San Francisco Regional Outlook, First Quarter 1999
Several of the Region's Metropolitan Areas May Be Vulnerable to Overbuilding as a Result of Rapid Commercial Real Estate Development
Growth in population, employment, and income, along with low interest rates and an ample credit supply, has helped real estate construction and development to flourish in recent years. Consistent with a regional economy that has outperformed that of the United States since 1995, several San Francisco Region real estate markets rank among the nation's most active in terms of new construction.
The In Focus article "Commercial Development Still Hot in Many Major Markets, but Slower Growth May Be Ahead," Regional Outlook, first quarter 1999, identifies four markets in the Region as vulnerable to overbuilding. Two of these metropolitan statistical areas (MSAs), Las Vegas and Phoenix, continue to grow rapidly, especially in the construction sector. The other two formerly fast-growing MSAs, Portland and Salt Lake City, are slowing down, with employment growth below the average for the Region. The four markets present different types of risks. The risk of continued commercial real estate (CRE) overbuilding may be heightened in Las Vegas and Phoenix in light of expectations of weaker market conditions nationally. Softening in general economic conditions in Portland and Salt Lake City is likely to affect CRE by reducing demand in a period of increasing real estate supply. While real estate investment trusts have been active players in financing new development activity, community banks in several San Francisco Region metropolitan areas also have provided construction and development financing at a rapid pace.
Although selected areas in the Region are experiencing considerable growth in construction and land development (C&D) lending, the aggregate exposure of community banks1 in the Region and the number of concentrated C&D banks2 have changed over the past decade. While Chart 1, below, shows that, as a percentage of total assets, community banks' aggregate C&D loan exposure in the Region remains below the Region's peak at year-end 1990, the Salt Lake City, Las Vegas, Portland, and Phoenix MSAs now have higher aggregate exposure than in 1990. Likewise, the number of concentrated C&D banks in the Region is lower than the year-end 1990 peak, falling from 152 in 1990 to 52 in the third quarter of 1998, but the number has risen in several markets outside California. Map 1, below, shows that at year-end 1990, 92 percent of the concentrated C&D banks were in California, primarily in Southern California. Conversely, Map 2, below, shows that as of third-quarter 1998, more than 67 percent of these banks are located outside Californiaprimarily in the Portland, Phoenix, Salt Lake City, and Seattle MSAs.
1 Community banks are non-credit-card commercial banks with less than $1 billion in total assets. Community banks exclude industrial loan companies, which are special-purpose lenders that are prevalent in the Salt Lake City MSA.
2 A concentrated C&D bank is a community bank with C&D loans greater than 15 percent of total assets.
The marked increase in exposure to C&D lending in some of the Region's MSAs may warrant additional monitoring because in the aggregate, concentrated C&D banks' earnings and asset quality in the San Francisco Region have historically been much more volatile during economic downturns than those of nonconcentrated C&D banks (see Charts 2 and 3). Furthermore, 42 percent of the Region's community bank failures during the past ten years had been concentrated C&D banks at one time during the five years prior to failure. Also, although national vacancy rates are falling and rental rates are climbing, market analysts are becoming increasingly cautious about the CRE outlook. Overbuilding in the 1980s demonstrated that development decisions at the peak of an economic cycle are often based on expectations that positive conditions will continue. Also, individual development decisions may not consider the actions of other developers. Therefore, active markets could become oversupplied rapidly because of a large volume of new development.
The following sections summarize real estate market conditions and insured institution C&D lending exposure in four of the Region's MSAs identified as vulnerable to potential overbuilding.
Rapid Growth Remains Dependent on Gaming and Construction
The In Focus article identifies the Las Vegas MSA as the most active construction market in hotel, office, and industrial space of the nation's major metropolitan markets. Las Vegas' retail space development also is among the strongest in the nation. Significant in-migration to Las Vegas spurred construction activity and boosted nonfarm employment to record levels during the 1990s. Although down from peak years, the area's nonfarm employment growth rate remains one of the fastest in the nation (see Chart 4).
