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Home > Industry Analysis > Research & Analysis > San Francisco Regional Outlook, First Quarter 2002

San Francisco Regional Outlook, First Quarter 2002

Regional Perspectives

  • The Region's real estate markets have softened, in part because of weakness in the high-tech and tourism sectors. The slowing in the dot-com, semiconductor manufacturing, and tourism sectors has dampened demand for real estate, and vacancy rates have increased in some markets.
  • Many insured institutions in the Region hold relatively high construction loan exposures at a time when demand for real estate is weakening. During the past several years, robust construction activity has contributed to higher construction loan concentrations among insured institutions in some areas. Recent deterioration in the real estate sector may affect construction loan quality adversely.
  • Community construction lenders active in areas dependent on construction employment face additional pressures. Construction loan concentrations among community institutions tend to be higher in areas that rely on cyclical construction employment. This reliance during a period of weakening construction activity may adversely affect the quality of other segments of the loan portfolio.

Declining Demand for Real Estate Could Signal the Potential for Credit Quality Weakening among the Region's Construction Lenders

Robust economic growth over the past several years fueled significant construction activity throughout many areas of the San Francisco Region. During this period, many insured financial institutions increased concentrations in traditionally higher-risk construction and development (C&D) loans. This elevated exposure is of concern because demand for office and industrial space in the Region began to dwindle in the first half of 2001, primarily as a result of slowing in the high-tech sector. At the same time, demand for hotel rooms, retail space, and housing was adversely affected by a downturn in the travel industry, declining consumer confidence, and rising unemployment; in some areas these factors have been exacerbated in the aftermath of the September 11, 2001, terrorist attacks.

The building boom in several of the Region's markets brought with it an increased dependence on highly cyclical construction employment (see Chart 1). Community construction lenders1 with greater exposures to C&D loans are often in areas with relatively high employment concentrations in this recession-sensitive sector. As a result, weakening in C&D loan quality could be accompanied by softening in other segments of the loan portfolio.

Chart 1

[D]Chart 1 The Region’s Construction Employment Is Volatile

1 Defined as insured institutions that report C&D loan exposures and hold less than $1 billion in total assets.

Many Insured Institutions Have Significant Construction Lending Exposure

One of the more significant vulnerabilities associated with C&D lending is the period between financing and completion of a project, the time during which market conditions can change dramatically. One key measure of the future marketability of construction in the pipeline is the vacancy rate. This analysis looked at the increase in vacancies over the past 12 months to gauge the degree to which current real estate conditions in different markets have fallen short of year-ago assumptions. For example, the San Francisco office vacancy rate was 3 percent in September 2000; by September 2001, the rate had jumped to 15 percent. The level of current construction relative to existing stock is another indicator of future marketability and suggests the level of C&D lending exposure in each property type.

Construction lending is a significant component of loan portfolios among many of the Region's insured institutions. Therefore, this article analyzes third-quarter 2001 vacancy trends and construction volume relative to stock for each of the Region's major market sectors to ascertain where conditions may be falling short of prior assumptions.

The Economic Downturn in High-Tech Areas Adversely Affected the Region's Office and Industrial Markets

Rapid increases in high-tech sector demand for office space in the late 1990s spurred real estate construction volumes. However, the pronounced slowdown in the high-tech sector during 2001 pushed up office vacancy rates in metropolitan statistical areas (MSAs) with high exposures to the dot-com and semiconductor manufacturing industries. Several of these high-tech-dependent markets, including San Francisco, San Jose, Seattle, Oakland, and Phoenix, have also experienced significant office space construction that has continued through much of 2001 (see Chart 2). These five MSAs have seen greater increases in office vacancies in suburban properties than in downtown areas, a reflection of the tendency of dot-com companies to rent cheaper upgraded warehouses near fiber optic lines on the outskirts of the central business district. Given that office space takes considerable time to develop, rapidly rising office vacancies and strong construction pipelines suggest the potential for oversupply in these markets.

Chart 2

[D]Chart 2 Areas with Significant Dot-Com Exposure Experienced Office Vacancy Increases and Relatively High Levels of Construction

Declining manufacturing output adversely affected demand for industrial space in several MSAs throughout the Region during the 12 months ending in September 2001. In particular, Sacramento not only experienced a significant increase in industrial vacancy rates during this period but also had a relatively high proportion of space under construction as of September 2001. In 2000, a number of companies relocated to Sacramento because it was seen as a more affordable alternative to the Bay Area. Subsequently, the drop in the stock market in 2001 depressed market values, and the loss of venture capital funding, particularly for dot-com firms, meant that fewer San Francisco companies were entering the Sacramento market.2 Declining manufacturing employment in Sacramento and reduced in-migration from the Bay Area contributed to increasing vacancy rates that adversely affected the outlook for current construction projects in this MSA.

