Skip navigation

Is it time to start speculative building.

In real estate markets across the nation, developers are starting to ask themselves: Is it time to start speculative building again? In more and more cases, they are answering, "Yes!" concerning apartments, industrial buildings and even office buildings. This is happening in spite of the vivid memories that all developers with positive IQs have of the catastrophic over-building in the 1980s. This article considers why developers are asking that question now, and what answers make the most sense under what conditions.

Why now?

Most U.S. commercial and industrial real estate markets are now in the gradual absorption phase of the three-phase real estate cycle that has so often been described in this column. The long and spectacular development boom phase in the 1980s led to a widespread collapse of property values in the overbuilt phase from late 1989 to about 1993. No new construction occurred in that overbuilt phase, which included the general business recession of 1990-1991. But that recession hit bottom in February 1991, when a new general economic expansion got under way.

During the five plus years of that general expansion, demand for all types of space gradually increased along with rising levels of economic activity. By 1996, the rising space absorption connected with continuing general prosperity had soaked up a lot of the surplus space that was vacant in the overbuilt phase. So, vacancy rates had fallen significantly in many markets, especially for industrial space, top-quality hotels and motels and well-located suburban offices.

Surplus space in retail facilities was not affected in the same manner, because retail markets were in the midst of a huge expansion of a new type of outlet: the power center built around discount merchants operating out of "big box" outlets. So, retail vacancy rate in older and relatively obsolete facilities tended to rise, rather than fall, as the overall economic expansion continued.

New construction considerations

* Purely spec development should be limited to relatively small projects in very tight markets.

* Local market conditions are crucial.

* Developers creating new space under present conditions should keep their borrowing to relatively low levels.

* Developers of new space should be willing to hold it as an investment for several years.

Although vacancy rates fell in all types of non retail space, little or no new construction was initiated in most markets. One reason is that rents had fallen so low that they had to rise substantially, often as much as doubling from 1991 levels, before they became high enough to make new development economically feasible. Also, especially before 1995, sources of financing burned by defaults and foreclosures in the early 1990s were reluctant to underwrite new space again. So, increasing occupancy did not generate a boom in new development, as had often happened in the past.

But by 1996, conditions had become more favorable to new development. Financial institutions that traditionally had supplied mortgage funds, such as banks and insurance companies, were back in business because mortgages offered them higher rate spreads over Treasuries than alternative investments. So, financing became easier to obtain, although most lenders still demanded notable pre-leasing before they would part with funds. By mid-1996, even that requirement had begun to weaken among some fund suppliers.

A second major change was an increasing shortage of space in certain selected markets. These involved mainly suburban industrial buildings at first (as in Kansas City and Jacksonville) but then spread to hotels, some downtown office markets (such as Charlotte and San Francisco) and to more suburban office markets (such as Northern Virginia and Salt Lake City). In these relatively tight markets, rents began rising at the margin. Recently, set rents have reached levels making new building feasible in many industrial markets and some suburban office markets.

A third change has been a big run-up in the market prices of existing top-quality, well-located commercial properties (other than retail). In many markets, intense competition among hungry investors in suburban industrial and office buildings has caused those investors to pay prices even higher than those justified by current rents. This has encouraged many holders of such properties to sell them and inspired many potential developers to think about how much value they could generate through new construction.

Should you start spec projects now?

The current general economic expansion is well into its sixth year -- a greater duration than most post-World War II periods of prosperity. Yet it appears likely to continue through 1996 and perhaps through most or all of 1997. The longer this expansion continues, the tighter most types of space markets will become in most regions, unless a new wave of development appears.

Therefore, development of additional space may be justified in many regions. However, this conclusion must be qualified in the following ways:

* Purely speculative development, which starts with no tenants in hand, should be limited to relatively small projects in very tight markets.

* Much more sensible is building new projects only when a sizable tenant has committed to occupancy, but then building more space than that tenant needs for leasing to other tenants not yet in hand.

* Local market conditions are crucial. In some markets, such as those for office space in downtown Los Angeles and downtown Dallas, persistent space surpluses have kept rents far too low to make new building feasible. Rents in your local market should have been driven by low vacancy rates to levels that can support new construction, and the long-run outlook for local economic growth should be a strong one before new development is undertaken, especially purely speculative development.

* Developers creating new space under present conditions should keep their borrowing to relatively low levels, using heavier-than-usual doses of equity to finance their products. This will protect them from foreclosure in case there is an economic downturn or the rent-up period takes longer than expected.

* Developers of new space should be willing to hold it as an investment for several years, rather than building it solely to sell immediately to other investors. Projects heavily dependent for success on short-run "flipping" are too vulnerable to a change in economic conditions to be sensible. After all, another general recession will occur sooner or later, and developers of new space should be capable of riding through it without bankruptcy.

Conclusion

It is doubtful that a full-fledged, nationwide commercial real estate development boom phase will occur within this general business cycle, as has occurred in past such cycles in the 1970s and 1980s. There is still too much space left over from the super-boom in new building in the 1980s, and financial institutions are still too cautious to fund another round of the immense largely speculative over-building that occurred then. But the longer the present general economic expansion lasts, the more new development projects will be undertaken in markets across the nation. They have already begun to appear in industrial, apartment, hotel and office markets in many regions. Such projects -- even speculative ones -- can be quite sensible if they are undertaken within the specific parameters described above. As in many aspects of life, the key to real estate success is timing. For many astute developers, the time to start building again is now.

Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish