Financial Crisis Casts Shadow Over

Vol. 3, No. 12 DECEMBER 2008 EconomicLetter

Insights from the Federal Reserve Bank of Dallas

Financial Crisis Casts Shadow Over Commercial Real Estate by Roland Meeks The commercial market is only The troubled housing industry has grabbed most of the headlines moderately off its because of its role in touching off the current financial crisis and economic slow- most recent down. Until recently, however, the commercial real estate sector had managed to peak. But ride out the storm without serious consequences. tougher times Now, increasingly ominous parallels with the residential market are appear to lie ahead. surfacing. Investment in all types of commercial structures has slowed after several years of rapid growth.1 Prices of office and retail properties, two large

commercial categories, have fallen from last year’s peaks. Many commercial

mortgages were packaged and sold as asset-backed securities, and funding for

projects has dried up because these markets are now all but closed.

The commercial and residential markets have differences as well as

similarities.2 The gap in size is a good place to start. In 2007, the nation’s stock of commercial structures was valued at more than $3 trillion, a little over a Chart 1 tenth of private wealth. By compari- Real Prices for Office and Retail Buildings Are Declining son, the residential housing stock was worth $14.5 trillion. While housing prices soared in recent years, com- Index, 1994:Q1 = 100 mercial property valuations don’t look 250 wildly out of line, judging by standard Office 3 comparisons to net income. And while 200 the issuance of commercial mortgage-

backed securities grew rapidly, the Retail shoddy standards of subprime residen- 150 tial lending were mostly avoided. Lately, the commercial market has 100 been wobbling. Real transaction prices for office properties were 11 percent lower in the third quarter of this year 50 than at the end of 2007, and retail properties changed hands for 6 per- 0 cent less (Chart 1). The Architecture 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Billings Index, a leading indicator of SOURCES: MIT Center for Real Estate; Bureau of Economic Analysis. commercial construction, has been exceptionally weak, with the low- est readings on record in the past six months (Chart 2).4 Overall spending on diverse categories of commercial Chart 2 structures—shopping centers and res- Architectural Billings Point to Slower Investment taurants, for example—has now gone

into reverse. Annual change (percent) Index For the economy as a whole, two 20 65 key risks loom in a downturn of the Billings commercial real estate market. First, a 15 60 steep and prolonged decline in con- 10 struction spending would place anoth- 55 er burden on growth in an economy 5 already reeling from falling housing prices and financial turmoil. Second, 0 50

a fall in property values could result –5 in losses for the banking sector. Such 45 losses could impair banks and the –10 financial sector, posing added risks to 40 the economy from a reduced willing- –15 Investment growth

ness to lend. –20 35 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Boom and Bust? NOTE: Index values above 50 indicate an increase in billings. Construction spending is a volatile SOURCES: American Institute of Architects, Architecture Billings Index; Bureau of Economic Analysis. component of GDP. Over the past 50 years, commercial real estate (CRE) investment growth’s standard deviation from the mean—a common measure Residential and commercial con- ful drag on fixed investment growth of volatility—was 10.7 percent. This is struction impact GDP growth through since the housing boom peaked two less than residential’s 14.4 percent but their contribution to fixed investment. years ago, amounting to more than 8 nearly five times higher than the vola- The decline in residential construc- percent in some quarters. Commercial tility of GDP growth. tion spending has exerted a power- building, meanwhile, still managed