Although Las Vegas remains one of the Region's fastest-growing MSAs, its growth is heavily dependent on the hotel/gaming sector, which directly accounts for more than 25 percent of its employment. The rapid expansion of the MSA's hotel/gaming industry in the 1990sLas Vegas had approximately 61,000 hotel rooms as of 1988 and more than 105,000 as of year-end 1997has both directly and indirectly stimulated its construction sector, which accounts for more than 10 percent of its employment. Gaming and construction, which together directly employ more than a third of the workforce, are both highly cyclical sectors that vary with the strength of the national economy.
The sustained building boom in Las Vegas has many industry experts concerned that several of its real estate market sectors may be oversupplied. For example, the National Real Estate Index estimates that in the hotel/casino sector, room supply will increase 20 percent to more than 125,000 rooms by year-end 2000. The increase in rooms is primarily due to the construction of five new theme casino/hotel/resorts, including the recently opened Bellagio. The National Real Estate Index estimates that in order to absorb the substantial additions to the hotel stock, visitor count must increase an additional 6 million per year by 2000. Increasing visitor count may prove difficult: Year-over-year visitor count through November 1998 has been flat despite the opening of Bellagio. While average occupancy rates in hotels have remained more than 86 percent through year-end 1997, several casino executives and analysts, most recently J. Terrence Lanni, chief executive officer of MGM Grand, Inc., have acknowledged the coming oversupply of hotel rooms in the Las Vegas market.
Las Vegas' office market also may be oversupplied, according to June 1998 information. The National Real Estate Index cites speculative construction activity for the recent increase in office development. The new supply has placed pressure on both rents and vacancy rates. As shown in Chart 5, vacancy rates, which at 14.3 percent are well above the national average, have risen for the fourth consecutive year. In addition, office completions increased more than 4 percent from second-quarter 1997 to second-quarter 1998. While the rate of increase in completed space appears to be falling, Coldwell Banker Commercial/Torto Wheaton Research (CBC) projects that office vacancy rates will reach 19 percent by the year 2000. Further, office rental rates have been virtually flat since 1995 in Las Vegas despite an average 17.1 percent increase in rents over the same period for the 54 markets that CBC tracks nationwide.
Las Vegas' industrial property market may be experiencing some oversupply as of June 1998. The National Real Estate Index estimates that 85 percent of the industrial buildings completed during 1997 were speculative. Because industrial projects generally require less lead time and planning than office projects, developers were able to cut back on new industrial supply during 1998, thus stabilizing vacancy rates. The vacancy rates have declined 1.4 percent to 9 percent from year-end 1997 through second-quarter 1998 because of a 65 percent decline in completed industrial square footage over the same period. CBC projects vacancy rates in this market segment will fall to 6 to 7 percent in future years.
CRE Construction May Pose Risks for Las Vegas Community Banks
The rapid hotel, office, and industrial market development may have heightened the risk exposure in the 29 insured financial institutions with operations in the Las Vegas MSA. Ten institutions in the MSA, which hold more than 85 percent of the MSA's deposits and each have total assets greater than $1 billion, are owned by large out-of-state bank holding companies that do not report geographic lending data. These institutions appear likely to have geographically diversified lending exposures and probably would not be materially affected by a downturn specific only to the Las Vegas MSA. However, the 11 smaller banks headquartered in the Las Vegas MSA, which have combined total assets of $1.2 billion and hold about 7.6 percent of Las Vegas MSA deposits, may not be as geographically diversified as their larger counterparts and therefore may be most at risk to a downturn in the local real estate markets. These smaller community banks, eight of which have been chartered within the past five years, have a disproportionately high exposure to C&D loans. As of September 30, 1998, the 11 community banks combined have C&D loans equal to 12.7 percent of total MSA community bank assets (see Chart 1). In addition, all three banks in the MSA with C&D loans in excess of 15 percent of total assets are community banks that were chartered within the past five years.
