Because the current general economic expansion has gone on so long, some observers are becoming concerned about potential overbuilding in commercial property markets. However, proponents of the "new real estate economy" argue that the importance of Wall Street funding in present property markets makes overbuilding a thing of the past. This column discusses which of these two views is most correct.
The traditional view As my readers know, I believe there has long been a three-phase real estate development cycle. The development boom phase typically begins when the economy in general is at the peak of an expansion, as we seem to have been for the past two years. In the current real estate cycle, we have been in a development boom since about mid-1997.
Normally, much of the new space begun in a development boom takes at least two years to come onto the market. Meanwhile, the general economy goes into a recession, which slows growth in demands for space. The result is the overbuilt phase. Our last overbuilt phase was from about 1990 to 1993.
After the recession in the general economy bottoms out, the economy begins expanding again. Gradually demands for more space soak up existing inventories. Yet new construction does not begin immediately because rents are still too low to justify development. This is the gradual absorption phase. Our last one lasted from about 1993 to 1997.
We have now been in a development boom for almost three years in some markets. In the past, three traits normally caused development booms to generate overbuilding: one, the willingness of developers to keep creating new space as long as they could get full financing; two, the eagerness of lending institutions to put their funds to work; and three the long lead times for many development projects. In other words, developers who began projects when markets were booming might not be able to get the space onto the market until those markets had cooled off.
Traditionalists assume this outcome is still a possibility. Developers are creating new space of all types all over the nation, with a few exceptions like the Boston office market. However, demands for space are still rising, so vacancies are not soaring. True, in the third quarter of 1999, suburban office vacancy rates rose in 56% of the markets tracked by CB Richard Ellis.
Those rates were still relatively low, and downtown office vacancy rates declined in more than half of those same markets. If the general economy turns down, a lot of space being built will soon create the usual overbuilt situation.
The "new Economy" view Another view is that serious overbuilding cannot occur again for four reasons. First, real estate lenders of all types have learned a bitter lesson from the 1980s and early-1990s, and will not overextend their activities again. Banks and insurance companies are being more cautious about requiring developer equity than they were in the late-1980s. Second, several irrational factors no longer exist, including the savings and loan industry's entry into commercial lending, Japanese and other overseas lenders using cheap foreign capital, and tax-driven investors spurred by the Tax Act of 1981.
Third, more complete information about real estate market conditions is now available to developers, lenders and investors. REIT stock analysts are now publishing much more data about what each REIT is doing and about specific markets, and development firms are pressured to provide a lot more data on their own activities.
Therefore, developers are much less likely to start projects in markets that already have plenty of space available - or soon will have it.
Fourth, REITs and CMBS now play a much greater role in funding commercial real estate development, and they draw their capital from Wall Street investors. Those investors are reluctant to extend funds to REITs planning new development in markets ripe for overbuilding. This is illustrated by the sudden withdrawal of Wall Street funding from real estate development in the fall of 1998, as part of a global credit crunch.
Which view is correct? In my opinion, each of these views is partly correct. Developers are still prone to overbuild if they can "finance out," despite more information. It was not ignorance of market conditions that caused massive overbuilding in the 1980s, but the egotistical view of each developer who thought he could capture a huge share of the available market because of the superiority of his project. Such self-confidence is a necessary trait of every successful developer's personality, because development requires overcoming the world's resistance to anything new.
Today's developers are just as egotistical as past ones. In addition, long lead times for certain types of projects are still with us. Finally, lenders are still under pressure to make deals.
On the other hand, there is more caution than in the 1980s among traditional real estate lenders, and Wall Street has been very reluctant to provide more capital to REITs lately. These factors make it harder for developers to flood markets with excess space. Finally, the persistence of this general economic expansion appears to have deferred any general recession for a while longer.
My conclusion is that overbuilding is still a potential problem, so both developers and investors should be cautious about starting new projects today - especially projectswith long lead times, or no pre-leased space. However, any overbuilding that occurs in the year 2000 will be much milder than that which occurred in the late 1980s.
Moreover, since a general recession seems unlikely in 2000, continued growth in space demands will mask near-future overbuilding for a while. Overbuilding in 2000 will be more localized than national in scope. It will begin to appear in some locations and markets - so be warned!