regional housing markets. The percentage of Texas homes sold accounted for by the state’s smaller metro areas has trended downward from 44.1 percent in 1980 to 25.8 percent in 2014 (Figure 7).

150 100

N ESSIO GREA T REC

40 20

50 1979 1984 1989 1994 1999 2004 2009 2014

Figure 10. Number of Homes Sold in Dallas, 1979–2014

ESSIO N

200

Source: Real Estate Center at Texas A&M University

Number (Thousands)

250

0 1979 1984 1989 1994 1999 2004 2009 2014

Figure 8. Number of Homes Sold in Texas 1979–2014

GREA T REC ESSIO

Number (Thousands)

300

100

Figure 9. Number of Homes Sold in Houston, 1979–2014

60 50

GREA T REC

exas did not experience a home price bubble during the GR because of ﬂexibility in the supply side of the state’s housing markets and abundant lands for new home construction. In the early 2000s, the state’s housing market responded to increased low-cost mortgage lending by building more housing units, unlike California’s and New York’s housing markets in which more credit availability coupled with limited supply led to higher home prices. When the housing bubble burst in the GR, the other states’ housing markets suffered both in the number of homes sold and prices. Because they account for more than 70 percent of Texas home sales, the five major metro areas bore the brunt of the housing crisis in the GR. Total number of homes sold in Texas fell from a pre-GR peak of 292,805 units in 2006 to 203,637 units in the trough year of 2010, a decline rate of 30.4 percent spread over four years (Table 1 and Figure 8). The home sales decline rates from 2006 to 2010 for Houston, Dallas, Austin, and San Antonio were 29.9 percent, 34 percent, 34.4 percent, and 29.5 percent, respectively (Table 1 and Figures 9 to 12).

Fort Worth suffered five years of home sales declines from 11,977 units in 2006 to 8,124 units in 2011, a decline rate of 32.2 percent (Table 1 and Figure 13). The state’s smaller metro areas collectively did slightly better than major metros. The number of homes sold in those areas fell from 79,155 units in 2006 to 56,436 units in 2011, a decline rate of 28.7 percent (Table 1 and Figure 14).

Number (Thousands)

Housing in the Great Recession

40 30 20

10 1979 1984 1989 1994 1999 2004 2009 2014 Source: Real Estate Center at Texas A&M University

Source: Real Estate Center at Texas A&M University

Table 1. Texas Regional Home Sales Bubbles in the Great Recession (GR) Home Sales Activity Peak, number of homes sold in 2006 Trough, number of homes sold Decline rate from peak to trough, % Peak-trough years Number of years of decline rates 2014 number of homes sold Number of years to recover pre-GR peak

Texas

Houston

Dallas

Austin

San Antonio

Fort Worth

Smaller Metros

292,805 203,637 30.4 2006–10 4 285,623 9

80,994 56,807 29.9 2006–10 4 83,412 8

64,226 42,383 34.0 2006–10 4 60,154 9

30,284 19,872 34.4 2006–10 4 30,953 8

26,169 18,449 29.5 2006–10 4 25,571 9

11,977 8,124 32.2 2006–11 5 11,728 9

79,155 56,436 28.7 2006–11 5 73,805 9

Source: Real Estate Center at Texas A&M University

TIERRA GRANDE

30 20 10

10 8 6 4

0 1979 1984 1989 1994 1999 2004 2009 2014

2 1979 1984 1989 1994 1999 2004 2009 2014

Figure 12. Number of Homes Sold in San Antonio, 1979–2014

Figure 14. Number of Homes Sold in Texas’ Smaller Metros, 1979–2014

24 20 16 12 8

4 1979 1984 1989 1994 1999 2004 2009 2014 Source: Real Estate Center at Texas A&M University

JANUARY 2016

70 60 50 40 30

80 Number (Thousands)

GREA T REC ESSIO

Source: Real Estate Center at Texas A&M University

GREA T REC ESSIO

Source: Real Estate Center at Texas A&M University

Number (Thousands)

