Real estate and the 'new' business cycle

The surprising length of the current general economic recovery -- now well into its seventh year -- has raised two fundamental issues about the basic nature of the American economy. The first issue is whether the traditional business cycle has been replaced by some new form of economic growth. The second issue is whether continuous inflation has ended and an era of zero inflation or even potential deflation has begun. This article focuses on the business cycle issue as it relates to real estate.

Some observers believe that several changed factors have created "a new paradigm" for the American -- and world -- economies. These factors include intensified global economic competition, the end of the Cold War, the triumph of market capitalism over all forms of socialism and communism, the downsizing of Corporate America and the consequent loss of job security among workers at all levels, the inability of central banks to control the exchange values of their own currencies in the face of immense volumes of foreign exchange trading, the ability of large international corporations to shift production to the lowest-cost locations anywhere, rising productivity due to computers and other new technology, and the tremendous mobility of financial capital around the world. As a result, the traditional business cycles of about three years of expansion followed by six months to a year of recession are no longer dominant. Instead, economic expansions - including rising stock prices -- can continue for almost indefinite periods, perhaps interrupted briefly by very short and shallow recessions.

How do these factors produce such a radical change in economic conditions? First, they reduce the linkage between high-level prosperity and rising inflation. In the past, when the economy enjoyed a sustained expansion, competition for workers drove wages up. Also, product shortages and bottlenecks would permit firms with some monopolistic market power to raise prices. But global competition and increased job insecurity prevent workers from demanding higher wages even when unemployment falls to very low levels, as it has recently. Also, increased product competition, including the entry into world markets of millions of former communist firms and workers, reduces the ability of American firms to raise prices. So our economic expansions can last much longer without causing significant inflation. Consequently, the Federal Reserve does not have to step into the midst of long expansions to cool off "economic overheating" by putting on the monetary brakes through higher interest rates that stop the expansion and start a recession.

Furthermore, central banks have less power to intervene in economic affairs than formerly. No central bank has enough capital to reverse strongly launched exchange-rate trends among private traders. And central banks have less ability to control the effective domestic money supply when so many types of "near money" are constantly generated by financial markets.

Because central banks have less need to intervene to slow down economic expansions, and less ability to do so effectively, such interventions are much less likely than in the past. Therefore, a general economic expansion can continue almost indefinitely, in the absence of some external shock such as the oil price increases of the 1970s. At least this is the view of many of the "new paradigm" advocates.

However, this argument has a fatal flaw: It ignores the potential role of commercial real estate in halting general economic expansions.

During recessions, commercial property markets are normally in the overbuilt phase of the three-phase real estate cycle. They are suffering from excessive space created in the preceding development boom phase. The general recession also causes growth in the overall demand for space to slow or stop just as the lot of new space created in the preceding development boom comes onto the market. This causes vacancies to rise, rents to stabilize or fall, property values to decline and new construction almost to cease.

But then the general economy starts expanding again, and demand for space gradually begins to grow. This pushes commercial property markets into the gradual absorption phase of the cycle. Vacancies decline as empty space is absorbed, so rents stabilize and eventually begin rising. At first, rents remain below the levels needed to make new construction possible; hence little new building commences. As space demands accelerate, space markets tighten and both rents and vacancies rise sharply, causing property prices to rise too.

Eventually rents reach levels that make new development profitable, and a new development boom phase begins. This normally occurs right at the peak of the general business cycle expansion. New building starts slowly at first, but it accelerates sharply if capital suppliers are overloaded with investable funds looking for someplace to go. That is occurring today because a lower federal deficit has increased the U.S. economy's overall savings rate, corporate profits are high, and foreign central banks -- especially in Japan -- have vastly expanded their own money supplies.

If this condition of financial surplus is sustained long enough, strong pressures exist on financial institutions to put their money out somewhere. As a result, new building overshoots even growing demands for space, causing substantial overbuilding. Such overbuilding weakens the profitability not only of newly created properties, but also of long-established ones, because the former compete strongly against the latter by cutting rents to fill up their empty spaces.

Thus, a combination of sustained general prosperity -- which increases demands for space of all types -- and high levels of capital availability -- which motivate capital suppliers to overinvest in new development -- almost automatically creates excesses of space that undermine the financial viability of all commercial properties, both old and newly developed. If this situation goes on long enough, the financial institutions that supplied the capital for overbuilding are seriously injured by defaults by borrowers. In the past, this has caused financial regulators to step in and halt further credit extensions by those institutions, including banks, savings and loans, and insurance companies. New development suddenly comes to almost a complete standstill, thus slowing economic growth, which had come to depend significantly upon the construction sector and its related industries. In 1974 and 1990, such sudden slowdowns in real estate development precipitated general recessions.

To put it another way, sustained general prosperity -- assuming it is accompanied by huge amounts of capital available in financial markets, as is happening now -- will lead to a serious overbuilding of commercial properties that will in itself cause that prosperity to slow down, perhaps enough to cause a recession.

Some observers -- especially in Wall Street -- argue that the shift of so much commercial property into real estate investment trusts (REITs) will change this situation. They claim that public capital markets will not continue to finance new development once overbuilding initially appears -- as banks and insurance companies repeatedly did in the past. Therefore, new development will not overshoot actual demands, as it has so often in the past. However, I am skeptical of this conclusion. REITs are under tremendous pressures to keep growing larger. Therefore, competition among them to buy properties tends to drive property prices so high that yields become too low -- as is now happening in many property markets. Then REITs will turn to new development as the only available way to keep growing with apparently satisfactory yields. In reality, their higher apparent yields from new development reflect the higher risks involved; hence those yields are not truly higher in a risk-adjusted sense. Yet most investors in REIT shares will not be well enough informed in advance of the resulting overdevelopment to prevent it altogether.

This analysis indicates that all the new factors described earlier have not eliminated the inherent tendency of the American economy to limit its own overall expansion by overbuilding its commercial property markets. Therefore, the "new paradigm" that denies the basic cyclicality of the general economy is wrong. The general business cycle is not dead because the real estate cycle will keep it alive.

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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