Las Vegas' strong economic growth continues to promote real estate development despite the potential oversupply in the hotel and office real estate markets. The economic well-being of the MSA remains dependent on growth in the hotel/gaming sector, which has historically followed national economic trends. While several insured depository institutions operate in the Las Vegas MSA, the 11 community banks headquartered there appear most at risk to a slowdown in the area's economy because of their lack of geographic diversification and their relatively high exposures to C&D lending. The concern about C&D lending exposure in these smaller, newer institutions is heightened because most of them have not been tested by an economic or real estate market downturn.
Salt Lake City
Slowdown May Adversely Affect Banks with High C&D Loan Exposure
Preparation for the 2002 Winter Olympics, in conjunction with past growth in the high-technology industry, helped propel Salt Lake City to among the nation's top three markets in office, industrial, and hotel development. However, some general economic indicators suggest that its growth may be slowing, as indicated by its job growth rate (see Chart 4).
The pace of economic and construction activity declined markedly in 1998; job growth slipped to 2.5 percent. As of November 1998, Regional Financial Associates, Inc. (RFA) forecasts that economic growth in 1999 will be only half that experienced during 1996 and 1997. RFA projects that future growth prospects will be similar through the year 2000. Construction employment growth has declined from 7.4 percent to 5.8 percent in the 12-month period ending December 1998. Total construction starts were down 20 percent in the first half of 1998 compared with the same period in 1997. The indicators in Salt Lake City all point to the same messages: (1) the economy is slowing and is expected to remain slow in the near future; (2) real estate market activity, whether measured in terms of construction employment or construction starts, has declined noticeably from 1997 to 1998.
Despite the 19 percent falloff in new office construction starts between 1997 and 1998, CBC forecasts rising vacancy rates as a result of additional office completions. As shown in Chart 5, office vacancy rates have already risen slightly over the past two years. The reason for the projected increases is the large supply of office real estate in the pipeline. CBC projects that between 1998 and 2001, about 5.8 million of the planned 14.2 million square feet will be completed.
While the supply of new office real estate is not slowing yet, the demand for office properties is. CBC notes that office employment rose 6.1 percent between 1996 and 1997. However, CBC forecasts that new office employment growth will fall to a little more than half that rate between 1998 and 2000. As a result, net absorption is expected to be 3.2 million square feet between 1998 and 2001, far less than the projected 5.8 million square feet of completions. Because the supply of office space will most likely exceed demand, vacancy rates are expected to reach 15.2 percent in 2001, far above the June 1998 rate of 6.6 percent.
Salt Lake City has the second highest level of hotel construction activity in the nation; about 29 percent of its hotel stock was either in the process of construction or in the planning stage in 1998. In 1997, about 1,660 rooms were added, representing a 12-fold increase in annual construction over 1996. Average occupancy rates for Salt Lake City hotels declined to 80.9 percent in August 1998 from 82.7 percent a year earlier. Grubb & Ellis indicates that the Salt Lake City hotel market is nearing saturation. Many new hotel developments in 1997 were smaller-budget or business-oriented projects that have lower development costs than the larger properties. Although the new hotel space will be needed for the 2002 Olympics, additional hotel expansion may not be economically feasible.
Community Banks Have High C&D Loan Exposure
The top four non-credit-card banks in Salt Lake City control nearly 54 percent of the MSA's deposits; however, only 4.1 percent of their assets are in C&D loans. Conversely, the MSA's community banks have the highest exposure to C&D loans of the four MSAs highlighted in this article. Although the C&D loan growth rate has slowed from 49 percent in 1996 to less than 1 percent through third-quarter 1998, C&D loans for Salt Lake City community banks are 15.2 percent of total assets, almost triple the 5.7 percent figure for the Region. More than half of the MSA's 11 community banks have C&D loan exposure of at least 15 percent of total assets. Historical evidence indicates that, in the aggregate, San Francisco Region community banks with greater than 15 percent C&D exposure could face substantial pressure during economic downturns.
Salt Lake City appears to be in the beginning stages of an adjustment period, one in which CRE activity may slow as a result of slower economic growth. This slowing may reduce the amount of new space coming on the market. However, it may also affect the city's ability to absorb new and existing office space. The situation is complicated by the fact that Salt Lake City's community banks have unusually high levels of C&D loan exposure.