14 Number (Thousands)

N GREA T REC ESSIO

Number (Thousands)

Figure 13. Number of Homes Sold in Fort Worth, 1979–2014

GREA T REC ESSIO

Figure 11. Number of Homes Sold in Austin, 1979–2014

20 1979 1984 1989 1994 1999 2004 2009 2014 Source: Real Estate Center at Texas A&M University

Regional Contributions to Total Home Sales Growth rates of Texas homes sold in any designated period is the weighted average of the growth rates of number of homes

Figure 15. Texas: Growth Rates of Homes Sold, 2006–14

10 Percent

fter four years of declines, Texas home sales began a weak recovery in 2011 (Figure 15). The regional housing markets of Houston, Dallas, Austin and San Antonio began recovering in 2011 while in Fort Worth and the state’s smaller metro areas, recovery started in 2012 (Figures 16 to 21). The home sales recovery in 2011 was not strong in the state’s major regional housing markets. The growth rates of number of homes sold in Houston, Dallas, Austin and San Antonio were 3.6 percent, 0.6 percent, 6.7 percent and 0.3 percent, respectively. The state’s local housing markets had stronger home sales recoveries in 2012 and 2013, reﬂected in double-digit growth rates (Figures 16 to 21). After two years of strong growth rates in home sales, housing markets weakened at the end of 2013. As of the end of 2014, only Houston and Austin had recovered their pre-GR levels in number of homes sold. However, the latest data for 2015 show the state and all its local markets are expected to recover their pre-GR levels of home sales when the 2015 year-end tally is taken.

RECOVERY 0

GREAT RECESSION

–10 –20

2006

2008

2010

2012

Source: Real Estate Center at Texas A&M University

2014

sold in the state’s local housing markets. Weights are the shares of homes sold in local markets. Each region’s contribution to the statewide growth rates of homes sold is equal to the growth rate of homes sold in the region multiplied by that region’s share of homes sold in Texas. Houston and Dallas made the largest contributions to the growth rate of number of homes sold in Texas in 2012 and 2013, followed by smaller metro areas and Austin, San Antonio and Fort Worth (Table 2). The state’s housing markets recovered

Table 2. Texas Regional Contributions to Growth Rates of Number of Texas Homes Sold, Percent Texas Home Sales Growth Rates

2006

2007

2008

2009

2010

2011

2012

2013

2014

9.74

–5.89

–15.67

–8.20

–4.55

1.06

15.70

16.13

3.32

1.27 1.59 0.58 3.07 0.80 2.43

–0.76 –1.55 –0.15 –1.14 –0.76 –1.53

–2.03 –3.21 –0.64 –4.54 –1.66 –3.59

–0.73 –2.13 –0.52 –2.18 –0.28 –2.36

–0.41 –1.64 –0.15 –1.55 –0.13 –0.67

0.66 0.13 –0.06 1.01 0.03 –0.71

2.10 3.77 0.47 4.76 1.00 3.60

2.06 3.91 0.76 5.13 1.49 2.78

0.19 0.16 0.30 0.93 0.53 1.21

Regional Contributions Austin Dallas Fort Worth Houston San Antonio Smaller Metro Areas

Source: Real Estate Center at Texas A&M University

TIERRA GRANDE

Figure 16. Houston: Growth Rates of Homes Sold, 2006–14

RECOVERY 0

GREAT RECESSION

–30 2006

2008

2010

2012

Source: Real Estate Center at Texas A&M University

2014

Figure 17. Dallas: Growth Rates of Homes Sold, 2006–14

Percent

2006

2008

2010

2012

2014

Figure 19. San Antonio: Growth Rates of Homes Sold, 2006–14

RECOVERY 0

GREAT RECESSION

–10

GREAT RECESSION

–10 –20

GREAT RECESSION

Source: Real Estate Center at Texas A&M University

Percent

–20

–10

RECOVERY

–10

–20

2006

2008

2010

2012

Source: Real Estate Center at Texas A&M University

2006

2008

2010

2012

Source: Real Estate Center at Texas A&M University

2014

lost ground but are currently cooling. The growth rate of number of homes sold in 2014 has fallen to a moderate rate of 3.32 percent because of smaller contributions from the state’s major metro areas. Houston’s economy was a major driver of the state’s economic recovery from the GR but is beginning to show the impact of lower oil prices and drilling activity. Consequently, Houston is expected to make a somewhat smaller contribution to the state’s total home sales for 2015 and especially in 2016. The growth rate of Texas home sales in the next couple of years will depend more on the contributions of Dallas, Austin and San Antonio.

RECOVERY 0

GREAT RECESSION

–20

2006

2008

2010

2012

Source: Real Estate Center at Texas A&M University

Figure 21. Texas Smaller Metros: Growth Rates of Homes Sold, 2006–14

RECOVERY 0

GREAT RECESSION

–10 –20

2006

2008

2010

2012

Source: Real Estate Center at Texas A&M University JANUARY 2016

2014

10 Percent

Texas regional home sales have recovered from the onslaught of the Great Recession, with Texas larger local regions leading the recovery followed by smaller regions. After two years of exceptionally strong home sales expansion in 2012 and 2013, the state’s home sales market experienced much slower and moderate growth in 2014.

Figure 20. Fort Worth: Growth Rates of Homes Sold, 2006–14

–10

Dr. Anari (m-anari@tamu.edu) is a research economist with the Real Estate Center at Texas A&M University.

THE TAKEAWAY

2014

10 Percent

Percent

20 Percent

Figure 18. Austin: Growth Rates of Homes Sold, 2006–14

2014

Legal Issues

LICENSING ACT changes

AND MORE

LEGISLATORS PASS NEW REAL ESTATE LAWS BY JUDON FAMBROUGH

SALESPERSONS

SALES agents RIP

he 2015 Texas Legislature passed new laws affecting real estate. Some directly affect real estate practitioners. Most of the ones described here took effect Sept.

1, 2015.

Real Estate Licensing Act For real estate licensees, the discussion of new laws starts with changes to the Real Estate Licensing Act found in Section 1101 of the Texas Occupations Code. Licensees must familiarize themselves with new titles and references. Real estate salespersons are now called real estate sales agents. These agents are no longer associated with a licensed broker but are sponsored by one. Sponsoring brokers must now attend at least six classroom hours of broker responsibility courses approved by the Texas Real Estate Commission during the term of their current license. Core real estate courses vanished, replaced by qualifying real estate courses. Finally, a licensee does not act as a broker or sales agent but instead engages in real estate brokerage. Activities requiring a real estate license changed. A license is now required for anyone dealing in options on real estate including a lease-to-purchase or buying, selling or offering to buy or sell options in real estate. A license is also required for someone who advises or offers advice to an owner of real estate concerning the negotiation or completion of a short sale.

On the ﬂip side, a license is not required for anyone who engages solely in the following activities: • constructing, remodeling or repairing a home or other building; • sponsoring, promoting or managing or otherwise participating as a principal, partner or financial manager of an investment in real estate; or • entering an obligation to pay another person that is secured by an interest in real property. Perhaps the most controversial change appears in the exemptions from the licensing requirements. The statute uses a double negative to determine when a license is needed. Here is how it reads. “This chapter (the Real Estate Licensing Act) does not apply to an attorneyin-fact authorized under a power of attorney to conduct not more than three real estate transactions annually.” One might conclude a real estate license is required for the first transaction if the power of attorney authorizes the attorney-in-fact to enter an unlimited number of real estate transactions annually, which is normally the case. If this is true, does the statute invalidate the transaction(s) and/or subject the person to a violation of the licensing act? This restriction appears in stark contrast to the promulgated Statutory Durable Power of Attorney Form found in Section 752.051 of the Texas Estates Code and the description of what constitutes real estate transactions found in Section 752.102. Neither places a limit on the number of authorized real estate transactions.

