In Focus This Quarter
Ranking Metropolitan Areas at Risk for Commercial Real Estate Overbuilding
- In analyses conducted in 1998 and 1999, nine metropolitan areas were identified as at risk for overbuilding; this analysis notes more vigorous building occurring across multiple property types and identifies 13 markets, including eight of the previous nine, as at risk for overbuilding.
- Construction activity has accelerated during the current economic expansion with cyclically high levels of supply and demand.
- Capital markets scaled back their investments in commercial real estate in 1998 and 1999, while FDIC-insured institutions increased their construction and development lending by more than 20 percent each year.
The banking industry and the FDIC learned during the late 1980s that once commercial real estate (CRE) markets become overbuilt, losses can mount quickly. During the 1980s and early 1990s, losses on CRE loans were responsible for hundreds of bank and thrift failures and billions of dollars in insurance losses for the FDIC. Since then, commercial vacancy rates have improved dramatically in a number of major U.S. metropolitan markets. In turn, CRE charge-offs reported by FDIC-insured institutions have fallen to very low levels--less than 0.05 percent of average loans in both 1998 and 1999.
Two recent studies published by the FDIC evaluate the risk of overbuilding in major U.S. metropolitan areas.1 These studies identified nine cities--Atlanta, Charlotte, Dallas, Las Vegas, Nashville, Orlando, Phoenix, Portland (Oregon), and Salt Lake City--as markets at risk for rising commercial vacancy rates. This article revisits the FDIC's previous analysis of CRE markets. Using a more restrictive definition of at-risk markets, we find that eight of the previously identified nine markets remain on the list, joined by five additional markets: Denver, Fort Worth, Jacksonville, Sacramento, and Seattle.2 In general, more markets are experiencing increased levels of construction activity across multiple CRE property sectors than was the case just two years ago.
1 See "Ranking the Risk of Overbuilding in Commercial Real Estate Markets," Bank Trends, October 1998, and "Commercial Development Still Hot in Many Major Markets, but Slower Growth May Be Ahead," Regional Outlook, First Quarter 1999.
2 The one metropolitan area identified in the prior analyses as at risk for overbuilding that did not fall into the same category using the stricter criteria in this analysis is Nashville. Nevertheless, Nashville still ranks high in terms of construction activity at fifth highest in the U.S. for retail and twelfth highest for office construction activity.
Like the two earlier studies, this analysis does not predict an imminent rise in vacancies and losses in the at-risk markets. Instead, as before, the goal is to raise awareness about substantial growth in real estate development and the corresponding increases in risk exposure to financial institutions.
Previous Real Estate Cycles Are Well Documented
Many analysts view the late 1980s U.S. experience as the very definition of adverse conditions in CRE markets. The factors that brought about these adverse conditions are well documented.3 During the early and mid-1980s, CRE construction boomed. Total office space completed in 54 major U.S. markets tracked by Torto Wheaton Research exceeded 100 million square feet per year every year from 1982 through 1987. Insured banks and thrifts were prime sources of credit for this building boom. Total outstanding construction and development (C&D) loans on the balance sheets of insured institutions grew by 52 percent, or $52.5 billion dollars, in 1985 alone, followed by three successive years of growth in outstanding C&D loans. A key factor behind this surge in lending was intense competition among lenders. In response to the heightened competition, many lenders loosened their underwriting standards, often extending credit on speculative projects on terms that did not protect them from downside risk. Examples of aggressive lending practices from this period included more collateral-based lending, higher loan-to-value limits, reliance on overly optimistic appraisals, and inattention to secondary repayment sources.