Real Estate Markets Show Signs of Overheating despite a Slowing Economy
In 1998, several of Portland's CRE marketsoffice, hotels, and industrialappeared to be at or near the top of the CRE business cycle. The supply of new space in these markets outpaced demand in 1998 and is expected to do so in the future. As a result, vacancy rates will be driven upward and rents and prices downward. Because these conditions exist in several property types, Portland was identified in the In Focus article as a market that may be vulnerable to potential overbuilding.
Economy Has Been Hurt as the Asian Crisis Continues
Portland's economic boom in the mid-1990s can be traced largely to the rapid expansion of the high-tech sector, aptly named the "Silicon Forest." The surge in semiconductor investment and plant construction triggered rapid growth in the local economy and played a key role in driving construction activity and the CRE market boom. In 1998, however, Portland lost 3,100 manufacturing jobs. The losses were centered in the high-tech and electronics industries, which have been hit hard by the slowdown in exports to Asia. Nearly half of Portland's exports (in dollar value) are high-tech or aerospace products.3 In 1997, the Portland MSA ranked 13th in the nation in exports among metropolitan areas; it accounted for about 90 percent of Oregon's $10 billion in exports. Agricultural and forest products also have been hurt by the decline in exports after mid-year 1997.
3 See Regional Outlook, second quarter 1998, for additional details on Oregon's and the Region's exposures to Asian exports.
Portland's economy has been slowing along with that of Oregon, and job growth slowed markedly in 1998, as shown in Chart 4. The decline was a sharp contrast with the growth rates of 3.7 percent or better that the MSA experienced from 1993 through 1997. In 1999, RFA projects that Oregon and the Portland MSA will add jobs at rates of 1.0 and 1.1 percent, respectively. Despite the slowdown, major players in the construction industry remain optimistic about current and future business; one builder noted, "It's simply not turbo-charged like it was a few years ago."
An Abundant Supply of Commercial Real Estate in the Pipeline
Despite the optimism, the weakness in the Portland economy in the past year is influencing conditions in the real estate markets. Before 1998, Portland's office market had been robust, with a steady rise in new construction activity, very rapid absorption of new properties, and declining vacancy rates, as shown in Chart 5. CBC reported a vacancy rate of 5.6 percent as of June 1998, the lowest since 1980. However, as the economy has begun to slow, new office supply may begin to outstrip demand, according to CBC. In the first half of 1998, new office construction starts outpaced year-ago starts by 249,000 square feet. While construction activity accelerated, demand for office space may be softening; the growth rate of office jobs, which was close to 6 percent per year from 1992 to 1997, fell to just over 3 percent in 1998. With increased supply and reduced absorption of office space, the vacancy rate in the year 2000 is expected to be 6.7 percent, which is still below the projected second quarter 1998 national vacancy rate of 9.4 percent. Because of the robust new office construction expected over the period from 1998 to 2003, CBC predicts Portland will add an average of 1 million square feet of office space per year, pushing the vacancy rate to more than 11 percent in 2003. This increase in new office space is expected to drive up vacancy rates and hold down rental rates. Finally, softening in the Portland economy in 1998 may add to the downside risks, if the addition of fewer office jobs reduces absorption of office space.
Portland also has experienced a hotel construction boom. In the first half of 1998, seven new hotels, with a total of more than 1,000 rooms, opened in the Portland area. This increased supply of hotel rooms appears to be affecting market fundamentals and raising concerns about overbuilding. According to The Business World, Portland's business journal, occupancy rates for hotel rooms in downtown Portland are falling more than room rates are rising. As of August 1998, the occupancy rate for downtown hotels stood at 82.2 percent, down 5.1 percent from a year earlier. For the same period, room rates climbed only 4.1 percent. Moreover, the increase in hotel rooms has prompted Wolfgang Rood of Gordon/Rood Hospitality Consulting, Bellevue, Washington, to predict that downtown occupancy rates will trend downward over the next two or three years while room rates remain flat. Finally, slower economic growth forecast for Portland may reduce both business and pleasure travel.
