In most postwar U.S. recessions, real estate has led the economy into recovery. Not this time. Housing is still scraping along its cyclical bottom and shows no signs of near-term recovery. While it's true that rental housing will experience a rapid increase in occupants, new apartment construction is not likely to soar soon.
That leaves office space, the largest form of commercial property, as the main candidate to generate new construction and falling vacancy rates. But four adverse conditions will prevent any big increase in office construction from occurring soon.
The first condition is a shortage of tenants who want to occupy enough vacant space to trigger a lot of new construction. According to CB Richard Ellis, the vacancy rate for U.S. office space was 16.6% in 2010, about the same as it was four years after the 2001-2003 economic downturn. (The vacancy rate dropped to 16.4% in the first quarter of 2011.)
Large corporations and institutional investors are sitting on plenty of money that could finance new offices. But high unemployment has undermined demand for both new and existing office space.
Investors see little sense in building new offices when existing spaces are still unoccupied. The economy must recover much more than it has before demand for office space will absorb existing vacancies and generate new construction.
Skittish lenders
The second factor is the unwillingness of lenders to make new construction and development loans until tenant demand for space becomes much stronger. About 16% of construction and development loans were at least 90 days delinquent in September 2010, with another 2% of loans 30 to 90 days delinquent.
The third adverse factor consists of a fundamental relationship between new office completions and office vacancy rates. Historically, office vacancy rates rise following several years of high office completions, as in the late 1980s, and from 1997 through 2003. In both periods, developers overbuilt office markets.
But high and rising vacancy rates discourage further new office construction, thus decreasing completions, as was the case from 1990-1993 and from 2001-2004.
Because office construction takes two or more years to complete, the impact of high vacancies upon completions lags by several years. Thus, vacancy rates peaked at more than 18.7% in 1991 during a weak economy, but then fell sharply for seven years to a low of 8.3% in 2000, according to CB Richard Ellis.
Completions peaked at over 110 million sq. ft. in 1989, but then fell 93% to a low of 7.4 million sq. ft. in 1994. Then completions surged because vacancy rates had fallen so low that developers rushed to build new space.
Lagging indicator
The fourth condition is that office completions trail changes in real gross domestic product (GDP). The annual change in U.S. real GDP fell to minus 1.9% in 1982, but then averaged gains of 4.3% from 1983 to 1989. This high-level prosperity led to a huge increase in new office construction. Completions peaked in 1989, then plunged sharply until 1994 due to overbuilding in the 1980s.
Another boom in real GDP occurred from 1993 to 2000, averaging 3.8% per year. New office completions began climbing around 1997, soaring to nearly 110 million sq. ft. in 1999. In 2001, real GDP gained only 1.1% because of the stock market crash in 2000.
Office completions fell from 2002 to 2005, lagging behind a rise in real GDP. Then real GDP growth plunged to zero in 2008 and negative 2% in 2009. That caused a sharp drop in new office completions in 2009 and 2010, again following the general economy. Real GDP then surged in 2010, but that hasn't yet affected new office construction.
Even if real GDP continues to improve slowly, it would still take several years for new construction to follow because of high vacancy rates and a slow recovery in tenant demand for space. So, new office space development is not going to lead the commercial sector into a boom for quite a few years to come.
Tony Downs is a senior fellow at the Brookings Institution in Washington, D.C. Contact him at [email protected].