SALESPERSONS

SALES agents

TIERRA GRANDE

or more information regarding powers of attorney and other related instruments, see Center publication Endof-Life Documents. While you are there, note that the Directive to Physicians Form changed slightly on Sept. 1, 2015. Now, when a lifesustaining treatment is deemed medically inappropriate, the patient or surrogate may request a ten-day extension in many situations to seek another facility that will provide treatment. Here is a surprising new disclosure requirement. Did you know that water levels in lakes fluctuate? Evidently, that is not an obvious fact. Starting Sept. 1, 2015, sellers of residential or commercial property adjoining an impoundment of water, including a reservoir or lake, constructed and maintained under Chapter 11 of the Texas Water Code and having a storage capacity of at least 5,000 acre-feet at its normal operating level must give purchasers written notice that the water level fluctuates for various reasons including droughts or floods. If the notice is not given on or before the effective date of the contract, the purchaser may terminate it within seven days after the purchaser receives notice from the seller or from another person. The seller may be sued for misrepresentation if the notice is not given when the seller had actual knowledge of the fluctuations. The new law is found in Section 5.019 of the Texas Property Code. The statute raises an interesting question regarding the definition of the word adjoining. This term received considerable attention in the 1927 case of Broun v. Texas & N.O.R. Co. (295 S.W. 670). The court attempts to distinguish the meaning of adjoining from adjacent. Adjoining means touching whereas adjacent means near, close or contiguous, but not touching. “That which is adjacent may be separated by some intervening object.” Section 5.008(b) of the Texas Property Code contains another required notice effective Jan. 1, 2016. The statute amends the seller’s residential disclosure form to include a statement of whether any portion of the property is in a groundwater conservation district or a subsidence district. The seller must disclose only what he or she knows. There is no duty to investigate.

Minerals, Foreclosures and Surface Rights Some interesting legislation effective Jan. 1, 2016, addresses the rights of purchasers of mortgage property at foreclosure sales. Here are the rules before the law went into effect on Jan. 1, 2016. JANUARY 2016

If a lender forecloses on mineral property having an oil and gas lease on it, the lease may or may not terminate. As a rule, first-in-time, first-in-right applies. If the mortgage was entered and recorded on the property before the lease was taken, the foreclosure terminates the lease. However, if the lease precedes the mortgage, the foreclosure does not terminate the lease. An exception exists for the first scenario. If the company taking an oil and gas lease on mortgaged property gets a subordination agreement from the lender, a foreclosure does not terminate the lease. Basically, the lender agrees to place its rights below that of the oil company in the event of a foreclosure. Chapter 66 Section 66.001 of the Texas Property Code changes the rules for unsubordinated leases placed on mortgaged property. The new statute provides that a subsequent foreclosure does not terminate the lease. Purchasers at the foreclosure sale begin receiving subsequent royalty and other payments due under the existing lease. However, the foreclosure terminates any surface rights the oil company has to operate the lease when the surface and mineral estate are subject to the same lien. The oil company must secure a surface-use agreement from the new owners. In a related matter, the San Antonio Court of Appeals recently rendered a decision regarding the rights of surface owners who own no minerals in Lightning v. Anadarko. Anadarko obtained a lease on Property A that prohibited drilling operations. Consequently, Anadarko secured a surface-use agreement from an adjoining surface owner of Property B to drill horizontally and complete wells on Property A. No production was to be taken from Property B. ightning held an oil and gas lease on Property B. It sued for an injunction alleging a trespass for Anadarko’s drilling through its leased acreage without permission. The court ruled in favor of Anadarko. No trespass occurred. While a surface owner owns no minerals, the surface owner still controls the below-ground structures containing the hydrocarbons. The court quoted from an earlier Texas case of Springer Ranch Ltd. v. Jones in which it held the “ownership of the hydrocarbons does not give the mineral owner ownership of the earth surrounding those substances.” For more information on the rights of surface owners without minerals, see Center publications Minerals, Surface Rights and Royalty Payments and “Surface Tension: Accommodation of the Estates Doctrine.”

