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EconomicLetter Vol. 3, No. 12 DECEMBER 2008 Insights from the Federal Reserve Bank of Dall as Financial Crisis Casts Shadow Over Commercial Real Estate The commercial by Roland Meeks 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 tenth of private wealth. By comparison, the residential housing stock was worth $14.5 trillion. While housing prices soared in recent years, commercial property valuations don’t look wildly out of line, judging by standard comparisons to net income.3 And while the issuance of commercial mortgagebacked securities grew rapidly, the shoddy standards of subprime residential lending were mostly avoided. Lately, the commercial market has been wobbling. Real transaction prices for office properties were 11 percent lower in the third quarter of this year than at the end of 2007, and retail properties changed hands for 6 percent less (Chart 1). The Architecture Billings Index, a leading indicator of commercial construction, has been exceptionally weak, with the lowest readings on record in the past six months (Chart 2).4 Overall spending on diverse categories of commercial structures — shopping centers and restaurants, for example — has now gone into reverse. For the economy as a whole, two key risks loom in a downturn of the commercial real estate market. First, a steep and prolonged decline in construction spending would place another burden on growth in an economy already reeling from falling housing prices and financial turmoil. Second, a fall in property values could result in losses for the banking sector. Such losses could impair banks and the financial sector, posing added risks to the economy from a reduced willingness to lend. Chart 1 Real Prices for Office and Retail Buildings Are Declining Index, 1994:Q1 = 100 250 Office 200 Retail 150 100 50 0 1994 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Chart 2 Architectural Billings Point to Slower Investment Annual change (percent) Index 65 20 Billings 15 60 10 55 5 50 0 –5 45 –10 40 –15 Investment growth –20 1996 Boom and Bust? Construction spending is a volatile component of GDP. Over the past 50 years, commercial real estate (CRE) investment growth’s standard deviation from the mean — a common measure of volatility — was 10.7 percent. This is less than residential’s 14.4 percent but nearly five times higher than the volatility of GDP growth. 1995 SOURCES: MIT Center for Real Estate; Bureau of Economic Analysis. 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 35 NOTE: Index values above 50 indicate an increase in billings. SOURCES: American Institute of Architects, Architecture Billings Index; Bureau of Economic Analysis. Residential and commercial construction impact GDP growth through their contribution to fixed investment. The decline in residential construction spending has exerted a power- EconomicLetter 2 F edera l Re serve Bank of Dall as ful drag on fixed investment growth since the housing boom peaked two years ago, amounting to more than 8 percent in some quarters. Commercial building, meanwhile, still managed to contribute modestly to investment growth through the second quarter of 2008. Commercial construction’s volatility is a standard feature of the U.S. business cycle. It has turned down, often sharply, in virtually every recession since 1970. At the trough of the previous commercial property bust — following the dot-com bubble’s collapse in 2001 — CRE construction contracted 18 percent on a year-overyear basis. However, the peak of the most recent construction cycle doesn’t appear high compared with five previous episodes since the early 1970s, suggesting the industry may not be set up for as big a fall this time (Chart 3).5 Overall, the CRE market’s retreat from its peak has been moderate—so far — and the amount of unoccupied commercial space on the market remains about average. But the fundamental outlook for commercial real estate soured somewhat in the first half of 2008, coinciding with the downturn in the business cycle. The third quarter showed continuing deterioration, and a deep recession in the U.S. would be 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 repeat of past declines in CRE investment would greatly damage overall economic growth. In the longer term, the slower pace of new construction will probably mean the overhang of vacant space won’t be severe. However, it’s reasonable to expect vacancy rates to rise, while rents and property prices fall, during 2009. Rents and Vacancies The sizable fluctuations seen in real estate investment might be put down to myopia or overexuberance. But they aren’t necessarily irrational. Cycles can be a feature of a market in which developers are fully rational, in the sense of making internally consistent, forward-looking decisions based on full information.6 To understand the economics of the commercial real estate market, we look first to the vacancy rate, which is unoccupied square footage as a proportion of total available space. U.S. office vacancies have fluctuated between 8 and 20 percent since the mid-1980s. In the third quarter of 2008, the rate was 13 percent, trending upward but average by historical standards. Retail vacancies stood at 10 percent, also rising but average. Imbalances between demand and supply show up as vacancies, which rise and fall but don’t disappear. A substantial stock