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San Francisco Regional Outlook, First Quarter 1999

In Focus This Quarter Commercial Development Still Hot in Many Major Markets, but Slower Growth May Be Ahead1 1 In fall 1998, the FDIC's Division of Insurance published a report ranking the risk of overbuilding within major metropolitan markets (see "Ranking the Risk of Overbuilding in Commercial Real Estate Markets," Bank Trends, October 1998). This paper, which was based mainly on market information as of year-end 1997, highlighted six major metropolitan areas where the rapid pace of current construction activities raised concerns over the potential for broad-based overbuilding. Oversupply within commercial real estate markets typically arises from the difficulty developers face in accurately predicting future demand for a given project, particularly when projections are based on temporary or unsustainable increases in demand. Easy access to investment capital in the form of lower borrowing rates or relaxed underwriting standards can exacerbate the overproduction of space. This analysis identifies nine major metropolitan markets believed to be vulnerable to broad-based overbuilding.2 This vulnerability stems from rapid ongoing development across multiple property types, which threatens to outpace absorption or demand levels over the next one to two years. Overbuilding concerns are heightened by cyclical and secular demographic and economic trends that portend lower demand for commercial space. 2 "Broad-based overbuilding" signifies potential overbuilding in two or more of five property types: office, industrial, retail, apartment, and hotel. Trends in the capital markets may have tempered the appetite for further development in some rapidly expanding metro areas. Should such trends continue, construction activity could moderate, thereby mitigating some of the overbuilding concerns expressed in this article. Since the boom development years of the 1980s, and the bust that followed, the financial community has devoted considerable resources to analyzing commercial real estate trends. The primary purpose of these efforts is to detect, as early as possible, warning signs of potential imbalances between supply and demand. The markets highlighted in this article are considered vulnerable to possible overbuilding on the basis of various early warning signs. Each of these markets is experiencing rapid commercial real estate development across multiple property types. In addition, each market exhibits one or more of the following characteristics: high vacancy rates relative to the pace of development, declining employment growth trends, declining in-migration trends, projected increases in vacancy rates by credible industry experts, and significant dependence on industry sectors vulnerable to either weak Asian markets or a slowing domestic economy. The term "vulnerable" is used here to signify a potential, as opposed to a certain, outcome. In previous cyclical downturns, falling commercial real estate values were preceded by economic events that resulted in lower demand: Declining energy prices preceded the mid-1980s decline in Southwestern real estate markets; weaknesses in the financial sector preceded the late 1980s decline in Northwestern real estate markets; and sharp defense cutbacks preceded the early 1990s decline in Southern California real estate markets. It remains to be seen whether weakening Asian markets or prospects for slower economic growth serve as catalysts for slower commercial real estate demand in the current cycle. Whatever the catalyst, markets most affected by a downturn in real estate values will be those in which optimistic expectations, the basis for current construction activity, fall farthest from the mark. Why Do Markets Become Overbuilt? Commercial property developers often face substantial lags between a project's conception and its completion: The longer the construction period, the greater the uncertainty surrounding demand projections. These risks can be largely mitigated if the developer enters into presale contracts or preleasing agreements with financially sound parties prior to breaking ground on construction. However, it is not unusual in rapidly developing and highly competitive markets for developers to anticipate or "speculate" what demand levels will be, based on current trends. If the market in question is experiencing a period of temporary or unsustainable growth (a "boom" period, for example), then projections may lead to an overly optimistic outlook for future demand, particularly when forecasts are weighted heavily toward recent rental, sales, and demographic trends. Projection error also arises from the failure to consider competitors' planned development activities. If a developer's demand projections fail to materialize, the result is an overhang of commercial property beyond what the market can absorb during a reasonable time frame. Easy access to investment capital can exacerbate overproduction of space by reducing or eliminating incentives to make reasoned and prudent investment decisions. Excessive leverage, where the developer has little