Portland's industrial market also shows some signs of overheating. The vacancy rate, as reported by CBC, bottomed out at 3.9 percent in 1996. As of June 1998, the vacancy rate rose to 5.5 percent, and new construction starts for warehouses, which make up more than 70 percent of Portland's industrial market, were on the rise. New industrial construction starts rose from a postrecession low of 325,000 square feet in 1992 to 3,780,000 square feet in 1997. The pace of construction starts in this market declined somewhat in the first half of 1998 compared with the first half of 1997, which may be a sign of developers pulling back projects in the face of changing market conditions. Still, the CBC forecast over the next six years shows new supply exceeding annual absorption; the vacancy rate is expected to rise gradually to 8.9 percent, while the growth of rental rates is predicted to slow. Conditions in this market could deteriorate further if the downturn in both exports and high technology continues to worsen and reduces the demand for industrial and warehouse space. In contrast, Portland's retail real estate market has been in an expansion phase but does not appear to be overheating like the other markets.
Community Bank Exposure to a CRE Downturn Is High
Portland community banks' relatively high levels of exposure to CRE lending have become more important as the real estate boom ages and the area's economy slows. Because of their relative lack of geographic diversity compared with larger multistate banking companies and relatively high exposure to C&D loans, community banks in Portland could be materially affected by a downturn in the local real estate market. As shown in Chart 1, C&D loans account for 9.2 percent of their total assets as of September 30, 1998, much higher than the comparable figures of 5.7 and 3.3 percent for the Region and nation, respectively. In addition, 5 of the 14 community banks in the Portland MSA have C&D loans greater than 15 percent of total assets. Community banks in the Portland MSA have combined construction, commercial, and multifamily real estate loans totaling more than 30 percent of their total assets, which also is high relative to the Region and nation. Finally, 6 of the 14 community banks in the Portland MSA were chartered in the past five years. The high levels of exposure to the construction and CRE sectors, and the large number of new banks, clearly increase the vulnerability of Portland banks to a downturn in real estate activity.
Several areas of commercial real estate in Portlandoffice, hotel, and industrialhave been expanding very rapidly and appear vulnerable to overbuilding. The risk of overbuilding also has risen because of the softening in Portland's economy, which will slow absorption of all types of new properties. Finally, community banks in the Portland MSA are much more highly exposed to construction and CRE lending than their peers in the Region or the nation.
The Phoenix MSA is in the top ten nationally in the development of industrial, hotel, and retail space. Phoenix also has recently shown strong development of office space. The Phoenix MSA, like the Las Vegas MSA, is one of the fastest growing in the United States, with 4.6 percent payroll employment growth in the 12 months ending December 1998 (see Chart 4). Strong employment growth in technology and services, as well as affordable housing prices, has spurred population in-migration, primarily from Southern California. However, the growth in technology over the past decade has made the MSA more susceptible to global developments affecting this industry, and the Asian financial crisis is beginning to affect technology employment. Two of Phoenix's largest employers, Motorola and Intel, have cut a combined 4,000 jobs nationwide, according to RFA. These layoffs could slow Phoenix's employment growth and lead to slower absorption of office, industrial, and retail space. Because of Phoenix's strong, broad-based real estate development, significant technology-sector exposure, and history of real estate booms and busts, the area also is susceptible to potential overbuilding.
The global turmoil affecting some technology companies will likely hurt Phoenix's industrial property market. This market has been strong throughout the 1990s because of relocating companies and technology employment growth. The rapid construction that occurred during 1996 and 1997 moderated through the second quarter of 1998 as the absorption of space slowed. Completed square footage declined more than 78 percent from the second quarter of 1997, and CBC projects that 1998 completions will decline about 33 percent from the year-end 1997 level. The industrial vacancy rate, which has hovered between 6 and 8 percent since 1993, remains relatively low at 7.2 percent. Absorption of space, which has declined significantly since 1996, could continue to be affected by the Asian crisis and technology-sector overcapacity problems.