Landowner Liability

icensees practicing in smaller towns and rural areas may find a new statute affecting landowner liability interesting. Again, some background information may be necessary to appreciate its significance. One of the ways landowners may limit liability to guests entering the property, whether paying or not, is to get waivers (save-and-hold-harmless agreements) from them. The guests, in essence, agree to hold the landowner harmless (meaning they will not sue) if they are injured on the property because of the landowner’s negligence. The agreement must meet five requirements. • The parties have equal bargaining power. • The guests receive consideration in return for signing the agreement, such as the right to enter. • The agreement states the guests release the landowner for his or her negligent conduct (the express negligence rule). • The agreement gives the guests fair notice of what they are signing. • The agreement is conspicuous, not hidden in the fine print. Waivers have limitations. They will not protect landowners from their intentional, malicious or grossly negligent conduct. Also, no valid waivers may be taken from minors, not even from the minor’s parent, guardian or conservator on behalf of the minors. A new statute found in Chapter 75A of the Texas Civil Practices and Remedies Code (CPRC) addresses some of the limitations regarding waivers for minors. Effective June 19, 2015, landowners may get effective waivers on behalf of minors from the parent, managing conservator or guardian before the minors enter the premises for educational or recreational purposes. These are referred to as “agritourism activities” in the new statute addressing “agritourism.” The guests are called “agritourism participants,” and the landowners the “agritourism entity.” The statute defines recreational activities to include activities associated with enjoying nature or the outdoors, such as hunting, fishing, swimming, biking, picnicking and boating (Section 75.001 CPRC). The statute describes two ways for landowners to secure protection. First, landowners may post and maintain a sign clearly visible on or near the premises where the educational or recreational activity occurs. The sign must contain the following language:

WARNING. UNDER TEXAS LAW (CHAPTER 75A, CIVIL PRACTICE AND REMEDIES CODE), AN AGRITOURISM ENTITY IS NOT LIABLE FOR ANY INJURY TO OR RESULTING FROM AN AGRITOURISM ACTIVITY. Alternatively, landowners may obtain a signed, written agreement and warning statement from the guests regarding the activity from which an injury may arise. The statement must contain the following heading and language: AGREEMENT AND WARNING. I UNDERSTAND AND ACKNOWLEDGE THAT AN AGRITOURISM ENTITY IS NOT LIABLE FOR ANY INJURY TO OR DEATH OF AN AGRITOURISM PARTICIPANT RESULTING FROM AGRITOURISM ACTIVITIES. I UNDERSTAND THAT I HAVE ACCEPTED ALL RISK OF INJURY, DEATH, PROPERTY DAMAGE AND OTHER LOSS THAT MAY RESULT FROM THE AGRITOURISM ACTIVITIES. The agreement must meet the following requirements. • It must be placed on or in a separate document apart from any other agreements between the landowner and participant. The statute implies the agreement can be included with a warning, consent or an assumption-of-the-risk statement between the parties, but the wording is ambiguous. • It must be printed in not less than ten-point bold type. • It must be signed before an adult participates in the agritourism activity. • If the participant is a minor, it must be signed by the minor’s parent, managing conservator or guardian before the minor participates in the activity. Because the statute makes no mention of landowners receiving protection for injuries or death to minors by posting warning signs on the premises, landowners would be wise to secure the agreement and warning statement from the entering parties when minors are involved if just one of the two procedures is used. The prudent practice would be to comply with both procedures. Likewise, even though the statute makes no mention of the signs or the agreement being in capital letters, it would be prudent to do so. Both appear in caps in the statute. The statute also mandates that: • agritourism includes displaying exotic animals to the public on agricultural land, • the risk of injury mentioned in the agreement and warning statement includes emotional stress, and TIERRA GRANDE