personal capital at risk on a particular project, is a familiar example often associated with the excessive development of the 1980s. Loan pricing that fails to adequately account for the risks involved in a construction project is another example of how financing incentives could lead to imprudent development decisions. Ranking the Risks of Overbuilding The October 1998 Bank Trends (see footnote 1) study employed a three-step process to rank the vulnerability of markets to possible overbuilding. First, major metropolitan markets were ranked in terms of current construction activity3 relative to existing space for each of five property types: office, industrial, retail, apartment, and hotel. Second, relative construction activity was compared with current vacancy rates to assess the competitive pressures faced by newly developed projects. Third, market-related research was reviewed to determine which markets analysts considered candidates for possible supply/demand imbalances. Although the same approach was used in this updated analysis, additional factors were considered, including employment and population growth trends, the dependence of rapidly developing metropolitan areas on specific employers or industries, and the relationship between current economic trends and the potential demand for commercial real estate space. 3 Construction activity generally refers to recent completions plus projects in process of being built. In the case of office and industrial properties, the source of data is CB Commercial/Torto Wheaton Research, and construction activity refers to completions for the last four quarters plus projects under construction. For all other property types, the source is F.W. Dodge and ERE Yarmouth, and construction activity refers to completions, projects in process of being built, starts, and pending projects. Most Active Construction Markets Charts 1 through 5 show the level of construction activity, for each property type, relative to the total stock of space as of June 30, 1998, for the top 15 major metropolitan markets. Although slowing somewhat, development in the Las Vegas market continues to lead all other markets in relative terms for office, industrial, and hotel construction. Las Vegas is also among the most active markets in apartment and retail construction. Other markets experiencing rapid development across multiple property types include Salt Lake City, Charlotte, Atlanta, Portland, Phoenix, Orlando, Dallas, Austin, Nashville, Jacksonville, and Seattle. As the charts show, office, industrial, apartment, and hotel construction activity rose from year-end 1997 levels among a majority of the fastest-developing markets. Retail development, however, appears to have slowed in a majority of the most active development markets during the first half of 1998. Chart 1 Chart 2 Chart 3 Chart 4 Chart 5 Comparing Construction Activity with Vacancy Rates Newly completed speculative projects must compete with existing vacant space. Accordingly, it is worthwhile to compare measures of relative construction activity with current vacancy rates (as shown in Charts 6 and 7 for office and industrial space). The main idea behind these charts is that market segments with high existing vacancy rates raise the degree of competitive pressure for newly built space; markets with high vacancies may have less justification for continuing increases in new stock. Chart 6 Chart 7 In the office sector, Las Vegas stands out as having the highest level of new development combined with high existing vacancy rates. Although the pace of development is markedly slower, office markets in both Atlanta and Dallas appear to be expanding rapidly despite high existing vacancy rates. In the industrial sector, Las Vegas, Atlanta, Riverside, Salt Lake City, and Phoenix all appear to be experiencing rapid development despite relatively high existing vacancy rates. Analyst Outlooks for Commercial Real Estate Advocate Caution The first six months of 1998 saw continuing strong market fundamentals in most major markets and most property types: CB Commercial/Torto Wheaton Research (CBC) reported continuing nationwide declines in office and industrial vacancy rates accompanied by increasing rental growth rates,4 Wheat First Union (Wheat) reported improvements in occupancy and rental rates across the 30 major apartment markets it follows,5 and Smith Travel Research (Smith) reported continuing improvements in average daily room rates despite a modest decline in occupancy rates for the lodging sector (through the first nine months of 1998).6 The performance of the retail sector has been more mixed, as indicated by a significant decline in estimated rental growth rates from 1996 to 1997 (CBC) while retail vacancy rates have held steady over the past 12 months (F.W. Dodge).7 4 CB Commercial/Torto Wheaton Research, The Office Outlook, The Industrial Outlook, and The Retail Outlook, Fall 1998. 5 Wheat First Union, Industry Report: Quarterly Apartment Review, October 21, 1998. 