2 Colliers International. July 2001. Industrial Market Report, Sacramento ($File/Midyear2001.pdf).

Although Sacramento is the only major market to experience a significant change in its industrial vacancy rate and have a large share of industrial space under construction relative to stock, vulnerabilities in the C&D sector could exist in several other markets. The economic slowdown has already produced significant increases in industrial vacancy rates in the San Jose, Honolulu, San Francisco, Portland, and Phoenix MSAs. Continued weakness in the high-tech sector and the slowing global economy could further pressure vacancy rates in these markets. Additionally, markets such as Riverside and Las Vegas are expecting significant increases in industrial space given the level of construction in the pipeline, which, if not offset with equally robust demand, could further heighten the amount of unused industrial space.

Fortunately, industrial real estate has a relatively short construction cycle. Consequently, builders typically can respond quickly to changing market conditions and avert severe supply and demand imbalances. Nevertheless, demand has shifted downward quickly in some of the Region's markets, and industrial property construction has been significant in others.

Waning Tourism Has Adversely Affected Hotel Demand

Hotel occupancy and revenue rates in the Region had been strong through 2000; however, the 2001 economic slowdown and aftermath of the terrorist attacks dampened business and leisure travel significantly. In reaction to these developments, some Las Vegas construction projects that were in the early stages have been stopped. Hotel properties require a lengthy time to develop; therefore, the adverse effects of lower occupancies and hotel revenue per available room (RevPAR) may depress the value of ongoing projects.

Third-quarter 2001 hotel occupancy rates in the San Francisco MSA dropped 10 percent from a year ago, reflecting the high-tech slowdown and the effects of the September 11 attacks. Although their declines were less dramatic than those of the San Francisco MSA, the rest of the Bay Area,3 Las Vegas, and Seattle reported steeper occupancy declines than the national average.4 Hotel RevPAR for the nation fell 15 percent in third-quarter 2001 compared with a year ago, and all of the Region's major markets experienced declines during this period. Markets that reported declines in RevPAR exceeding the national average include the Bay Area, Las Vegas, and Phoenix, as lower occupancies in the final days of September 2001 prompted aggressive room rate cuts.

3 Defined in this article as the Oakland, San Francisco, and San Jose MSAs.

4 For real estate figures, the "average" or national number is based on the sum of metropolitan markets for which data are collected.

The tourism market softened noticeably following the attacks; however, hotel construction pipelines remain relatively robust in Sacramento, San Diego, Orange County, and San Francisco. Overall, the San Francisco MSA may represent one of the more vulnerable areas given its depressed revenue, lower occupancy levels, and the volume of ongoing construction relative to rooms available. Luxury developments may be affected more adversely because these properties have reportedly experienced the greatest declines in occupancy and RevPAR.

Consumer Sector Pressures Have Affected Demand for Retail Development

Relatively high levels of consumer confidence and favorable employment trends prior to 2001 buoyed prospects for retail development. However, demand for retail space during the year declined in some markets as a result of the slowing economy and the aftermath of the attacks. Net absorption of retail space was negative in the second and third quarters of 2001 in all of the Region's MSAs except Salt Lake City. A considerable increase in the retail space vacancy rate combined with a relatively significant volume of construction starts could challenge C&D lenders in certain high-growth retail markets, such as Las Vegas and Phoenix. Las Vegas has experienced a slowdown in visitor volumes as a result of decreased air travel,5 especially following the terrorist attacks. The Las Vegas economy relies heavily on the travel-sensitive hotel and lodging sector,6 and, as a result, the MSA's unemployment rate rose 1.7 percentage points in October 2001. The Phoenix MSA experienced job losses during the first ten months of 2001, in part because of the area's exposure to the slowing semiconductor manufacturing sector.

5 According to the Las Vegas Convention and Visitors Authority, 46 percent of visitors in 2000 arrived by air.

6 Hotel, amusement, and recreation employment in Las Vegas accounted for 24 percent of total nonagricultural employment as of October 2001.