• Chapter 75A applies without regard to compensation. The statute does not give blanket protection to landowners. Landowners are still liable for an intentional injury or one that is proximately caused by the landowner’s negligence, evidencing a disregard for the participant’s safety (gross negligence). Likewise, landowners are still liable when they knew or reasonably should have known that a: • dangerous condition existed on the land, facilities or equipment used in the activity or • particular animal used in the activity had a dangerous propensity and the fact was not disclosed to the participant. Finally, landowners are liable if they fail to train employees involved in an agritourism activity or train them improperly. Disclosing or warning guests of dangerous conditions that are known or should have been known by the landowner regarding the land, facilities or equipment apparently does not relieve the landowner of any liability. The dangerous conditions must be corrected, not just disclosed, to avoid liability. What is so significant about the new statute? andowners may now secure waivers for minors. Before the statute passed, liability insurance gave landowners the only protection for minors killed or injured on the property. Landowners may now secure enforceable waivers for minors who come onto their agricultural land for educational and recreational activities for school, church, charitable or social events. Apparently, the parent, guardian or conservator do not have to be present. Likewise, the signature of one parent appears to suffice. The activity must be conducted on agricultural land. This is land suitable for growing plants and fruits for human or animal consumption or suitable for keeping domestic or farm and ranch animals for use or profit. The term premises, where the warning signs may be posted, includes the land, roads, water, watercourses and private ways. The term also includes the buildings, structures, machinery and equipment attached or located on the land, roads, water, watercourses and private ways. The new statute makes no reference as to how it interacts with the attractive nuisance doctrine. Chapter 75 of the CPRC, better known as the recreational guest statute, states that the attractive nuisance doctrine still applies to anyone under the age of 16. For more information on landowner liability, see Center publication The Texas Deer Lease.

JANUARY 2016

New Deed: Transfer on Death

s of Sept. 1, 2015, Texans have a new vehicle for transferring an interest in real property found in Chapter 114 of the Texas Estates Code (TEC). The new statute, better known as the Texas real property transfer on death act (TOD), represents a way to deed real property today but delay the transfer until the grantor dies. In the meantime, the grantor retains the right to revoke the deed at any time before his or her death. The new procedure avoids probate. To be effective, the deed must state the transfer takes effect at the grantor’s death. It must be executed with the same formalities as a regular deed and be recorded before the grantor dies. However, the deed requires no consideration and need not be delivered to or accepted by the grantee during the grantor’s lifetime. The deed cannot be executed on behalf of the grantor under a power of attorney. The statute details several ways to revoke the TOD including recording a subsequent instrument specifically revoking the TOD or recording another TOD to another person. Divorcing the grantee revokes the TOD as does transferring all interests in the property to another person prior to the grantor’s death. The deed has no effect on the grantor’s present interest in the real property. The TOD does not preclude the grantor from transferring or mortgaging the property. It will not trigger a due-on-sale clause, affect the rights of the grantor’s creditor or create any legal or equitable interests in the grantee. Grantees taking the property take subject to all matters of record at the time of the grantor’s death. For purposes of evaluating creditor’s claims, the TOD is deemed to have been recorded at the grantor’s death. Section 114.151 of the TEC contains a sample deed form. Section 114.152 contains an optional form for revoking a TOD.

RIP

Fambrough (judon@tamu.edu) is a member of the State Bar of Texas and a lawyer with the Real Estate Center at Texas A&M University.

THE TAKEAWAY Texas legislators dealt with a number of real estate related issues this year, ranging from nomenclature (salespersons are now called sales agents) to exactly what types of transactions require a real estate license.