of commercial real estate is always unoccupied, suggesting that demand and supply are never perfectly matched. Why don’t rents fall to bring the market into balance? An excess supply of commercial space can be consistent with stable rents in markets where owners and tenants must engage in a timeconsuming and costly search before making a match. Increased search costs, contracting costs and uncertainty raise the vacancy rate at which there is no pressure to change rents. It’s unlikely that even a repeat of past declines in CRE investment would greatly damage overall economic growth. Chart 3 Commercial Investment Peak Lower in Current Cycle Deviation from trend (percent) 20 15 Investment 10 5 GDP 0 –5 –10 –15 –20 ’69 ’71 ’73 ’75 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 SOURCES: Bureau of Economic Analysis; author’s calculations. F ederal Reserve Bank of Dall as 3 EconomicLetter ’97 ’99 ’01 ’03 ’05 ’07 The surge in global commodity prices, especially metals, has been a major factor in pushing up the price of construction materials. Real estate economists call this equilibrium point the natural vacancy rate.7 When vacancies are few relative to the natural rate, rents tend to rise. When vacancies are relatively high, rents tend to fall (Chart 4). For example, office rents have come under pressure as vacancy rates have increased in 2008. Rents also have a secondary effect on the value of real estate assets: In an efficient market, what investors are willing to pay for a building depends on the rental income it’s expected to yield.8 Demand and Supply The basic tools of demand and supply can provide insight into the CRE market and the determination of vacancy rates. It’s helpful to think separately about decisions made by builders, owners and users of real estate, each of them operating in distinct, but interrelated, markets. Builders demand materials and labor and supply structures. Owners demand structures and supply leased space. Users demand leased space and supply goods and services. The three Chart 4 Real Office Rents Fall As Vacancy Rates Rise Percent Index, 1987:Q1 = 100 120 21 19 Real rents 17 110 100 15 90 13 80 11 70 9 Vacancy rate 7 5 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 SOURCES: Torto Wheaton Research; Bureau of Economic Analysis. EconomicLetter 4 F edera l Re serve Bank of Dall as 60 50 categories may overlap; for example, a store may own the building it occupies. But it’s still useful to think of these functions as distinct. Builders. Over horizons of two or more years, the main source of variation in available space is the construction of new buildings. Activity depends on real estate prices, the cost of materials and labor, and the availability of financing. Higher prices encourage building. When prices are constant, construction activity tends to fall if building costs rise or financing becomes less favorable. Commercial builders have felt a considerable increase in cost pressure over the past five years. The surge in global commodity prices, especially metals, has been a major factor in pushing up the price of construction materials (Chart 5). In September, hourly wages in commercial construction were up almost 8 percent for the year, despite layoffs in residential construction. Most likely, higher costs played a role in holding down the peak of the current construction cycle. If the same 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 increasing proportion of under-construction space being abandoned, especially in the CRE market’s weakening retail segment, suggests builders are now facing pressures from both higher costs and falling prices.9 Owners. Pension funds, banks and real estate investment trusts are among the owners of CRE.10 For them, the properties are a capital asset, held to generate income. A key factor determining how much property they want to hold is the user cost of capital, sometimes called the rental equivalent price of capital. It sums the direct financing cost of funding the asset, the cost of depreciation and expected capital losses, adjusted for taxes.11 The user cost of capital tells us the total costs incurred by holding real estate, and Chart 5 Construction Costs Rise Fast in Recent Years Annual change (percent) 14 12 Owners of commercial 10 buildings have seen 8 Hourly commercial construction wages 6 their profits squeezed 4 from both the revenue and 2 cost sides this year, 0 –2 –4 putting downward Materials 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 SOURCE: Haver Analytics. pressure on demand. Rents have begun it’s weighed by owners against the revenues earned from those assets. Owners of commercial buildings have seen their profits squeezed from both the revenue and cost sides this year, putting downward pressure on demand. Rents have begun falling in real terms, reducing revenues, and user costs have risen. This is partly the result of owners anticipating capital losses on their real estate holdings. It’s also the result of declines in many of these investors’ net worth, which lowers their creditworthiness and signals lenders to charge them higher interest rates. Compounding the situation is the credit crunch. General corporate financing costs have risen because the compensation investors and lenders require for bearing all types of risk has increased.12 Users. The major users of commercial real estate are retailers and other