Market watchers look for possible signs of overbuilding As more and more commercial real estate markets swing into a genuine development boom in 1998, wise observers will start searching for signs of potential overbuilding. This article describes two signs to look for to help individual investors avoid possible disaster.
In most U.S. commercial property markets, 1997 has seen a transition from the gradual absorption phase of the three-phase real estate development cycle into a new development boom phase. The gradual absorption phase began around 1993 after markets had suffered through three years of the worst overbuilt phase since the 1930s. Since the overall economy came out of its short recession and started expanding in early-1991, we have had over six years of continuous economic prosperity. The resulting increases in space demand have gradually absorbed most of the vacant space created in the 1980s. So rents have recently been rising, and investors are bidding market prices of individual properties higher and higher -- often higher than the cost of creating new space. In addition, there is an immense amount of financial capital looking for something in which to invest other than stocks and bonds.
Under these conditions, more and more developers are launching new projects of all types. This is most evident in industrial and apartment markets, but is also spreading into office and hotel markets. (New retail space was being constructed right through the overbuilt period because of shifts to new forms of space -- power centers featuring big boxes.) Is it sensible to be creating more space now? The answer is often "Yes," because the economy's expansion is generating genuine demand for more space. Therefore, a shift in most markets from gradual absorption without much new building to a development boom featuring a lot of new construction can lead to solidly profitable projects.
As the boom proceeds, however, the question of just how far it should go will come up. When will new projects solidly supported by market demands be replaced by overly speculative development? I believe two specific indicators will provide strong clues to the answer.
The first indicator is the degree to which developers can "finance out" of individual projects. Under today's lending conditions, developers may not be able to "mortgage out" -- that is, borrow more than the total cost of the project. But they can get mortgages covering as much as 75% to even 85% of project cost, and then round up equity investment funds from other sources to cover the remaining costs. In some cases, this occurs when investors offer to buy out the developer's equity position before the project actually gets under way, or soon thereafter. The more developers who can thus launch projects without risking any of their own money, the greater the likelihood that they will be tempted to undertake projects not soundly supported by demand. This is most likely to happen among traditional individual developers who mortgage individual projects and then raise equity for those projects. But real estate investment trusts (REITs) can also "finance out" when they are easily able to raise fresh capital on the stock market by floating secondary stock issues or using private placements. And REITs are under immense pressures to expand their holdings, even when they cannot buy existing properties at decent going-in yields. Even if REITs are not able to finance out, there are enough private developers around to do so at a large enough scale to jeopardize the soundness of all new projects in a given market.
The second indicator is the degree to which developers create new space without preleasing commitments. Up to now, most new buildings in all but industrial markets have had at least some preleased space to genuine tenants. But more and more new buildings are being launched by developers without any advance leasing, on the presumption that the market is so tight that someone will show up to rent the space before the project is done -- or not long thereafter. This presumption is still holding true in many markets. But I believe there will be a flood of new projects in 1998 that will make this presumption less and less valid by the end of 1998. Therefore, savvy investors will keep track of the amount of preleasing on all new projects in their markets -- especially those potentially competitive to their own properties.
Some people believe that the information about what is happening in space markets is much better today than it was in the 1980s, thanks to pressure from Wall Street analysts demanding more facts about REITs. Therefore, no one will be foolish enough to overbuild markets as they did in the 1980s. But it was not ignorance of market conditions that caused the massive overbuilding of that decade. No, the cause was financial incentive structures that rewarded lenders for putting out more money and developers for starting more projects -- regardless of their true feasibility. We may come perilously close to duplicating that situation by the end of 1998 if the economy keeps booming along and there is no big crash in stock prices. So keep your eyes on those two indicators, and behave with caution as 1998 progresses. *
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.
* The degree to which developers can "finance out" of individual projects. * The degree to which developers create new space without preleasing commitments.