3 See, for example, Freund et al. 1997. History of the Eighties: Lessons for the Future, Chapters 9 and 10. FDIC.
Poorly underwritten credit and massive increases in construction resulted in overbuilding in a number of large U.S. metropolitan markets. Nationwide, the office vacancy rate for competitively leased space peaked at over 19 percent in 1991.4 In the Southwest and New England, where the cycle of overlending and overbuilding was most pronounced, metro real estate markets were in even worse shape. Office vacancies in Dallas peaked at over 27 percent in 1988, while office vacancies in Boston reached over 17 percent in 1990. As vacancies rose and rents fell, lenders in the Southwest, Northeast, and elsewhere increasingly found themselves in possession of nonperforming loans and impaired real estate assets. The result was a sharp increase in the number of failed banks in the Southwest and Northeast.5
4 The U.S. vacancy rate is calculated as an aggregate of selected major markets tracked by Torto Wheaton Research.
5 As further detailed in the History of the Eighties, combined assets of failed banks in the Northeast and Southwest comprised over 70 percent of assets of all banks failing between 1980 and 1994.
Following the CRE debacle of the late 1980s and early 1990s, commercial construction and lending volumes slowed. C&D loan growth at FDIC-insured institutions declined every year from 1989 through 1994, while a similar drop in private construction expenditures lasted through 1993.
Factors Contributing to Cycle of Overbuilding in CRE
One reason that CRE markets are prone to periodic bouts of overbuilding is the business cycle itself, which saps demand for new space when business activity turns downward. But another important contributing factor is the lag time in the development process as new construction moves from inception to completion. Heavy demand at the start of a project may wane or vanish before completion occurs. In general, the time lag associated with CRE development is longest for hotel and office projects and becomes shorter for retail, multifamily, and industrial properties, respectively. The associated degrees of lending risk mostly follow the same pattern. In general, less risk is associated with industrial buildings and multifamily projects, which typically take less than one year to build.
To the extent that commercial construction projects involve a lag between inception and completion, net additions to supply can be anticipated in advance. Much progress has been made during this real estate cycle toward increased availability of information on CRE markets, particularly in regard to supply characteristics. Market transparency has been promoted in part by a heightened level of public ownership of CRE properties and the corresponding higher degree of disclosure by the owned entities, such as real estate investment trusts (REITs) and commercial mortgage-backed securities (CMBSs).
Changes in demand are harder to predict. A current example may be the high level of demand generated by Internet start-up companies that rely heavily on financing provided by venture capital funds and initial public stock offerings. Because many of these start-ups depend so heavily on cash inflows from investors as opposed to operating revenues, their viability as tenants and their continued demand for high volumes of office space may depend more on capital market conditions than on their own business performance. While demand may appear strong under robust business conditions, it is prone to decline rather suddenly in the event of an economic downturn. Given these attributes of CRE markets, the process of gauging the success for lease-up of a proposed project involves not only looking at new supplies of competitive space coming onto the market, but also evaluating how vulnerable the market is to a downturn in demand for space.
Recent Developments
Following a lull in commercial construction activity that resulted from adverse market conditions in the early 1990s, construction activity has gradually accelerated during the current economic expansion. The increased pace of construction occurred first in industrial and retail markets, where growth in net new completions of space picked up starting in 1993. The pace of multifamily construction accelerated in 1995, followed by increasing levels of office and hotel construction in 1997. Regionally, commercial construction activity recovered first in the Southeast and Northwest, where the effects of the previous overbuilding had been the least pronounced. Only later did the pace of construction increase in California, the Southwest, and the Northeast. As the U.S. economic expansion endures into its tenth year, construction activity continues to pick up steam across most property types. In the 54 major metropolitan areas tracked by Torto Wheaton Research, total annual office space completions rose from just over 3 million square feet in 1994 to 78.7 million square feet in 1999.
National private expenditures on hotel and retail construction for 1999 exceeded all prior years on both a current-dollar and an inflation-adjusted dollar basis. Similarly, national private construction expenditures on office space in 1999 were at an all-time high on a current-dollar basis. On an inflation-adjusted dollar basis, office construction expenditures in 1999 were still not as high as they were during the mid-1980s.
