Money & Real Estate

A national commercial RE building boom is under way Since about 1990, I have been forecasting that no national commercial real estate building boom would occur before the next general economic recession sometime in the mid- or late-1990s. I thought the vast overhang of surplus space of all types created in the huge 1980s development boom would satisfy the nation's need for additional space without calling forth a lot of new building. But the surprising length and strength of this general economic expansion, now in its seventh year, have created conditions causing me to change that forecast. I believe that a new nationwide commercial real estate development boom is already under way in most of the United States, and it will intensify markedly in 1998.

This boom has been stimulated by three major factors. One is the continuous demand for additional commercial property space generated by the nation's still burgeoning prosperity. The U.S. economy is today in as strong and widespread a period of prosperity as I can remember -- one benefiting all regions simultaneously.

The second factor is that the resulting expanding demands for space have absorbed a large part of the vacant inventory created by the building boom of the 1980s and the overbuilt period of the early-1990s. Hence, vacancy rates in Class-A offices, industrial buildings, hotels and even some retail facilities have fallen low enough to cause widespread increases in rents of all types, compared to their levels in the early- to mid-1990s. These rising rents have in turn stimulated big increases in the market prices of both existing properties and vacant land zoned for commercial use. In weaker markets, such as New England, prices are rising at moderate levels. But in the strongest markets -- especially California's Silicon Valley -- rents have as much as doubled within the past year, and land prices have sometimes far more than doubled. Therefore, both rents and market prices of properties are surpassing the levels needed to make new development feasible.

The third factor is that commercial real estate markets -- like all investment markets in the United States -- are flooded with financial capital looking for something in which to invest. Loan-to-value ratios have been steadily rising since their rock-bottom levels of the early-1990s and are now in excess of 75% in many cases. Real estate investment trusts are raising large amounts of capital in Wall Street and almost frantically using it to buy properties so as to increase their total capitalized market values. This REIT "race to hugeness" is stimulated by many factors. The most important is the need for each REIT to get large daily stock transaction levels. That might persuade big financial institutions that they can buy stock in that REIT and have true liquidity if they want to sell a big block of that stock all at once. At the same time, expanding mortgage conduits are making capital available through commercial mortgage-backed securities channels at very low spreads over Treasuries. And pension funds and other large institutions are trying to offset the immense increases in their portfolio weighting in stocks caused by rising Wall Street values. So they are allocating more funds to commercial properties than they did when they withdrew from those markets right after 1990.

The result is that shrewd developers can "finance out" of new projects -- that is, raise more money from others than it costs them to build those projects. They usually cannot do so simply by borrowing over 100% of project costs, because most mortgage lenders are still more cautious than they were in the late-1980s. But mortgage funds can be supplemented by money from equity investors looking for higher apparent yields than they can get from buying existing properties. So many developers can once more undertake new projects without putting any of their own capital at risk. That will surely motivate many to undertake high-risk new projects.

These three conditions create an explosive mixture that is already leading to significant new developments in most U.S. property markets. The biggest relative degree of growth is occurring in retail markets -- largely because of technical changes in retailing (mainly the appearance of power centers and "big boxes") -- and in industrial space markets. But new office and hotel construction is well under way in many places too. Not all of this new development is purely speculative; much of it involves at least some preleasing. Yet the degree of speculative development is rising rapidly concerning industrial space and is beginning to appear more widely concerning suburban office space. Up to now, most speculative deals are leasing up quickly, confirming the optimism of their developers. But there is no guarantee that will last.

The true extent of this boom is not yet visible, because many more new projects are planned for 1998 than have been, or will be, built in 1997. If general economic prosperity continues at today's high levels throughout 1998, by the end of that year, the real estate cycle will be in the midst of another really big national development boom phase -- though probably not as big as the one in the mid- and late-1980s. Whether this new national boom will lead to another round of massive overbuilding and a subsequent collapse in rents and values remains to be seen.

Two important conclusions can be drawn from this situation for those who own existing commercial real estate or are about to develop more. The first is that any new projects should be launched only with extreme concern for possible overbuilding in the markets involved. Experience proves that, when motivated by conditions like those now prevailing, developers collectively will build far more added space than their markets require. That will occur even if each of them knows that the others are starting projects that will add up to an overall surplus. It is not ignorance of the behavior of the other developers that permits each to proceed with his or her own project. It is the basic optimism and egotism of all developers -- qualities necessary for their success -- that lead them to conclude their projects will succeed even if a general space surplus results and everyone else fails.

The second major conclusion is that this is a great time to sell existing real estate. The best time to sell is when everyone else is buying and building; just as the best time to buy is when everyone else is selling and no one is building. No one can reliably predict the exact point at which the present cycle of rising rents and values will reach its peak. So if you sell right now, you might predate the peak somewhat and "leave some money on the table" for the buyer. But that is a far better strategy than waiting until the market starts to turn down so you can be sure the peak has been reached. Then you will have to try to unload your property along with everyone else while values are falling -- and they can collapse mighty fast. So I recommend that all owners of existing property seriously consider selling it into this booming market before values reach their peak -- not afterwards.

Anthony Downs is senior fellow at the Brookings Institution, Washington, D.C. The views in this article are those of the author and not necessarily those of officers, trustees or other staff members of the Brookings Institution.

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