As the current economic expansion moves ahead in 2005, the key issue for real estate is simply this: Will the normal relationships between overall economic activity, demand for space, increasing demands for money, and rising levels of new property development prevail as in many past cycles? Or will the unusual current flood of capital into real property markets cause different cyclical outcomes?

In the normal business cycle, as the economy moves out of a recession into strong overall expansion, growing levels of business activity raise demand for both money and space. This dual increase puts upward pressure on both interest rates and occupancy levels in office, retail, hotel, and industrial space. Rising interest rates, plus still-high vacancy rates and still-low rental rates, continue to inhibit construction of new commercial real property. In addition, investors are drawn away from real estate into competing asset forms, especially stocks of successful companies.

These conditions produce what I call the gradual absorption phase of the three-phase real estate cycle. Vacancies are falling and rents are stable or rising, but neither have moved far enough to justify new development, especially since interest rates are rising along with more investment competition from stocks.

However, as the general expansion accelerates, increased competition for existing space drives vacancies lower and rents higher. Eventually, these changes stimulate developers to initiate new construction projects, in spite of higher interest rates. This begins the development boom phase of the cycle. New projects are started across the nation just as the overall business cycle peaks. The resulting expansion of available space, combined with a slowdown in economic activity, eventually generates the next overbuilt phase just as the general economy goes into a recession.

Mending space markets in '05

Most commercial markets are in the gradual absorption phase, with high levels of vacancy declining and rents stabilizing. CB Richard Ellis reports that the downtown office vacancy rate dropped slightly to 14.4% in the third quarter of 2004, compared with 14.5% in the second quarter, while the national industrial vacancy rate was unchanged at 11.2%. Yet, both office and industrial vacancy indices are more than double the low rates they attained in late 2000.

As a result, as of late 2004 new office construction was 75% less than what it was in 2001 and early 2002. New industrial development is also well below its 2001 levels. Yet, one condition is remarkably different compared to most past real estate cycles. The demand to buy well-occupied real properties of all types remains abnormally high because of the flood of money going into real property investment.

Well-qualified experts like Ken Rosen of the University of California predict this situation cannot last. He claims rapidly rising interest rates will soon make real estate seem less attractive and cause values to fall, especially REIT stocks, which he believes are overvalued. But other observers think so much money is still trying to invest in real properties that the Federal Reserve's attempts to raise long-term interest rates, which have initially failed, will not soon dampen investor enthusiasm for real estate.

Nothing lasts forever

My own view is that demand for property will not collapse unless the stock market takes off more sharply than seems likely. Sufficient uncertainty remains about world economic conditions to inhibit investor enthusiasm to plunge into stocks. Also, underlying property market conditions are slowly improving, supporting positive investor attitudes toward real estate.

In addition, this flood of money has not stimulated a massive move into new property development, which in the past would have resulted if funds were available so easily. Finally, the ability of real estate to pay cash incomes substantially higher than most stocks or bonds makes property increasingly attractive to pension funds facing rising payouts and retiring baby-boomers needing good incomes.

Consequently, I do not foresee any near-future collapse of real property values, except in some condominium housing markets where speculative purchasing could lead to a sudden shrinkage of occupancy. Yet, today's huge investor appetite for properties makes this an ideal time to sell real estate. These unusual selling conditions will not last forever. As time passes, they are increasingly susceptible to some unforeseeable external shock.

Moreover, the Fed's desire to raise rates, combined with increasing expansion in the overall economy, will surely increase rates in 2005. If present favorable borrowing conditions continue, more developers will be tempted to start building new projects that lead to another development boom phase. That would undermine improving space-market conditions, as it has so often in the past, and eventually dampen investor demand for properties. So, make hay while the sun shines now.

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.