Shaky ground?

In my February column, I said prices, rents and occupancy in most commercial property markets had already peaked and were either stabilizing or trending downward. This transition has occurred even faster than I anticipated, especially in markets heavily influenced by the dot-com and Internet industries.

The collapse of stock prices on the Nasdaq has made it almost impossible for several firms in these industries to raise more capital to finance their continuing expenses in the face of tiny revenues and negative profits. Hence, many such firms have had to cut back on the amount of space they occupy, and quite a few have gone broke.

The result is a sudden drop in the demand for space in office and industrial markets heavily dominated by high-tech firms in general, and by dot-com and Internet firms in particular.

San Francisco feels the pinch

This shrinkage of space demand has been most drastic in San Francisco's South of Market Street area, and significant within many parts of Silicon Valley itself. Because vacancy rates for Class-A space were so low in both these areas, and in many other high-tech-dominated markets, even absolutely sizable declines in demand will not cause vacancies to rise to anything like the very high levels they reached in the late 1980s. Moreover, office rents have dropped much more sharply than vacancy rates have risen. Some other high-tech markets — such as Washington, D.C., and Boston — have been less dramatically affected, but they too will feel some pinch soon.

Office rents will be affected more than occupancy. That's because in the super-heated markets, where occupancy had risen about as high as it could get, rents had zoomed by even greater percentages. After all, occupancy cannot exceed 100%, but there are no theoretical limits on how high rents can go — at least at the margin — when competition for space is intense.

So, some office rents in downtown San Francisco exceeded $100 per sq. ft. at the peak. Rents at those levels have already disappeared at the margin as the pressure for space has slacked off considerably. However, in the markets where rents had risen most, the current drop will not render most existing properties unprofitable, even when tenant turnover occurs.

The sublease factor

Another trend is that the sublease space market has been flooded with space being offered at rents undercutting most now-vacant space, especially in new buildings. Firms that had already signed leases, but have been forced to cut back on expenses, are shrinking their own use of space and trying to recapture revenues by renting some of their space to others.

The amount of such sublease space is hard to measure, but it is bound to depress the level of rents in normal space markets. This situation is going to appear in all types of office space markets as the economy slows down, not just in high-tech dominated markets.

How far will rents and occupancy fall? The answer will differ from market to market, depending upon two factors: one is the overall drop in high-tech business volume in this general period of economic retrenchment; the other is the degree of concentration in high-tech space occupancy in each particular market.

If the overall economic shrinkage is relatively mild, as most economists are forecasting, then office markets will not return to anything like the high levels of vacancy, depressed property values and rock-bottom rents typical of the early 1990s. Even if we encounter a significant recession, I do not believe space markets will revisit those terribly adverse conditions because there is only relatively mild overbuilding today.

Contrarian play?

Another change in the current situation of commercial real estate is its improved value as an investment relative to the stock market, in spite of falling occupancy and rents. Real property values have not yet dropped very much, and none have fallen anywhere nearly as dramatically as Nasdaq stock prices, with the Nasdaq index down from its peak by over 50% at the time of this writing.

Since the widespread fall in stock prices in late 1998, I have said that REIT share prices would not recover significantly until the soaring values of high-tech stocks took a nosedive, because real estate looked so much less attractive as an investment than those stocks. Now that such a nosedive has occurred, REIT shares have done a lot better in the past year. Their ability to pay significant dividends adds to their relative attraction.

Yet so far, there has been no real institutional “rush to real estate” as an investment, partly because of the way that many institutional investors decide how to allocate funds. When stock prices fall sharply but real property prices do not, the percentage of a fund's total capital invested in real estate rises, thereby putting it out of balance with depressed stock prices. This equation motivates many institutions to reduce their allocation of capital to real estate precisely when its performance has dramatically improved compared with the performance of stocks. Investors not mentally imprisoned by such rigidity over allocations should now consider raising their allocations to real property, even though rents and occupancy are currently in a period of decline.

Real estate is a safe investment

The real issue is not whether conditions are getting worse in real property markets — they are — but whether they are getting “less worse” than those in the stock market. It is at least plausible that the downside value potentials in commercial property markets — where there are few major oversupply imbalances — are smaller than the downside value potentials in many other industries represented in the stock market. In many high-tech industries, the overcapacity has reached huge proportions.

True, commercial property is a mature industry and does not have the very long-term expansion potential of many high-tech industries. But in the medium-term, where fortunes are made and lost, commercial property looks like it might be a safer and more rewarding place to put capital than many sectors of the stock market.

Anthony Downs is senior fellow at the Brookings Institution in 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. You can contact the columnist directly through e-mail at [email protected] .

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