In the past, whenever financial capital has inundated commercial real estate markets during the expansion phase of a business cycle, developers started creating a lot of new space. That normally launched the development boom phase of the three-phase real estate cycle: the development boom phase, followed by the overbuilt phase, followed by a phase of gradual absorption of excess space.

U.S. commercial property markets are still swamped with financial capital seeking real properties. Yet, there doesn't seem to be much evidence that a new commercial development boom is starting.

The absence of a commercial boom can be seen from two data sets: the rate of new construction of industrial and office space, and vacancy rates. An accompanying chart shows the amount of new space generated in each quarter beginning in early 1999 and continuing through the first quarter of 2006.

The construction of industrial space has outpaced office construction in most of this period. In 1999, industrial developers launched over 25 million sq. ft. per quarter (except for a slight dip in late 1999) and that trend continued through the second quarter of 2001. After that time, due to the stock market collapse in 2000 and the terrorist attacks on 9-11, industrial construction dropped more than 50% and hovered near 10 million sq. ft. per quarter from 2002 halfway through 2004. Then industrial development soared again in 2005.

In contrast, new suburban office construction stayed high until mid-2001, then plunged to very low levels and has not recovered much to this point. New downtown office construction started out low in 1999 and has remained low.

Persistent vacancy

One major reason that there hasn't been a development boom is that vacancies in the office and industrial sectors have remained high in relative terms. In the first quarter of this year, suburban office vacancy in the metropolitan regions tracked by CB Richard Ellis remained at 14%, downtown office vacancy at 12%, and industrial vacancy at 10% — all above their levels in 1999.

What's clear is that the recession of 2001 didn't hurt the property markets nearly as badly as in past downturns. Peak office vacancy rates in 2004 were well below the scary levels set in 1990 when the market tanked. What's different this time around is that the rate of improvement has been more gradual.

In some locations, however, office vacancy rates fell to under 10% in the first quarter of 2006. Among those markets are Orange County, Calif.; Midtown Manhattan; Palm Beach County and Ft. Lauderdale, Fla; San Diego; Orlando; Honolulu; as well as downtown Washington, D.C. The unhappier end of the scale includes markets such as Detroit, San Jose, Louisville, Hartford, Austin, Cleveland, Dallas, Columbus and Cincinnati — all above 20%.

Other limiting factors

There are several other reasons no development boom has started. First, construction costs have soared as Chinese and other foreign demand pushed up prices for cement, steel, and oil. Also, rising interest rates increased borrowing costs. Another factor is the escalating cost and great scarcity of available land in many dense cities, such as New York City and San Francisco.

The entitlement process to build high-rise buildings in any major city has also grown more difficult. A final factor is that much developer energy has gone into the residential building boom, which has also driven up construction costs.

Yet two positive factors are creating pressure on developers to think hard about starting new construction projects. One is the immense availability of financing as investors from all over the world pour cash into American real estate. The second positive factor is that competition among investors has driven prices of existing properties so high that yields have fallen to record lows, with cap rates in the 4% to 5% range.

If an investor cannot achieve a decent yield from buying existing buildings, the thought soon occurs to him that he might do better creating a new one. The temptation to build will become stronger and stronger, the longer the current excess supply of investor funds remains in place. True, up to now, there is no real sign that a new development boom is about to appear, but real estate operators should keep their eyes open just in case.

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 anthonydowns@csi.com.