The real estate industry is puzzled by the current disconnect between the excellent performance of properties owned and operated by real estate investment trusts (REITs) and the dismal performance of REIT share prices. This disconnect is caused by two major factors: One, is the shift of ownership of many real properties from developers who had long-term time horizons to stock market investors who have very short-term time horizons. The other is the sharp decline in the importance of commercial properties in the nation's overall asset portfolio.

Factors influencing real estate importance Two basic factors influence the importance of commercial real estate. The first factor is the average level of real incomes in the society as a whole. A basic principle of economics is that the higher the level of real incomes in a society, the more of all goods and services its members will demand. This principle applies to all forms of real estate and refers to the amount of real estate demanded and supplied in total.

The second factor is the current stage in the technological evolution of society. In early societies, nearly all long-term wealth sprang from the ownership and use of land. Therefore, most material wealth consisted of real estate. But as societies evolved technologically, they developed other means of generating wealth such as trading goods and services and later manufacturing goods. As these activities expanded to comprise larger and larger shares of the total activities within a society, the forms of wealth associated with them - machines, inventories, bank accounts - increased in importance in society's overall asset portfolio. Consequently, the relative importance of land in society declined while the relative importance of commercial real estate increased.

A more recent stage of technological evolution shifted the emphasis from goods to services. This further devalued agricultural land and factories, increasing the value of human skills, office buildings, specialized shopping centers, hotels and other services.

The most recent development has involved telecommunications services - computers, cell phones and the Internet - that leap over traditional space boundaries. This stage of economic development assigns high financial value to intangible elements that occupy very little physical space. Therefore, increases in the importance of these assets do not require increases in real properties. The values assigned to such assets have recently increased faster than commercial real estate values because of the rising importance of the former in society. This is reflected in the huge gains in stock prices in high-tech and Internet firms in the 1990s compared to recent declines in the stock prices of REITs.

Thus, technological and social evolution also increase demand for other types of assets faster than demand for real properties. Some examples are demand for education, financial services, computers and cell phones. The cost of producing those assets falls as they are more widely used. Rising demand increases their value and this decreases the value of other assets, including real estate.

Maturity and saturation reduces attractiveness This situation produces several outcomes adverse to commercial real properties. First, the supply of real properties in society does not grow as fast as the supply of newer types of assets. The reason is that most potential users of commercial real estate already occupy space. In fact, the total supply of real properties will probably not grow much faster than total gross domestic product, plus allowance for replacing obsolete inventories. An exception occurs when a new type of real property is invented, such as big-box outlets. In contrast, the supply of these newer types of assets grows much faster because their use is spreading to higher fractions of society. Therefore, commercial real property businesses do not grow as fast as businesses that produce newer types of assets.

Second, since commercial properties have been around a long time, innovations concerning their production and use do not occur as rapidly as innovations in industries producing new products. This means profit opportunities with existing properties are not as great as those connected to still-evolving, fast-growth products.

High supply expandability Another key factor affecting the attractiveness of commercial properties as investments is the ease with which additional supplies can be created. If a temporary shortage of some type of property appears, its local market price rises. That motivates developers to build more of that property type, which drives down the price of both existing and new properties. The cost of producing added properties establishes the long-run market price of both new and existing ones.

Commercial real estate is regarded by most local governments as fiscally profitable because it usually generates more local taxes. Hence, local governments compete with each other to attract such properties, regardless of the balance of supply and demand in the overall market.

Finally, the real estate finance industry is periodically flooded with investment money. When this happens the finance industry makes starting new projects easier for developers. This gives them an incentive to build additional space even if there is no market.

During periods of prolonged economic prosperity, local governments tend to make new real estate development more difficult. The fundamental institutional structures in which commercial real property markets are embedded - fragmented local governments and a periodically permissive set of financial institutions - create a tendency for markets to expand space, which limits long-run increases in the price of space. Commercial markets rarely generate enough excess demand to drive existing property prices far above space production costs unless there are strong governmental obstacles to new development. This limits the potential profitability of investing in commercial properties much more than the limits applicable to many other types of assets.

Evolutionary forces and institutional structures in American society have greatly reduced the importance of commercial real estate. These factors have decreased the attractiveness of investing in commercial property, compared to investing in other types of assets. These basic forces explain why the share price of REITs has declined, even though market performance of most REIT properties has been successful.