EconomicLetter 2 Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas EconomicLetter to contribute modestly to investment To understand the economics of growth through the second quarter the commercial real estate market, of 2008. we look first to the vacancy rate, Commercial construction’s volatil- which is unoccupied square foot- ity is a standard feature of the U.S. age as a proportion of total available business cycle. It has turned down, space. U.S. office vacancies have often sharply, in virtually every reces- fluctuated between 8 and 20 percent sion since 1970. At the trough of since the mid-1980s. In the third the previous commercial property quarter of 2008, the rate was 13 per- It’s unlikely that bust—following the dot-com bubble’s cent, trending upward but average by collapse in 2001—CRE construction historical standards. Retail vacancies even a repeat of contracted 18 percent on a year-over- stood at 10 percent, also rising but year basis. average. past declines in CRE However, the peak of the most Imbalances between demand and recent construction cycle doesn’t supply show up as vacancies, which investment would appear high compared with five previ- rise and fall but don’t disappear. A ous episodes since the early 1970s, substantial stock of commercial real greatly damage overall suggesting the industry may not be set estate is always unoccupied, suggest- up for as big a fall this time (Chart 3).5 ing that demand and supply are nev- economic growth. Overall, the CRE market’s retreat er perfectly matched. Why don’t rents from its peak has been moderate—so fall to bring the market into balance? far—and the amount of unoccupied An excess supply of commer- commercial space on the market cial space can be consistent with remains about average. But the fun- stable rents in markets where owners damental outlook for commercial real and tenants must engage in a time- estate soured somewhat in the first half consuming and costly search before of 2008, coinciding with the downturn making a match. Increased search in the business cycle. The third quarter costs, contracting costs and uncer- showed continuing deterioration, and tainty raise the vacancy rate at which a deep recession in the U.S. would be there is no pressure to change rents. bad news for the CRE sector. On the other hand, commercial building’s share of GDP is around 1 percent, so it’s unlikely that even a Chart 3 repeat of past declines in CRE invest- Commercial Investment Peak Lower in Current Cycle ment would greatly damage overall economic growth. In the longer term, Deviation from trend (percent) the slower pace of new construction 20 will probably mean the overhang of vacant space won’t be severe. 15 Investment

However, it’s reasonable to expect 10 vacancy rates to rise, while rents and property prices fall, during 2009. 5 GDP 0 Rents and Vacancies The sizable fluctuations seen in –5 real estate investment might be put down to myopia or overexuberance. –10 But they aren’t necessarily irrational. –15 Cycles can be a feature of a market in which developers are fully rational, in –20 the sense of making internally consis- ’69 ’71 ’73 ’75 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’01 ’03 ’05 ’07 tent, forward-looking decisions based SOURCES: Bureau of Economic Analysis; author’s calculations. on full information.6

EconomicLetter Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas 3 EconomicLetter Real estate economists call this equi- categories may overlap; for example, librium point the natural vacancy a store may own the building it occu- rate.7 pies. But it’s still useful to think of When vacancies are few rela- these functions as distinct. tive to the natural rate, rents tend to Builders. Over horizons of two rise. When vacancies are relatively or more years, the main source of high, rents tend to fall (Chart 4). variation in available space is the con- For example, office rents have come struction of new buildings. Activity The surge in global under pressure as vacancy rates have depends on real estate prices, the increased in 2008. Rents also have a cost of materials and labor, and the commodity prices, secondary effect on the value of real availability of financing. Higher prices estate assets: In an efficient market, encourage building. When prices are especially metals, has what investors are willing to pay for a constant, construction activity tends to building depends on the rental income fall if building costs rise or financing been a major factor it’s expected to yield.8 becomes less favorable. Commercial builders have felt a in pushing up the price Demand and Supply considerable increase in cost pressure The basic tools of demand and over the past five years. The surge in of construction materials. supply can provide insight into the global commodity prices, especially CRE market and the determination of metals, has been a major factor in vacancy rates. It’s helpful to think sep- pushing up the price of construction arately about decisions made by build- materials (Chart 5). In September, ers, owners and users of real estate, hourly wages in commercial construc- each of them operating in distinct, but tion were up almost 8 percent for interrelated, markets. the year, despite layoffs in residential Builders demand materials and construction. labor and supply structures. Owners Most likely, higher costs played a demand structures and supply leased role in holding down the peak of the space. Users demand leased space and current construction cycle. If the same supply goods and services. The three material and labor price increases had taken place in the late 1990s, it would have meant less building activity in the early years of this decade. The increas- Chart 4 ing proportion of under-construction Real Office Rents Fall As Vacancy Rates Rise space being abandoned, especially in the CRE market’s weakening retail seg- Percent Index, 1987:Q1 = 100 ment, suggests builders are now facing 21 120 pressures from both higher costs and falling prices.9 19 Real rents 110 Owners. Pension funds, banks