Phoenix's expansion as a tourist destination has spurred strong construction of new retail and hotel space. The Phoenix MSA was ranked sixth among the 54 CBC markets in growth of retail space from 1990 to 1997. According to F.W. Dodge, retail construction starts increased more than 12 percent from second-quarter 1997 to second-quarter 1998. Retail vacancy rates, currently above the national level of 8.1 percent at 10.3 percent, are expected to remain close to this level through the year 2000, according to CBC. In addition, Phoenix added an estimated 6,064 hotel rooms in 1998, according to a Paine Webber research report, making it the third most rapidly expanding hotel market in the United States.
After several years of stagnant construction activity, the Phoenix office market expanded rapidly during 1997 and through second-quarter 1998. Until 1997, absorption of new space had outpaced completions in this market since 1991; however, completed square footage of office space has increased more than 11 percent since second-quarter 1997, and CBC estimated a 62 percent increase in completed square footage by year-end 1998. The office vacancy rate, currently below the national average at 8.8 percent, was expected to rise to more than 10 percent by year-end 1998, which would be the first time it has exceeded 10 percent since year-end 1995. In addition, F.W. Dodge reports that more than 15 million square feet of office space is in the planning stages, indicating that construction of new space could remain strong through 1999.
The current building boom in Phoenix has presented increased C&D lending opportunities to the 49 insured financial institutions with branches in the MSA. While the 29 community banks in the Phoenix MSA have grown their C&D portfolios significantly in the past several years, their exposure to C&D loans remains well below that of similar-sized institutions in Las Vegas, Salt Lake City, or Portland. Four community banks do have C&D loans totaling more than 15 percent of total assets, but aggregate C&D loan exposure to total assets is only 4.8 percent, well below the year-end 1988 high of 12.2 percent (see Chart 1). The exposure is slightly higher, at 5.6 percent of total assets, for the 13 institutions chartered within the past five years, 9 of which were chartered in 1997 or 1998.
While the Phoenix office market had not experienced significant construction activity until 1997, the hotel and retail markets appear to be moving toward a period of increasing supply, which could adversely affect vacancy and occupancy rates in 1999. In contrast, the industrial market has seen construction activity decline as absorption of space has slowed. This market, because of the Asian crisis and uncertainty in the technology sector, could be negatively affected in 1999; however, supply appears to be much more flexible in the industrial sector than in other real estate market sectors, so overbuilding could be less of a concern in this market segment. In aggregate, community bank exposure is not near the level seen in the other three San Francisco Region markets discussed in this article, and it is well below the level noted in 1988, before the area's last severe real estate recession. However, given the high percentage of banks chartered within the past two years in this market and the rising exposure levels in these newer institutions, the Phoenix market should be monitored closely for future real estate sector problems.
This article identifies four MSAs as vulnerable to overbuilding because of rapid CRE development in recent years. Even though the current pace of CRE activity is different in each of the four MSAs, construction projects coming on line and in the planning stages represent a substantive increase in supply. The two fast-growing MSAs, Las Vegas and Phoenix, may be at risk for sustained overbuilding, as CRE development continues to rise in economies that show no sign of slowing despite uncertainties surrounding national CRE market trends. The two slowing MSAs, Portland and Salt Lake City, are beginning to show signs of softening in CRE development, and the weakening economies may decrease absorption of new space at a time when ample supply is coming onto the market.
Real estate disequilibrium, caused by overbuilding or a change in economic circumstances, could pose a risk to insured institutions actively supplying C&D financing. Community banks in the Salt Lake City, Las Vegas, and Portland MSAs have C&D loan exposure significantly above that of other major metropolitan areas in the nation. Managers of insured institutions, especially newly chartered ones where C&D activity is strong, should closely monitor local real estate market conditions and C&D lending exposures to avoid undue concentrations in this potentially volatile product.
San Francisco Region Staff
A special thanks for contributions by Thuan Le, Financial Economist, Division of Research; and the Division of Insurance Regional Offices in Atlanta, Kansas City, and New York.