Employment and Affordability Issues Heighten Residential Construction Concerns

Deteriorating job markets coupled with eroding housing affordability could adversely affect multifamily and single-family markets. The number of apartment vacancies has risen in some markets. For instance, demand softened in some Bay Area submarkets following a significant decline in high-tech-related employment. The Phoenix, San Diego, Sacramento, and Orange County apartment markets experienced rising vacancies in the 12 months ending September 2001 and also are expected to face relatively significant additions to apartment stocks in the 12 months ending September 2002. As a result, C&D lenders in these markets should carefully scrutinize project assumptions.

Softening employment trends and deteriorating housing affordability have adversely affected some single-family home markets. Specifically, the San Jose, San Francisco, Portland, Oakland, Las Vegas, Phoenix, Seattle, Santa Cruz, and Eugene MSAs experienced above-average increases in unemployment rates. Job losses in these markets could dampen housing demand.7 Additionally, in the Bay Area, Orange County, and San Diego markets, home price increases have significantly outstripped personal income growth over the past five years, a trend that might not be sustainable in the long term.8 The confluence of job losses and low and deteriorating affordability in the Bay Area has already contributed to declining median home prices in several submarkets. Recent anecdotal evidence suggests that higher-end homes have experienced greater pricing pressure and longer marketing periods. Insured institutions with C&D loan exposures in areas with rapidly deteriorating employment or affordability pressures could face deteriorating single-family C&D credit quality, particularly if they are financing high-end residential development.

7 For more information on this subject, please refer to the In Focus portion of this publication.

8 For more information, see "Regional Perspectives," San Francisco Region, Regional Outlook, Fourth Quarter 2001 (

Robust Construction Activity Contributed to High C&D Loan Concentrations in Some Areas

As of September 30, 2001, C&D lending was particularly important to community C&D lenders headquartered in 15 of the Region's larger MSAs (see Table 1). Rapid changes in commercial and residential real estate market conditions could adversely affect insured institution credit quality, particularly among lenders that specialize in construction lending in the higher-risk markets.

Table 1

[D]Table 1 Community Construction Lenders in Some Markets Reported High Concentrations in Traditionally Higher-Risk Construction Loans

Median C&D loan-to-Tier 1 capital ratios were particularly high among community construction lenders based in the Provo, San Jose, Las Vegas, Oakland, Portland, Sacramento, Salt Lake City, Riverside, and Phoenix MSAs. As noted in Chart 3, at least half of the community construction lenders in some of these markets reported delinquencies in their C&D loan portfolios. Although at a relatively low level, median construction loan delinquency ratios were higher among community construction lenders headquartered in the San Jose, Santa Rosa, Provo, Portland, and Salt Lake City MSAs compared with the Region's other large MSAs. Additionally, at least one-quarter of community C&D lenders in the Portland, San Jose, and San Francisco MSAs reported third-quarter 2001 past-due C&D loan ratios exceeding 5 percent. Delinquencies in C&D portfolios are of particular concern because lenders typically fund or defer interest payments that the borrower will make over the term of the construction loan (e.g., through "interest reserves"). Thus, if a C&D borrower is past due, it could be the result of unforeseen building delays or difficulties with project sale or leasing.

Chart 3

[D]Chart 3 Community Construction Lenders in Parts of Utah, Oregon, and Northern California Are Experiencing Loan Delinquencies

Lenders Active in Areas Dependent on Construction Employment Face Additional Challenges

The current real estate slowdown could adversely affect more than just C&D credit quality. Historically, construction sector employment has been highly cyclical. For example, during the 1990 to 1991 downturn, construction employment in the Region declined 7 percent. Although the construction employment expansion buoyed job growth in several markets through 2000, job growth in this sector has begun to slow and has turned negative in several markets (see Chart 4). As the economy continues to weaken, the construction sector could again be disproportionately vulnerable to further job cuts.

Chart 4

[D]Chart 4 Falling Construction Employment May Signal Broader Economic Slowing

Median C&D loan concentration levels tend to be greatest in markets with relatively high levels of construction employment (see Chart 5). Thus, insured institutions active in the Las Vegas, Riverside, Phoenix, Salt Lake City, and Santa Rosa markets could be particularly vulnerable given the heavy construction lending activity and the reliance of these markets on construction employment. Softening real estate markets and slowing demand for construction sector employment are typically a function of broader economic weakness. As a result, some weakening in asset quality and earnings among insured institutions in these MSAs could appear in other loan portfolio segments.

Chart 5

[D]Chart 5 Community Construction Lenders Headquartered in Markets Dependent on Construction Sector Employment Tend to Hold Higher Construction Loan Exposures
By the San Francisco Region Staff

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Last Updated 03/25/2002

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