A new characteristic of the CRE industry in the current expansion has been the marked increase in capital availability through the financial markets. Annual issuance of CMBSs has grown from negligible amounts in 1990 to over $67 billion in 1999. Financing made available through REITs has been the other link to the capital markets. REIT market capitalization increased from approximately $10 billion in 1994 to nearly $145 billion in 1999.
While the availability of market-based sources of capital has helped to facilitate growth in construction during this expansion, the financial market turmoil of late 1998 cast a cloud over the CMBS market that has yet to lift fully. Significant events in the global capital markets in 1997 and 1998, including the Asian economic crisis and the Russian government bond default, significantly curtailed the ability of major CMBS issuers to go to the market for financing. Significant liquidity problems resulted for a number of commercial mortgage firms. Nomura, Lehman Brothers, CS First Boston, and others incurred losses, while Criimi Mae, Inc., was forced to declare bankruptcy.
As the capital markets pulled back from CRE investments, insured banks and thrifts stepped in to fill the void. Chart 1 shows that the total volume of C&D loans on the balance sheets of FDIC-insured institutions rose by more than 20 percent per year in both 1998 and 1999, even as growth in U.S. private construction expenditures slowed to a crawl.6
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6 U.S. private construction expenditures, as calculated by the Bureau of the Census, include multifamily (two or more units), industrial, office, hotel, and retail space.
In terms of overall construction market activity, the current situation appears to be one of cyclically high levels of supply and demand. Because significant growth in net new space is forecast for many markets and property types during 2000 and 2001, a drop in demand for space could impair absorption rates and lead to higher vacancies and lower rents. Most analysts feel that future trends in real estate demand will be closely linked to national and regional economic conditions.
Identification of Markets at Risk for Overbuilding
Previous FDIC studies have identified CRE markets at risk for broad-based overbuilding on the basis of comparative rankings in the rates of growth in commercial space. In a 1998 study, U.S. metropolitan areas were ranked according to 1997 new construction activity as a percentage of existing stock for the five main property types: office, industrial, retail, multifamily, and hotel.7, 8 In that study, any metro area that appeared in the top 15 for any two of the commercial property types was labeled "at risk." Nine cities were identified as being at risk for overbuilding: Atlanta, Charlotte, Dallas, Las Vegas, Nashville, Orlando, Phoenix, Portland (Oregon), and Salt Lake City.
7 Federal Deposit Insurance Corporation. October 1998. Ranking the Risk of Overbuilding in Commercial Real Estate Markets, Bank Trends.
8 Construction activity is measured in square feet and includes projects completed during the year, plus projects still under construction as of year-end. This figure is then divided by the total stock of space to obtain a construction activity percentage for use in comparative rankings.
This study updates the previous results using year-end 1999 data.9 In doing so, it applies more restrictive criteria to identify at-risk metropolitan real estate markets. As before, the metro areas are ranked according to new construction as a percentage of existing stock in each of the five main commercial property types. However, in this analysis, to be considered at risk, a metro area must rank in the top ten for any two of the property types. Despite the fact that it was harder for individual markets to qualify as being at risk, all but one of the previously identified nine markets remain on the at-risk list. Moreover, they are joined by five additional metropolitan areas: Denver, Fort Worth, Jacksonville, Sacramento, and Seattle. It is evident that more metropolitan areas are emerging with vigorous CRE construction and development across multiple property sectors.
9 For the five property sectors reviewed in this report, data sources were Torto Wheaton Research for office and industrial and F.W. Dodge for retail, multifamily, and hotel. Torto Wheaton Research's data for office and industrial encompass 54 and 53 metropolitan statistical areas (MSAs), respectively. F.W. Dodge's data for retail, multifamily, and hotel encompass 58 MSAs.