service-sector establishments, whose demand for space depends on demand for their products. Spillovers from the housing downturn are evident in the finance, insurance and real estate segment of the economy. These industries, which account for a quarter of total office employment, have shed 150,000 jobs since November 2007. The demand for retail space has been dampened by both weak consumer spending and the downturn in suburban housing markets. Credit availability is a key factor in each stage of CRE activity. Builders, owners and users depend on the smooth functioning of financial markets to bridge the gaps between expenses and income. The current financial crisis, however, has thrown credit markets into disarray. falling in real terms, reducing revenues, and user costs have risen. The Credit Crunch Commercial real estate lending is one of banking’s central activities. In summer 2008, it accounted for 24 percent of the industry’s loan book, or some $1.7 trillion, compared with 28 percent for residential real estate.13 Looking at the past 20 years, both these proportions are relatively high, and banks now have more exposure to real estate as a whole than they did at the last lending peak in 1991. The exposure is highest at small domestic F ederal Reserve Bank of Dall as 5 EconomicLetter The credit crunch that began with the revaluing of subprime residential mortgages in August 2007 has affected all stages of commercial real estate financing. banks. CRE makes up 40 percent of their loans, compared with 17 percent at large domestic banks. History offers ample reason for finding this trend troubling. When the commercial property market slumped in the early 1990s, banks took charges against reserves totaling 2 percent of their loans in both 1991 and 1992. Many banks subsequently failed, a lot of them in Texas and Oklahoma, where concentrations of real estate loans were high. In the present cycle, delinquency and charge-off rates for commercial lending have risen alongside those for residential loans (Chart 6). This pattern is partly explained by the inclusion of multifamily residences in the CRE category. But they were also included in the 1990s, when banks didn’t face problems with both segments of their real estate portfolios simultaneously. To understand how the declining availability and higher cost of credit may be hurting the commercial real estate market, we need to understand how the funding process operated prior to the financial crisis. Chart 6 Quality of Bank Real Estate Loans Deteriorating Percent 14 12 Commercial delinquency rate 10 8 6 Commercial charge-off rate (net recoveries) Residential charge-off rate (net recoveries) 4 2 Residential delinquency rate 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 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. SOURCE: Federal Reserve Board. EconomicLetter 6 F edera l Re serve Bank of Dall as Builders typically financed construction with two- or three-year bank loans. The building’s buyers then paid off the loan, with their own funds or a mortgage. The lender may have held the mortgage on its balance sheet or joined with others to create a pool of mortgages and issued bonds linked to the pool’s income. These bonds are called commercial mortgage-backed securities (CMBS), and the process of turning pools of mortgages into bonds is an example of the now-familiar securitization, or originate-to-distribute, model that for a time proved highly profitable for investment banks. The credit crunch that began with the revaluing of subprime residential mortgages in August 2007 has affected all stages of commercial real estate financing. Federal Reserve Board surveys show that banks have sharply tightened credit standards for CRE loans since the third quarter of last year (Chart 7). Current-cycle loan growth peaked in 2005 but remained fairly robust in the third quarter of 2008, even amid banks’ reluctance to lend and weaker loan demand. This discrepancy may reflect the use of preexisting credit lines and is unlikely to persist. Appetite for CMBS has all but vanished this year. The premium investors demand to hold CMBS has risen sharply since the onset of the credit crunch (Chart 8). Although the stock of outstanding CMBS remained historically high, it began falling in first quarter 2008. Indeed, issuance of new CMBS has now all but ceased, with Bloomberg reporting less than $25 billion worth of deals in the first half of this year. The increased cost and reduced availability of financing have direct consequences for the commercial real estate market and secondary effects on banks and investors. First, the supply of new structures is pinched when builders can’t borrow. Second, banks are less willing to extend new credit when they can’t securitize loans. Buyers are likely to find that mortgages have become expensive or even Chart 7 Tightening Loan Standards Crimps Loan Growth Net proportion tightening Annual change (percent) 20 100 Loan growth 80 15 lie ahead. Worsening 60 10 40 20 5 0 0 Loan standards –20 macroeconomic conditions, particularly in the retail and other service sectors, are –5 –40 hurting CRE 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 NOTE: The net tightening is the number reporting tighter standards less the number reporting looser standards. fundamentals. SOURCE: Federal Reserve Board. Chart 8 Market for CMBS Stalls in 2008 Basis points Billions of