Institutional real estate investors confront the frayed-collar economy

Real Estate Issues, Dec 1995 by Rabin, Sol L

American real estate is beginning to surrender some of its secrets. Like the shadow on Plato's cave wall, real estate is the physical reflection of the needs and tastes of the American economy. Real estate has served as a lagging social indicator of short term trends, and now coincidentally, it is one of the leading indicators of long term fundamentals.

The thesis of this paper is that American society is undergoing a profound, deep and troubling long term transition from a middle income to a predominately lower income society. This transition erodes the value of some traditional forms of institutional real estate, but it also increases the economic viability of newer forms of real estate. White collar workers decanted into blue collar jobs lead to a "frayed-collar" economy, and institutional investors who now shun some of the newer frayed-collar product will embrace it in coming years.

This fundamental socio-economic shift is having and will continue to have profound impacts on American real estate, some of which today are all too visible to the naked eye. The Schumpaterian process of creative destruction has always been championed by the real estate community as obsolescence creates new profit making opportunities. Change is the only constant and major factor in earning real estate profits.

Income Trends

American households have not been winning the battle to keep median income growth ahead of inflation. Figure 1 shows the long term trend in real median family income measured in thousands of 1992 pretax dollars.(l) Added to the series are two piece-wise linear regression lines which illustrate two distinct periods--the Ozzie and Harriet years after 1947 and the Roseanne years after 1973.(2) From 1974 to 1994 real median family incomes increased at a modest 0.2% per year (despite the sizeable number of women entering the labor force). This slow growth trend, however, has been turbulent and filled with micro-cycle ups and downs. Note that over the ten year period 1985-94, real median family incomes increased and then fell back; that is, median family income in 1994 was about the same as it was in 1985 on a real basis! Without question, a new reality has set in since the early 1970s when competitive global pressures (especially from Japan and emerging Asia) destroyed millions of middle income jobs in automobiles, electronics, textiles, etc.).(3)

Household Distribution By Income Class

It is not a new observation that the middle income class is shrinking. But the extent of the change is not fully understood. Figure 2 shows three groups of four vertical bars, each of the three groups representing lower, middle and upper income households as a percent of total households, and each of the four bars representing years 1973, 1985, 1991 and 2000.(4)

Middle income households are on a down escalator shrinking from 53% of total households in 1973 to a projected 39% in 2000.(5) The results have been an increase in lower economic income classes from 39% to 49% over the 28-year period. What is emerging on the American landscape for the first time in half a century is a majority economic household class in the United States that is not the middle income but rather the lower income household.

The upper income group is modestly increasing market share (4%), the middle is losing sizable market share (-14%) and the lower income group is gaining (10%).(6) While income redistribution is an arresting subject, it does appear that the biggest and most important battle is preventing too many middle income households from stepping on the down escalator and not pushing a few upper income households onto it.

Federal Income Tax Shares

The polarization of incomes is even more dramatically shown in Figure 3 which illustrates for 1991 the percent of federal income tax returns filed by three economic groups (left cluster of bars) and the share of income taxes paid by each group (right cluster of bars).(7) A staggering 58.7% of the households contributed only 9.4% of income tax paid. This is in stark contrast to 6.1% of the households shouldering 46.8% of the tax burden. The middle income class at 35.2% of households contributes 43.8% of the income. This chart reinforces the concept that significant gains in U.S. income tax receipts would be dramatic if both lower and middle economic households were moved up the economic escalator. But it is not the long term trend, and economic miracles are difficult to execute.

Conclusions

Real median family income has barely increased in over 20 years (4.8% in total during that period). The middle income household class is shrinking and will not be a majority or dominate class in the future. There is substantial income polarization. These are very deep and long term trends which define the frayed-collar economy. Such trends make institutional investors nervous.

International And Domestic Polarization Comparisons

The previous section illustrated the dynamics of U.S. income polarization. Turning to cross-sectional data will allow comparisons between countries and metropolitan areas. A convenient method for showing income disparity is to compare the income earned by the top 20% of the households to the income earned by the bottom 20%: the higher the number, the greater the income polarization. The income inequality indices of 14 countries for 1994 are shown in Figure 4.(8)