Most Active Construction Markets
Charts 2 through 6 represent the property sectors of office, industrial, retail, multifamily, and hotel. They also list, for each property sector, the metropolitan areas having the highest levels of construction activity, relative to existing stock, for the year ending December 31, 1999. The overall national construction activity rate is also shown for comparative purposes for each of the property sectors. Each metropolitan area is ranked from the highest to lowest for levels of construction activity.
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As shown in these charts, Las Vegas, Orlando, and Phoenix are standouts, with each placing among the top ten metropolitan areas in the country for construction activity in at least four of the five different property sectors. Las Vegas is among the top ten in construction activity for all five property sectors except for hotel construction, where it ranks twenty-sixth.10 Las Vegas ranks first in retail construction and second in industrial construction. Orlando is first in both office and multifamily construction. Phoenix is among the top ten for each of the five property sectors except hotel construction, where it ranks sixteenth.
10 Las Vegas has the most hotel rooms in the country, with slightly fewer than 124,000 rooms as of year-end 1999. During 1999, Las Vegas experienced the greatest addition of rooms (in absolute numbers) of any market. With over 13,000 new rooms added during 1999, Las Vegas had nearly twice the level of the next highest metropolitan area, which was Orlando, with an additional 7,000 rooms.
Other markets deserve notice for their high or moderately high levels of construction activity in one or more property sectors. Columbus, Ohio, ranks sixth in the nation for its high level of office construction and twelfth for both multifamily and hotel construction. Greenville is tenth in the nation for hotel construction and twelfth for retail. West Palm Beach is ninth for retail and eleventh for office. Austin is eighth for office, eleventh for both multifamily and industrial, and thirteenth for hotel.
C&D Loan Concentrations
Concentrations of C&D loans at community banks in the at-risk markets are generally higher now than they were at the peak of the last cycle in the 1980s.11 As shown in Chart 7, the median ratio of C&D loans to total assets as of March 31, 2000, was higher than the median ratio as of December 31, 1988, in ten of the thirteen at-risk markets.12 The median C&D loan concentration is currently higher than the national average in all 13 at-risk markets.13
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11 Community banks are FDIC-insured institutions with assets less than $1 billion.
12 For community banks that have C&D loans.
13 Since 1992, the aggregate C&D-to-asset ratio for the nation's community banks has been higher than the C&D-to-asset ratio for institutions larger than $1 billion. This is a reversal of the condition from 1984 through 1991 when the aggregate C&D-to-asset ratio for institutions larger than $1 billion exceeded the C&D-to-asset ratio for community banks.
At present, overall loan performance remains very good for the C&D portfolios of insured institutions. Reported delinquent and nonaccrual C&D loans remain at nominal levels as a percentage of total loans, although the ratio for both measures increased marginally during the first quarter of 2000.
Construction Employment Concentrations
The percentage of a metropolitan area's workforce employed in construction is an indicator of the sensitivity of the local economy to construction. Six of the 13 metropolitan areas at risk for overbuilding are found among the top 12 most concentrated construction employment markets (see Chart 8).14 In addition, all of the 13 have construction concentration levels exceeding the national average. With slightly under 10 percent of its nonfarm workforce employed in construction, Las Vegas has the highest construction-concentrated workforce of all metropolitan areas in the United States and is slightly over twice the national rate of 4.8 percent.
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14 Construction concentrations are the percentage of construction employees relative to the nonfarm workforce.
High Construction Activity and High Vacancy Levels
Newly constructed, speculative space competes directly for tenants against already-built and vacant space. To assess at-risk markets fully, it is useful to compare the levels of construction activity for each metropolitan area's property sector against its associated vacancy levels.15
15 The data vendors do not provide category breakdowns for construction activity into speculative versus nonspeculative (preleased) properties.
Charts 9 through 13 show, by property sector, each city's level of construction activity plotted against the corresponding vacancy rate. It is axiomatic that a metropolitan area with high vacancies and high construction is cause for concern for builders and lenders alike.