Taxes

tax rules By Jerrold J. Stern

for

vacation home sales

acation homeowners may be interested in selling for a variety of reasons — lack of use, desire to buy a vacation home in a different location, or appealing investment alternatives, among others. Selling at a profit generally leads to taxation at favorable capital gains tax rates, ranging from zero to 23.8 percent depending on the size of the seller’s other income. However, selling at a loss produces a nondeductible personal loss unless the home is first converted to rental property. The rules for selling a vacation home used partly for personal use and partly for rental is beyond the scope of this article. Real estate taxes and mortgage interest are typically the only deductible expenses associated with personal residences and vacation homes. If the home is converted to rental property, however, additional costs are deductible, including a loss from its sale. Such costs may include maintenance and management fees. But there are major pitfalls to avoid. Vacation homes converted to rental property are subject to IRS review if the taxpayer is audited. The IRS and the tax court (if litigation occurs), perform a “facts and circumstances” analysis, meaning that each conversion is evaluated on its own merits. The IRS and the court ordinarily try to determine if the primary intent of the taxpayer is to create a rental property as illustrated in a 2015 tax court case involving Mr. and Mrs. Redisch. Five factors were reviewed: “(1) The length of time the house was occupied by the individual as a residence before placing it on the market for sale; (2) whether the individual permanently abandoned all

further personal use of the house; (3) the character of the property (recreational or otherwise); (4) offers to rent; and (5) offers to sell.” The Redisches purchased a vacation home in 2004 for personal seasonal use. The home never became their primary residence. They stopped using the home in 2006. The home was not used for any purpose from 2006–08. In 2008 and 2009, they tried unsuccessfully to rent it. They sold it in 2010 at a loss. The Redisches said they signed a oneyear contract with a realty company to assist in renting the property in 2008 but did not have a written agreement to show the court. Most of that company’s agents lived in the same community as the vacation home. he realty company operated an information center in the community providing information and tours to potential buyers and renters. The Redisches’ home was featured in the company’s portfolio of available properties. However, the court pointed out that there was no evidence the property was marketed to potential renters who were not already interested in owning or renting a property in that community. Two potential renters were turned away by the Redisches for several reasons. With no success in renting the property, it was listed for rent or sale in 2009 with another agent. The new agent included the property in a multiple listing service but never showed the property to potential renters. The property was shown to potential buyers. The property was sold in 2010 at a substantial loss. On their tax returns, the Redisches deducted various 2008–10 expenses along with the loss. They used

a paid return preparer for their returns. The court case does not indicate the preparer’s level of real estate knowledge or other details about the preparer. The court determined that the Redisches’ efforts to rent and sell the property were “minimal.” Also, the court considered the Rediches’ personal vacation use of the home to be substantial. Thus, the court decided that the property did not pass the necessary tests for conversion to rental property. All rental-related deductions on the 2008–10 tax returns (including the loss) were denied. Thus, the Redisches owed taxes and interest. Moreover, they had to pay a 20 percent accuracy-related penalty. The court viewed the underpayment of tax as being the result of negligence and disregard of tax rules and regulations. The use of a paid tax return preparer was no defense. To avoid the problems illustrated here, the Redisches could have obtained advice from a tax accountant or attorney knowledgeable in real estate matters before attempting to convert the vacation home to income-producing real estate. Dr. Stern (stern@indiana.edu) is a research fellow with the Real Estate Center at Texas A&M University and a professor of accounting in the Kelley School of Business at Indiana University.

THE TAKEAWAY Selling a vacation home at a profit will generally lead to taxation at favorable capital gains tax rates. A loss from such a sale is not deductible unless the home is converted to rental property prior to the sale. TIERRA GRANDE

ITâ&#x20AC;&#x2122;S OUR ANNIVERSARY

Helping Texans make better real estate decisions since 1971. Learn more about our history at https://www.recenter.tamu.edu/about-us/our-history/ JANUARY 2016