Niagara of Capital

The flood of investor capital that has been flowing into all types of real estate in the United States since 2000 has continued almost unabated through the first quarter of 2006. This wave even includes money invested in residential housing by households and home builders.

Though most economists forecast that housing construction and prices would slow down this year, new home construction has remained high in 2006 despite slowing activity in home sales markets, mainly at the highest-priced end. It now takes longer to sell costly homes than it did six months ago, and the inventory of unsold houses at all levels has built up as more owners seek to “cash in” on high prices.

But investors continue to seek commercial properties of all types. Lawyers specializing in real estate transactions are swamped with business. True, the frenzied competitive bidding for investment properties that prevailed a year ago has calmed down. Even so, there is a lot of interest among investors in acquiring well-occupied properties, and among opportunity funds in acquiring not-so-well-occupied properties at what they hope are bargain prices. But there are few signs of price declines in commercial property markets.

Improving fundamentals

The one big change in those markets is that the expanding U.S. economy has improved space-market conditions for all types of commercial properties. Even Silicon Valley, once overloaded with 44 million sq. ft. of available space, is now experiencing rising occupancy rates and even some increases in rents.

CB Richard Ellis reports that the national downtown office vacancy rate in 52 markets in the first quarter of 2006 registered 12.3% compared with 13.8% a year ago. The suburban office vacancy rate finished the first quarter at 14.3%, down from 16.3% one year ago. Six downtown office markets posted single-digit vacancy rates (Charlotte, Honolulu, Midtown Manhattan, Orlando, Tucson, and Washington D.C.), as did seven suburban office markets (Ft. Lauderdale, Honolulu, Miami, Nashville, Orange County, Orlando, and San Diego). There's more good news: CB Richard Ellis also reports that the national industrial vacancy rate in the first quarter of 2006 registered 9.9%. That's up a tad from 9.7% in the first quarter, but near the lowest point since the stock market crash of 2000.

Construction boom

In past real estate cycles, a prolonged combination of plentiful capital and improving space-market conditions has typically led to a boom in new construction. I have been predicting that this would happen in this cycle, too — but only if the extraordinary flood of capital into real estate continued. That flood has driven prices of existing commercial properties so high that some new developments promise to offer higher yields — despite recently soaring construction costs.

There are some signs that such a new development boom phase may be starting in this cycle. CB Richard Ellis data shows that new suburban office construction escalated in the last two quarters to 5.9 and 5.4 million sq. ft. respectively, though downtown office building remains relatively low. Meanwhile, a building spree is taking place in the industrial sector. New industrial construction totaled 28 million sq. ft. in the second quarter of 2006.

The impact of the massive inflows of capital into real estate is clearly visible in Federal Reserve Board Flow of Funds data on household balance sheets. Whereas the total value of corporate equities held by households (and non-profits) is still 8.6% below what it was in 2001, the total value of real estate assets held by households at the end of 2005 was 58.4% higher than in 2001. As a result, real estate has moved from 30.7% of all households' net worth in 2001 to 38% in 2005.

In contrast, corporate equities have fallen from 16.5% of household net worth in 2001 to 11.7% in 2005. At the end of 2005, real estate was 3.2 times as great as corporate equities on household balance sheets. Of course, most of this improvement in households' real estate holdings has been in the form of equities in their own homes.

But some of this increase in household real estate holdings also reflects greater investments by ordinary citizens in commercial properties of all types. And that does not include increases in their pension fund reserves, which rose by $2 trillion from 2001 to 2005. Much of those pension fund gains also occurred in the form of more valuable real estate assets.

Altogether, the “Niagara of capital” that has stormed into world real estate markets since 2000 has hugely expanded the importance of real estate in the lives and asset structures of American households and corporations. True, this inflow cannot continue forever at its present fabulous levels. But as long as the money keeps coming in, real estate will keep benefiting tremendously.

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].

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