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It follows for metropolitan areas with high construction and high vacancy that newly arriving CRE projects will face significant competitive pressures in obtaining tenants. Consequentially, barring any preleasing or any fundamental upward shifts in demand, rental concessions may be needed to obtain tenants, and property values may be depressed.
As shown in the referenced charts, multiple cities are experiencing high volumes of construction activity concurrent with high vacancy rates. Seven of the 13 at-risk cities show up in the upper-right quadrants, exhibiting both high rates of construction and vacancy: Atlanta for industrial and multifamily; Dallas for office and retail; Fort Worth for retail and hotel; Jacksonville for office and hotel; Las Vegas for office and industrial; Orlando for office and multifamily; and Salt Lake City for office and hotel.
Other metropolitan areas beyond these 13 are precariously situated at the furthermost positions on the charts for high vacancy and high construction levels: Austin and Houston for multifamily; Greensboro for hotel; Greenville for retail and hotel; and West Palm Beach for office and retail.
What Market Analysts Are Saying
Views of industry analysts provide additional perspective on the risks pertaining to each of the five property sectors and the individual metropolitan areas.
Office
Newly constructed nationwide office supply will outpace demand in 2000 and beyond, according to Torto Wheaton Research.16 Some 65 million square feet of space is scheduled for completion in 2000. However, net absorption is projected to be only 58 million square feet in 2000, resulting in an excess supply of 7 million square feet. Torto Wheaton Research predicts that office completions will outpace absorptions for all projected year-ends through 2005, and corresponding vacancy rates will climb to slightly more than 14 percent at year-end 2005.
16 Torto Wheaton Research. Spring 2000. Office Outlook.
Overall office fundamentals are in equilibrium, according to Donaldson, Lufkin & Jenrette (DLJ), thanks to preleasing and sufficient demand.17 Still, DLJ identifies a number of markets as being at greater risk for excess new supply. DLJ's markets to watch for possible overbuilding are Charlotte, Fort Lauderdale, Minneapolis, and Sacramento. More than 9 percent in new supply is projected for Sacramento over the next 18 months, with only a 3 percent increase in demand. DLJ identifies the Sacramento suburbs as the major center of construction activity and notes with concern the existing 13 percent suburban vacancy rate for this metropolitan area.
17 Thierry Perrein, Donaldson, Lufkin & Jenrette. April 2000. DLJ REIT Corporate Handbook, "Cautious Optimism."
Overall office construction levels will peak this year, according to the Urban Land Institute (ULI).18 Increases in suburban office vacancy rates to nearly 11 percent by the end of 2000 are projected, with downtown rates falling to slightly over 8 percent. ULI notes the possibility of a rash of space returns by Internet companies and others in the technology sector as a significant going-forward risk.
18 Urban Land Institute. ULI 2000 Real Estate Forecast.
Many analysts caution about the ability of new office construction to be absorbed in certain markets where labor supplies remain tight. In recent Wall Street Journal articles, Dallas and Seattle are reported to be actively recruiting high-tech engineers through immigrants from India and China to fill in the gaps in their tight labor-market pool for high-technology jobs.19, 20
19 Templin, Neal. June 7, 2000. Economic Focus: Houston, Dallas Are Draw for Immigrants. The Wall Street Journal.
20 Barnes, Brooks. June 7, 2000. Economic Focus: Seattle Enjoys Influx of Foreign Workers. The Wall Street Journal.
In a recent office market report by Moody's Investors Service, three metropolitan areas (Jacksonville, Nashville, and Phoenix) are coded as "red"--indicating danger for high supply and declining demand factors.21 Charlotte is coded as "yellow," and its office demand is projected to grow by only 5 percent this year, while supply will increase by over 11 percent.
21 Gordon, Sally. June 2, 2000. Moody's Investors Service, Special Report--CMBS: Red-Yellow-Green Update, Second Quarter 2000, Quarterly Assessment of U.S. Property Markets.
