COMMERCIAL OFFICE, INDUSTRIAL AND research property markets are experiencing highly paradoxical conditions. On one hand, the fundamental balance of supply and demand for space is extremely unfavorable. This is particularly true in high-tech markets such as Silicon Valley, San Francisco, Boston, and Austin, Texas, where vacancy rates have soared from the minuscule levels of early 2000 to as high as 15% or more in early 2002. Leasing activity is sluggish because few firms need more space while most need less. The latter companies are flooding markets with sublease space.

On the other hand, for properties fully leased at favorable rents, market demand has been strong with property prices on the rise. The stock prices of REITs have also been driven upward while the rest of the stock market has stumbled.

“Rarely has market demand for a lot of real properties been so strong when basic conditions in property markets were so weak,” says Tom Nolan, president of AEW Partners Funds, a player in the above markets.

Hungry investors

The main reason for this paradox is that recent investment yields have been so low on stocks and bonds that the steady, positive yields on real properties that are well occupied look very attractive to cash-laden investors. Shares of well-run REITs also are attractive. The Federal Reserve policy of combating the recession by cutting interest rates has reduced bond yields.

Yield-hungry investors looking for a way to obtain decent returns have shifted a lot of money from stocks and bonds into commercial real estate, which often produces yields of 8% to 9%. These trends have helped stabilize or even raise prices on many well-occupied properties in spite of adverse real estate conditions.

This incongruous situation only applies to properties with high enough occupancy rates to produce steady net incomes. Investors are avoiding properties with high vacancy rates because such properties do not produce competitive yields. Moreover, potential buyers cannot obtain loans on properties with high vacancy rates because capital suppliers are leery of such risky collateral.

This paradox is occurring within property markets that are experiencing unusually low levels of both leasing and sales transactions. Buyers are deterred from making offers because there is uncertainty about the true value of properties that have high vacancies. Property owners are deterred from selling by similar uncertainty.

This situation differs markedly from conditions in 1990 and 1991. At that time, owners of similar high-vacancy properties were mainly developers that had heavily mortgaged those properties. High vacancies forced them to default on their loans, leading to foreclosure by banks and insurance companies. Those properties were then sold to high-risk investors — so-called “vulture funds” or “opportunity funds.” Those funds sold the properties after the general economy became strong enough to improve property market conditions. Transaction levels also were quite low initially in the 1990-1992 recession.

A market shift

Today, many owners of troubled commercial properties are REITs with much lower leverage than traditional developers, and hence not under much pressure to default or sell. The other predominant owners are large firms that have been using the space themselves and pension funds. Many large firms have shrunk their operations because of the recession and the collapse of dot-com and telecom markets, but they still occupy the resulting surplus space. In some cases, they have put such space on the sublease market. Many companies simply are sitting on more space than they need because they cannot see any easy way to convert the vacant space into income or cash.

However, no one has reliable data on how much surplus space such firms really have. This contributes to the general uncertainty that inhibits both buyers and sellers from making deals. Also, the fact that so much surplus space is in the hands of large firms or investors not facing bankruptcy reduces the pressure on owners to sell, as compared to the foreclosures in the early 1990s. These are other factors keeping the number of transactions abnormally low.

How long will this paradoxical situation last? One way it could end is by the return of economic prosperity. That would eventually expand space demands on the one hand, and raise interest rates and stock prices on the other, thereby attracting more investors away from real estate back into stocks and bonds.

If yield-seekers shifted capital away from real properties as yields on alternative yields rose, the upward pressure on property prices would diminish, and such prices might fall.

True, this change would be offset somewhat by falling vacancy rates as demands for space rose. Yet vacancy rates are now high enough so that even expanding space demand will not create much upward pressure on rents and prices for at least two years, and perhaps longer.




Anthony Downs is a senior fellow at the Brookings Institution in Washington, D.C. The views are those of the author and not necessarily those of officers, trustees or other staff members of the Brookings Institution.