17 and real estate investment trusts are 100 among the owners of CRE.10 For them, 15 the properties are a capital asset, held 90 to generate income. 13 A key factor determining how 80 11 much property they want to hold is

70 the user cost of capital, sometimes 9 called the rental equivalent price of

Vacancy rate 60 capital. It sums the direct financing 7 cost of funding the asset, the cost 5 50 of depreciation and expected capital ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 losses, adjusted for taxes.11 The user SOURCES: Torto Wheaton Research; Bureau of Economic Analysis. cost of capital tells us the total costs incurred by holding real estate, and

EconomicLetter 4 Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas EconomicLetter Chart 5 Construction Costs Rise Fast in Recent Years

Annual change (percent) 14 12 Owners of commercial 10

8 buildings have seen Hourly commercial 6 construction wages their profits squeezed 4 from both the revenue and 2

0 cost sides this year,

–2 Materials putting downward –4 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 pressure on demand. SOURCE: Haver Analytics. Rents have begun

it’s weighed by owners against the the economy. These industries, which falling in real terms, revenues earned from those assets. account for a quarter of total office Owners of commercial buildings employment, have shed 150,000 jobs reducing revenues, and have seen their profits squeezed from since November 2007. The demand both the revenue and cost sides this for retail space has been dampened user costs have risen. year, putting downward pressure on by both weak consumer spending and demand. Rents have begun falling in the downturn in suburban housing real terms, reducing revenues, and markets. user costs have risen. Credit availability is a key fac- This is partly the result of own- tor in each stage of CRE activity. ers anticipating capital losses on their Builders, owners and users depend real estate holdings. It’s also the result on the smooth functioning of financial of declines in many of these inves- markets to bridge the gaps between tors’ net worth, which lowers their expenses and income. The current creditworthiness and signals lenders to financial crisis, however, has thrown charge them higher interest rates. credit markets into disarray. Compounding the situation is the credit crunch. General corporate The Credit Crunch financing costs have risen because the Commercial real estate lending compensation investors and lenders is one of banking’s central activities. require for bearing all types of risk has In summer 2008, it accounted for 24 increased.12 percent of the industry’s loan book, or Users. The major users of com- some $1.7 trillion, compared with 28 mercial real estate are retailers and percent for residential real estate.13 other service-sector establishments, Looking at the past 20 years, both whose demand for space depends on these proportions are relatively high, demand for their products. and banks now have more exposure Spillovers from the housing to real estate as a whole than they did downturn are evident in the finance, at the last lending peak in 1991. The insurance and real estate segment of exposure is highest at small domestic

EconomicLetter Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas 5 EconomicLetter banks. CRE makes up 40 percent of Builders typically financed con- their loans, compared with 17 percent struction with two- or three-year bank at large domestic banks. loans. The building’s buyers then paid History offers ample reason for off the loan, with their own funds or a finding this trend troubling. When the mortgage. The lender may have held commercial property market slumped the mortgage on its balance sheet or in the early 1990s, banks took charges joined with others to create a pool of against reserves totaling 2 percent of mortgages and issued bonds linked to The credit crunch their loans in both 1991 and 1992. the pool’s income. These bonds are Many banks subsequently failed, a called commercial mortgage-backed that began with the lot of them in Texas and Oklahoma, securities (CMBS), and the process of where concentrations of real estate turning pools of mortgages into bonds revaluing of subprime loans were high. is an example of the now-familiar In the present cycle, delinquency securitization, or originate-to-distribute, residential mortgages and charge-off rates for commercial model that for a time proved highly lending have risen alongside those for profitable for investment banks. in August 2007 has residential loans (Chart 6). This pattern The credit crunch that began with is partly explained by the inclusion the revaluing of subprime residential affected all stages of of multifamily residences in the CRE mortgages in August 2007 has affected category. But they were also included all stages of commercial real estate commercial real in the 1990s, when banks didn’t face financing. Federal Reserve Board sur- problems with both segments of their veys show that banks have sharply estate financing. real estate portfolios simultaneously. tightened credit standards for CRE To understand how the declining loans since the third quarter of last year availability and higher cost of credit (Chart 7). Current-cycle loan growth may be hurting the commercial real peaked in 2005 but remained fairly estate market, we need to understand robust in the third quarter of 2008, even how the funding process operated amid banks’ reluctance to lend and prior to the financial crisis. weaker loan demand. This discrepancy may reflect the use of preexisting credit lines and is unlikely to persist. Chart 6 Appetite for CMBS has all but vanished this year. The premium Quality of Bank Real Estate Loans Deteriorating investors demand to hold CMBS has risen sharply since the onset of the Percent credit crunch (Chart 8). Although the 14 stock of outstanding CMBS remained historically high, it began falling in 12 Commercial delinquency rate first quarter 2008. Indeed, issuance of new CMBS has now all but ceased, 10 with Bloomberg reporting less than