6 Smith Travel Research, Smith Travel Research Announces 1998 September and Third Quarter U.S. Lodging Industry Reports, www.str-online.com/news/releasedir/pr981104_3rdqtr.html. 7 F. W. Dodge, Real Estate Analysis and Planning Service: 2nd Quarter 1998. Despite these generally positive trends, market observers are becoming more cautious about the outlook for commercial real estate markets. Much of their concern stems from significant increases in projected supply in the face of moderating absorption rates. CBC, for example, projects that nationwide office vacancy rates will rise from 9.3 percent as of June 1998 to 12.1 percent by June 2000 as a result of a sharp increase in completions combined with moderating absorption. Markets with the highest and most significant increases in projected office vacancy rates are highlighted in a recent Lehman Brothers study, which identifies 17 office markets as "danger zones." 8 8 These markets are Salt Lake City, Columbus, Austin, Nashville, Charlotte, Orlando, Las Vegas, Baltimore, Atlanta, Dallas, Phoenix, Philadelphia, Indianapolis, Chicago, Sacramento, Miami, and Houston (Lehman Brothers, Commercial REIT Research: Eye on Office Markets, October 1998). Analysts have also raised concerns over rapid development in other property types. F.W. Dodge, for instance, anticipates a sharp rise in the ratio of retail completions to absorptions over the coming two years. In addition, the pace of hotel development has picked up substantially over the past two years to levels not seen since the late 1980s (see Chart 8). According to Smith, hotel completions continue to outpace demand and are expected to result in lower occupancy levels in 1999. For the apartment sector, Wheat cautions against a continuing escalation in apartment permits despite some expected slowing in employment growth in various markets over the coming 12 months.9 9 Wheat specifically notes deteriorating supply/demand ratios in Dallas, Houston, Orlando, Charlotte, Nashville, and the San Francisco Bay area. Chart 8 Economic Conditions May Temper Commercial Real Estate Demand The nation's economy has shown unprecedented resiliency, even as some indicators suggest that growth may moderate in the near term. For instance, weakened global markets have placed increasing pressures on exporters, who have seen a falloff in demand in the wake of weaker foreign currencies relative to the dollar. Domestic firms, too, face rising competition from cheaper imports. These factors have created negative near-term expectations for corporate profitability, which in turn have resulted in rising layoffs and slowing employment growth. Although most economists feel that prospects for a recession are remote in the near term, even a modest slowdown in economic growth could result in higher vacancy rates in markets experiencing rapid development. Over the longer term, various economic and demographic trends imply a weaker outlook for commercial real estate demand relative to past real estate cycles. In a recent analysis of the commercial mortgage-backed securities (CMBS) market, Moody's identifies the following trends, each of which implies secular declines in demand for one or more property types10: 10 Moody's Investor Service, CMBS and the Real Estate Cycle: Less Margin for Error, October 9, 1998. more efficient office space utilization as measured by continuing declines in square feet per worker; more efficient inventory management as measured by a proportional increase in the ratio of inventory growth to growth in warehouse space; shifts in spending patterns by baby boomers, the largest age cohort, away from goods and toward services; declining scrappage rates of obsolescent buildings because of a decline in the average age of the current stock of space relative to the comparable stage of prior cycles; and expected declines in labor force growth as the proportion of older workers increases. In addition to these factors, other analysts have pointed out that tight labor markets and overtaxed infrastructure (e.g., water, roads, sewer, and public transportation) constrain demand by limiting growth within a particular market. Suburban areas that have seen the bulk of new construction over the past few years may be particularly hard hit if there is a backlash against the congestion and infrastructure capacity issues that accompany rapid growth.11 11 See, for example, Price Waterhouse/Lend Lease Investment Research, Emerging Trends in Real Estate 1999. Markets Most Vulnerable to Overbuilding Based on a review of supply and demand trends coupled with analyst opinions and projections, the following markets appear to be most vulnerable to broad-based overbuilding in the coming one to two years (see also Table 1, below, for prevailing trends in these markets). These markets are discussed in more detail in the Regional Perspectives section. Las Vegas Las Vegas's hotel, office, and industrial development far surpasses that of other major markets, with ratios of construction activity to current space of 37 percent, 19 percent, and 12 percent, respectively. Rapid development is occurring despite high and increasing office and industrial vacancy rates, which place additional competitive burdens on newly completed space. The area's retail and apartment sectors are also developing