dollars 450 700 400 600 350 500 CMBS value outstanding 300 400 250 200 150 Tougher times appear to 300 Spread 200 100 100 50 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 0 NOTE: The spread is the difference in yield between AAA-rated commercial mortgage-backed securities and Treasuries. SOURCE: Bloomberg; Federal Reserve Board. unavailable, which crimps demand for CRE and reduces the number of transactions. What happens to banks if a builder is unable to sell a property or a mortgage holder is unable to refinance? If the bank has to convert the construction loan into a longer-term mortgage or take ownership of the property, it would need to finance this F ederal Reserve Bank of Dall as unanticipated expansion of its balance sheet at a time when funds are costly. If the asset were marked-to-market— shown at market value — or subsequently sold at a discount, a charge would be made against the bank’s capital, hurting its capacity to lend. Little wonder, then, that a general desire to reduce CRE exposure has taken hold across the banking sector. Although an individual bank can free up capital by disposing of its real estate assets, fire sales of commercial properties would weaken prices further, with implications for other banks. In short, tougher times appear to lie ahead. Worsening macroeconomic conditions, particularly in the retail and other service sectors, are hurting CRE fundamentals. Meanwhile the intensification of the credit crunch is dampening market activity. And if commercial property’s situation does grow worse, banks are likely to face further losses. One factor that might limit these risks is that the commercial real estate sector wasn’t as grossly overbuilt heading 7 EconomicLetter EconomicLetter into the current economic slowdown as it had been in the early 1990s. 7 See “The Price-Adjustment Process for Rental Housing and the Natural Vacancy Rate,” by Kenneth T. Rosen and Lawrence B. Smith, Meeks is an economist in the Research Department of the Federal Reserve Bank of Dallas. American Economic Review, vol. 73, no. 4, 1983, pp. 779–86. 8 Notes 1 In general usage, commercial real estate may consist of any property that is not an owneroccupied dwelling unit. Examples include offices, For a fuller exposition, see “The Role of Speculation in Real Estate Cycles,” by Stephen Malpezzi and Susan M. Wachter, Journal of Real Estate Literature, vol. 13, no. 2, 2005, pp. 143–64. industrial buildings, hospitals, warehouses, retail 9 stores and apartment buildings. This article 10 TWR/Dodge Pipeline. 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 housing stock are from the Bureau of Economic Analysis. Private wealth was calculated as mainly in loans secured by real estate, rather than owning properties directly. 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: capital and net foreign assets. A Neoclassical Interpretation,” by Fumio Hayashi, 3 For national office and retail properties, Torto Wheaton Research shows the capitalization Econometrica, vol. 50, no. 1, 1982, pp. 213–24. This theory makes the striking prediction that rate spread over 10-year Treasury bonds was investment spending is determined only by the between 1 and 2 percent in second quarter 2008, price of installed relative to new capital. well above levels seen during the late-1980s 12 commercial property boom. Studies using aggregate data and user costs based on risk-free rates have struggled to find 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 construction because it includes industrial individual firms’ cost of capital when specifying structures. user cost terms in investment equations. See 4 5 Looking at Chart 3, caution is needed in assessing “Investment and the Cost of Capital: New 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 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. which show newly completed office buildings were 13 Federal Reserve Statistical Release H.8, Assets a proportionately smaller addition to the stock of and Liabilities of Commercial Banks in the United existing structures in the current cycle than in the States, Aug. 22, 2008, p. 1 (line 10 divided by construction booms of the late 1990s or the 1980s. line 5). 6 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 Federal Reserve System. Articles may be reprinted on the condition that the source is credited and a copy is provided to the Research Department of the Federal Reserve Bank of Dallas. Economic Letter is available free of charge by writing the Public Affairs Department, Federal Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX 75265-5906; by fax at 214-922-5268; or by telephone at 214-922-5254. This publication is available on the Dallas Fed website, www.dallasfed.org. Richard W. Fisher President and Chief Executive Officer Helen E. Holcomb First Vice President and Chief Operating Officer Harvey Rosenblum Executive Vice President and Director of Research W. Michael Cox Senior Vice President and Chief Economist Robert D. Hankins Senior Vice President, Banking Supervision Executive Editor W. Michael Cox Editor Richard Alm Associate Editor Monica Reeves Graphic Designer Ellah Piña 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 William C. Wheaton, Real Estate Economics, vol. 27, no. 2, 1999, pp. 209–30. Federal Reserve Bank of Dallas 2200 N. Pearl St. Dallas, TX 75201
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