8 $25 billion worth of deals in the first Commercial half of this year. charge-off rate 6 (net recoveries) The increased cost and reduced Residential charge-off rate availability of financing have direct 4 (net recoveries) Residential consequences for the commercial real delinquency estate market and secondary effects on rate 2 banks and investors. First, the supply of new structures is pinched when 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 builders can’t borrow. Second, banks are less willing to extend new credit NOTE: Residential loans include loans secured by properties with one to four units. Commercial loans include loans secured by residential properties with at least five units. when they can’t securitize loans. SOURCE: Federal Reserve Board. Buyers are likely to find that mortgages have become expensive or even

EconomicLetter 6 Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas EconomicLetter Chart 7 Tightening Loan Standards Crimps Loan Growth

Net proportion tightening Annual change (percent)

100 20

80 Loan growth Tougher times appear to 15 60 lie ahead. Worsening 10 40 macroeconomic

20 5 conditions, particularly

0 in the retail and other Loan standards –20 service sectors, are –40 –5 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 hurting CRE NOTE: The net tightening is the number reporting tighter standards less the number reporting looser standards. SOURCE: Federal Reserve Board. fundamentals.

Chart 8 Market for CMBS Stalls in 2008 unanticipated expansion of its balance sheet at a time when funds are costly. Basis points Billions of dollars If the asset were marked-to-market— 450 700 shown at market value—or subse-

400 quently sold at a discount, a charge 600 would be made against the bank’s 350 capital, hurting its capacity to lend. CMBS value outstanding 500 300 Little wonder, then, that a general desire to reduce CRE exposure has 250 400 taken hold across the banking sec- 200 300 tor. Although an individual bank can

150 free up capital by disposing of its real Spread 200 estate assets, fire sales of commercial 100 properties would weaken prices fur- 100 50 ther, with implications for other banks. In short, tougher times appear to 0 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 lie ahead. Worsening macroeconomic conditions, particularly in the retail and NOTE: The spread is the difference in yield between AAA-rated commercial mortgage-backed securities and Treasuries. other service sectors, are hurting CRE SOURCE: Bloomberg; Federal Reserve Board. fundamentals. Meanwhile the intensifi- cation of the credit crunch is dampen- ing market activity. And if commercial unavailable, which crimps demand a mortgage holder is unable to refi- property’s situation does grow worse, for CRE and reduces the number of nance? If the bank has to convert the banks are likely to face further losses. transactions. construction loan into a longer-term One factor that might limit these risks What happens to banks if a mortgage or take ownership of the is that the commercial real estate sec- builder is unable to sell a property or property, it would need to finance this tor wasn’t as grossly overbuilt heading