rapidly, ranking third and fourth, respectively, among major markets. Although Las Vegas continues to enjoy one of the fastest employment growth rates in the country, the rate of job growth has slowed considerably from 1994 to 1996 levels. Its real estate markets are highly dependent on the gaming sector, which could be especially vulnerable to a nationwide slowdown in economic activity. The city would be particularly hard hit by a downturn in real estate prices, as fully 10 percent of its workforce is employed in the construction sector (twice the national rate). Atlanta Of the nation's largest metropolitan markets, Atlanta ranks among the top ten in office, industrial, retail, and apartment construction, with ratios of construction activity to current space of 12 percent, 8 percent, 7 percent, and 5 percent, respectively. Development, much of which is widely reported to be speculative, is very active despite relatively high office and industrial vacancy rates. Atlanta's expanding real estate markets have been driven largely by strong in-migration and employment growth rates. However, both these rates are slowing, and many market observers are concerned that the area's development cycle has reached its peak.12 12 See the November 1998 issue of the Federal Reserve Board's Beige Book. Nashville Nashville ranks among the top ten metro markets in office and apartment development, with ratios of construction activity to existing space of 10 percent and 6 percent, respectively. Although not among the top 15 markets, Nashville's hotel sector is expanding rapidly as well (construction activity stands at 12 percent of current space). Nashville's economy is reported to be slowing because of recent losses in manufacturing-sector jobs and slowing net-migration rates. The rapid pace of development has recently placed downward pressure on office, industrial, and hotel occupancy rates. Salt Lake City Salt Lake City ranks among the top five markets in the nation in office, industrial, and hotel development, with ratios of construction activity to current space of 14 percent, 6 percent, and 27 percent, respectively. The main drivers behind the area's rapid development have been high-tech corporate expansions, population in-migration, and preparation for the 2002 Winter Olympic Games. However, both job growth and in-migration rates are slowing, which could result in lower absorption rates for commercial space in the near term. Over the longer term, analysts have expressed concerns that development and job growth attributable to the Olympics will result in a significant glut of space following the Winter Games. Charlotte Charlotte ranks among the top five metro areas in office, retail, and apartment development, with ratios of construction activity to current space of 15 percent, 7 percent, and 6 percent, respectively. The area's hotel sector is also developing rapidly. Charlotte's real estate markets are highly dependent on the health of the financial industry, which has been the primary driver of development activity. However, job growth in the financial services sector has recently slowed, and the manufacturing sector (which accounts for 19 percent of all jobs) is experiencing net job losses. Portland Portland has the third most active hotel and apartment development in the nation, with ratios of construction activity to current space of 25 percent and 7 percent, respectively. The area's office market is also expanding rapidly. Portland's development has been driven largely by in-migration and job growth in the technology sector. However, because of the significance of exports to the overall economy (exports to Asia account for approximately 7 percent of Oregon's gross state product), the technology sector is particularly vulnerable to weak Asian markets. Accordingly, job growth has moderated, reaching its lowest level in five years. The area has also experienced a recent decline in construction-sector jobs. Although still strong, in-migration rates have fallen from 1996 levels. Phoenix Phoenix ranks among the top ten metro markets in industrial, retail, hotel, and apartment development, with ratios of construction activity to existing space of 6 percent, 6 percent, 18 percent, and 6 percent, respectively. The area is also experiencing rapid development in the office sector. Phoenix has one of the fastest-growing job markets in the country. Although still strong relative to the nation, employment growth has slowed somewhat since 1996, as has the rate of in-migration. The prominence of the semiconductor and high-tech businesses makes Phoenix especially vulnerable to the economic slowdown in Asia. Dallas Dallas ranks among the top ten metro markets in office, hotel, and apartment development, with ratios of construction activity to existing space of 10 percent, 19 percent, and 6 percent, respectively. The area is also experiencing rapid development in the retail sector. Dallas's economy remains one of the fastest growing in the country, and in-migration to the area continues to rise. However, economic growth has slowed somewhat recently because of weakening high-tech and energy sectors. Although its industrial