In the past 10 years, the American real estate market has been stimulated by massive inflows of financial capital from around the globe. That influx of capital led to soaring prices for housing and commercial properties, which in turn compressed cap rates on the latter. Nothing lasts forever, as the recent downturn in the housing market proves.
I believe that new housing construction will slow down even more in the next year. That will cut consumption and reduce the overall growth rate of the U.S. economy somewhat, but most likely not enough to cause a recession — certainly not in 2007, and probably not in 2008.
Although interest rates in commercial property markets are rising somewhat, making borrowing more expensive, there is still a lot of investment capital looking for a home. Much of the money that moved into real property after the stock market crash of 2000 will stay there because global investors recognize the desirability of real estate as an asset class.
It is true that if the non-real estate parts of the stock market were to soar in value, a lot of money that fled from stocks into real estate would return to stocks. But a lot would still remain in real estate, too.
Blessing and a curse
The tremendous inflow of capital into commercial real estate has in some respects undermined its continued attraction as an investment. As competition among investors drove prices of existing properties up and their yields down, more investors began to consider building new properties rather than buying existing ones.
Investors today believe that they can get higher initial yields from new and “greener” — or more high-tech — properties than from older, existing ones that have become technically obsolete. This trend could start another new development boom like those that have ended so many real estate cycles in the past.
Why has no new development boom appeared up to now? For one, vacancy rates in the office and industrial sectors have remained relatively high. Construction costs also have been driven to unusually high levels by strong demand for concrete, steel, and wood from China and other nations. Lastly, information about what new projects are under construction or proposed has become readily available.
Still, a continuing oversupply of capital in commercial property markets may keep borrowing relatively cheap, if interest rates do not rise significantly. If so, that would encourage investors to put their capital to work funding new property developments to get higher yields.
The Federal Reserve did cut the fed funds rate and discount rate by 50 basis points each in September, and has been pouring liquidity into the system. But it did so because problems with subprime mortgages caused nearly all lenders to wake up to the reality that they have been underestimating the risks of their loans and insufficiently underwriting them.
The Fed's action was designed to restore more certainty, and therefore liquidity, in credit markets, but interest rates are still likely to rise somewhat. Even so, there is still plenty of money out there looking for something in which to invest. That is why a boom in new development is still possible once greater calm is restored in the credit markets.
If such a boom continued for several years, it could create enough new property to depress existing and new space markets by increasing vacancies and putting downward pressure on rents of all properties. That would reduce the relative attraction of investing in all commercial properties compared with investing in non-real estate stocks and bonds, assuming they get more attractive.
Subprime scare overblown
The August-September turmoil in the debt markets, though notable, has been deliberately exaggerated by Wall Street interests who tried to pressure the Federal Reserve to bail them out of their self-inflicted subprime-related problems.
If that turmoil is sustained enough to cut off cheap debt for a prolonged time, little new development will occur. It is true that Wall Street has lost a lot of jobs, as has the housing industry. But economies in the rest of the world are doing better than they have been for a long time, and that will help counteract lower consumption in the U.S. economy.
If the credit markets regain a more realistic perspective and calm down, the existence of a lot of surplus capital looking for somewhere to go could keep borrowing costs low enough to generate a major commercial development boom.
Such a scenario could affect all commercial properties, including existing ones now selling for high prices that would not survive a big wave of development.
Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at [email protected].