Multifamily
Recent mortgage rate increases will slow purchases of single-family homes, thereby increasing the demand for multifamily properties, according to a recent article by PaineWebber.22 Nevertheless, concerns are raised for oversupply conditions for multifamily construction in Atlanta, Dallas, Houston, and Las Vegas--cities characterized as "low barrier-to-entry markets."
22 PaineWebber. June 6, 2000. Real Estate Investment Trust--Initiating Coverage on the REIT Industry.
Markets appearing weak to DLJ for the multifamily property sector include Charlotte, Denver, Jacksonville, Orlando, Portland, Raleigh, Salt Lake City, and Seattle.23
23 Ibid.
Industrial
Atlanta and Dallas are weaker for the industrial property sector, according to DLJ, because of significant new supply levels.24 A 7 percent supply growth is projected for Phoenix in 2000, with only a 4 percent increase in demand.
24 Ibid.
Retail
For retail properties, DLJ believes a number of markets have excess supply; the standouts are Austin, Las Vegas, Orlando, Phoenix, and Sacramento.25
25 Ibid.
Hotel
Analysts point to specific concerns for a "glut" of limited-service hotels in certain markets and note many hotel developers taking advantage of low barriers to entry for hotel construction. In response, many developers argue that "product differentiation" within different hotel sectors justifies further development.
Growth in expenditures on hotel construction has been above 7 percent for each of the past several years, while room revenues grew at a more moderate pace, according to PaineWebber.26 The poor growth in room revenue is attributed to supply exceeding demand.
26 PaineWebber. June 1, 2000. Industry Outlook Lodging, U.S. Hotel Construction Update--First Quarter 2000.
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Conclusion
Since 1997, responding to a void left by the departure of other capital market lenders, community banks have stepped up their CRE lending activity. At the same time, more metropolitan areas are emerging with vigorous CRE construction and development across multiple property sectors. In the 1998 and 1999 FDIC analyses, nine metropolitan areas were identified as being at risk for overbuilding across multiple property types. In the present analysis, 13 metropolitan areas, including eight of the nine from the prior analyses, receive this designation. Given strong levels of CRE completions, these metropolitan areas are particularly sensitive to any decline in real estate demand that could result from a slowdown in the national or regional economy.
Thomas A. Murray, Senior Financial Analyst
Markets Most Vulnerable to Overbuilding
On the basis of the preceding information, the following six markets are considered to be most at risk for broad-based overbuilding: Atlanta, Charlotte, Dallas, Denver, Fort Worth, Jacksonville, Las Vegas, Orlando, Phoenix, Portland, Sacramento, Salt Lake City, and Seattle.
San Francisco Region Markets Most Vulnerable to Overbuilding
Las Vegas
Las Vegas ranks among the top ten metropolitan areas for new construction in four of the five property types. With 10 percent of its workforce employed in construction, Las Vegas is the most construction-concentrated metropolitan area in the country. In addition to its popularity as a gaming resort, the area also has become a popular site for business startups and relocations because of its low cost of living, business-friendly tax structure, and telecommunications infrastructure. Of the property types for which Las Vegas has been identified to be at risk, office (see chart), industrial, and retail seem to be the most vulnerable. Without strong in-migration, the resulting constriction in the labor market would damage the gaming industry and associated economies, particularly construction and retail. Gaming continues to be the most significant driver of Las Vegas' economy, and while the gaming industry is currently strong, the effect of just-approved gambling on Indian land in California has yet to be felt.
As a group, the 17 community banks in the Las Vegas metropolitan area report slightly higher concentrations in construction and CRE than the San Francisco Region as a whole. Since March 1998, these concentrations have roughly doubled in magnitude. As of March 2000, average construction and commercial real estate loans stood at 9.8 percent and 33.0 percent of assets, respectively. Reported past-due ratios of all Las Vegas community banks do not differ significantly from those of the Region as a whole.
Stephanie Galloway, Financial Analyst