base is more diversified today than in the mid-1980s, Dallas remains exposed to a large energy sector, whose profits are vulnerable to declining oil and energy prices. Concerns over the volume of planned office development have led to widely published reports of curtailments in credit availability to speculative office projects. Although tighter credit availability may ease pressures on vacancy rates over the long term, the market will still have to absorb the large volume of space presently under construction, much of which is speculative. Orlando Orlando ranks among the top three metro markets in office, retail, and apartment development, with ratios of construction activity to existing space of 15 percent, 9 percent, and 7 percent, respectively. Of the nine markets discussed in this article, Orlando's current pace of construction is perhaps easiest to support, thanks to rising employment and in-migration growth. However, despite strong employment growth, office vacancy rates have edged higher over the past 12 months because of the rapid pace of construction. Orlando may be more vulnerable than other metropolitan areas to a slowdown in the national economy owing to its dependence on the tourism sector. Credit Availability Affects the Pace of Commercial Development CMBS and real estate investment trusts (REITs) have generated a significant share of funding for commercial real estate over the past several years.13 As a result, any disruption in CMBS and REIT markets strains credit availability for new commercial development. For instance, widening CMBS spreads in the wake of September's market volatility have caused many issuers to either delay or cancel new CMBS issues. REITs, too, have reportedly curtailed purchases because of falling per-share values and a corresponding decline in equity issues to support acquisitions. 13 See "Strong Demand and Financial Innovation Fuel Rebounding Commercial Real Estate Markets" in Regional Outlook, fourth quarter 1997. Weaknesses in the CMBS and REIT markets also may be dampening many lenders' enthusiasm for commercial real estate development. Construction lenders will be less willing to make speculative loans to the extent that permanent funding is not available, and CMBS and REITs served as major providers of such funding. REITs were particularly aggressive purchasers in such markets as Atlanta, Orlando, and Dallas.14 Tightened construction lending conditions appear to be borne out by the November 1998 issue of the Federal Reserve Board's Beige Book, which indicates that new construction for speculative commercial projects has either been curtailed or come to a virtual halt throughout many Federal Reserve districts, including Atlanta and Dallas. Most districts also reported tightened credit conditions and higher loan pricing, which could further dampen construction activity. 14 See Lehman Brothers, Commercial REIT Data Book, December 9, 1997. The turmoil faced by CMBS and REITs presents both opportunities and risks for banks. Many industry participants view tighter credit accessibility as a positive development in light of the rapid pace of construction, which, in some cases, has been accompanied by extremely tight loan pricing margins and a loosening of underwriting standards. However, some lenders may view the changing fortunes of CMBS and REITs as an opportunity to regain market share. In any case, it will take several months for recent market events to be fully reflected in hard numbers for construction activity. Whether tightening credit availability proves to be a temporary phenomenon given the recent, albeit gradual, recovery in CMBS spreads and the broad recovery in the equity markets, remains to be seen. Summary This article updates a previously published analysis that used year-end 1997 data to rank the potential vulnerability of major metropolitan areas to overbuilding. Using primarily midyear 1998 information, this update adds three markets to the six identified in the initial analysis as vulnerable to broad-based overbuilding. This assessment is based on a number of factors including construction activity trends, local area employment and population migration trends, as well as a collection of views and projections from credible industry analysts. For many of these markets, the prospects for near-term declines in commercial real estate demand may be increasing because of slower economic growth and weakened markets abroad. Certain secular demographic and economic trends also suggest the possibility of lower demand levels in the current cycle relative to prior cycles. Although data through June 1998 indicate ongoing rapid development, there is growing evidence that recent events in the capital markets have at least temporarily tempered the appetite for further development in some rapidly expanding metro areas. For these markets, most participants view the curtailment in credit availability in a positive light because it would serve to moderate the severe cyclical swings in real estate values experienced by several markets during the 1980s. Steven Burton, Senior Banking Analyst Regional Outlook Information Return to Regional Outlook main page