EconomicLetter Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas 7 EconomicLetter EconomicLetter is published monthly by the Federal Reserve Bank of Dallas. The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the 7 into the current economic slowdown See “The Price-Adjustment Process for Rental Federal Reserve System. as it had been in the early 1990s. Housing and the Natural Vacancy Rate,” by Articles may be reprinted on the condition that Kenneth T. Rosen and Lawrence B. Smith, the source is credited and a copy is provided to the Research Department of the Federal Reserve Bank of Meeks is an economist in the Research Department American Economic Review, vol. 73, no. 4, 1983, of the Federal Reserve Bank of Dallas. Dallas. pp. 779–86. Economic Letter is available free of charge 8 For a fuller exposition, see “The Role of by writing the Public Affairs Department, Federal Notes Speculation in Real Estate Cycles,” by Stephen Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX 1 75265-5906; by fax at 214-922-5268; or by telephone In general usage, commercial real estate may Malpezzi and Susan M. Wachter, Journal of consist of any property that is not an owner- at 214-922-5254. This publication is available on the Real Estate Literature, vol. 13, no. 2, 2005, pp. Dallas Fed website, www.dallasfed.org. occupied dwelling unit. Examples include offices, 143–64. industrial buildings, hospitals, warehouses, retail 9 TWR/Dodge Pipeline. stores and apartment buildings. This article 10 According to the National Association of Real largely focuses on nonresidential real estate. Estate Investment Trusts, the bulk of public Office and retail are two important categories of REITS are direct owners of, or have equity in, commercial real estate discussed in some depth, real estate, which they hold for the rental income but data sources don’t always separate them they generate. A subset of REITs, representing from other market segments. 7.5 percent of the overall market in 2007, deals 2 Basic data on commercial structures and mainly in loans secured by real estate, rather than housing stock are from the Bureau of Economic owning properties directly. Analysis. Private wealth was calculated as 11 User costs alone can only help us understand current-cost net stock of private nonresidential how much capital (in this case, structures) firms commercial structures, divided by total private want to hold, not how they time their spending on fixed assets. A more expansive definition new investment. A complete theory of investment of private wealth would include the stock of that incorporates user costs as one component is consumer durables, an estimate of intangible described in “Tobin’s Marginal q and Average q: Richard W. Fisher President and Chief Executive Officer capital and net foreign assets. A Neoclassical Interpretation,” by Fumio Hayashi, 3 For national office and retail properties, Torto Econometrica, vol. 50, no. 1, 1982, pp. 213–24. Helen E. Holcomb Wheaton Research shows the capitalization This theory makes the striking prediction that First Vice President and Chief Operating Officer rate spread over 10-year Treasury bonds was investment spending is determined only by the Harvey Rosenblum between 1 and 2 percent in second quarter 2008, price of installed relative to new capital. Executive Vice President and Director of Research well above levels seen during the late-1980s 12 Studies using aggregate data and user costs commercial property boom. based on risk-free rates have struggled to find W. Michael Cox 4 Senior Vice President and Chief Economist The Architecture Billings Index is likely to support for this model. Recent research has understate the downturn in office and retail highlighted the need for careful treatment of Robert D. Hankins construction because it includes industrial individual firms’ cost of capital when specifying Senior Vice President, Banking Supervision structures. user cost terms in investment equations. See Executive Editor 5 Looking at Chart 3, caution is needed in assessing “Investment and the Cost of Capital: New W. Michael Cox the magnitude of cyclical movements in real time, Evidence from the Corporate Bond Market,” by as estimates become less accurate toward the end Simon Gilchrist and Egon Zakrajšek, National Editor Richard Alm of the sample. However, this statistical evidence is Bureau of Economic Research Working Paper no. consistent with data from Torto Wheaton Research, 13174, June 2007. Associate Editor which show newly completed office buildings were 13 Federal Reserve Statistical Release H.8, Assets Monica Reeves a proportionately smaller addition to the stock of and Liabilities of Commercial Banks in the United Graphic Designer existing structures in the current cycle than in the States, Aug. 22, 2008, p. 1 (line 10 divided by Ellah Piña construction booms of the late 1990s or the 1980s. line 5). 6 For a detailed theoretical discussion, see “The Persistence of Real Estate Cycles,” by Steven R. Grenadier, Journal of Real Estate Finance and Economics, vol. 10, no. 2, 1995, pp. 95–119, and “Real Estate ‘Cycles’: Some Fundamentals,” by Federal Reserve Bank of Dallas William C. Wheaton, Real Estate Economics, vol. 2200 N. Pearl St. 27, no. 2, 1999, pp. 209–30. Dallas, TX 75201