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FRBSF

WEEKLY LETTER

July 6, 1990

Real Estate Problems in the West?
During the 1980s, serious real estate downturns
followed booms in Texas, Arizona, and the New
England states. In each case, signs of overbuilding were apparent before the downturn. This
Letter sorts out some of these signals, and then
examines current conditions in California, Washington, and Nevada to see whether similar
signals exist in those markets.

Measures of market vulnerability
A common worry is that rapid increases in real
estate values increase the risk of a real estate
downturn. However, most downturns are associated with supply and demand conditions in real
estate markets, and thus are not caused by high
and/or rising prices alone. Prices generally fall
when supply exceeds the market's ability to
absorb it.
To determine whether a market is particularly
vulnerable to a downturn, then, this article
focuses on three simple measures of supply and
demand conditions, called "measures of vulnerability!' These are the office vacancy rate in a
given area, the share of total employment provided by the construction sector, and the number
of housing permits awarded for each new resident. Although these simple measures are not
comprehensive, anyone of these measures that
is "high" can be a signal that there may be "too
much" building in the region.
However, these kinds of statistics can only
suggest whether a given market is vulnerable,
and cannot accurately forecast whether it will
experience a downturn. Robust construction
activity may be entirely appropriate if the state's
economy continues to grow rapidly. On the other
hand, overbuilding could become a problem if
the pace of growth were to fall below the optimistic expectations that generated the robust
building activity. Overbuilding also could be
a problem in a market that did not show early
signs of vulnerability if actual growth were to
fall significantly below the expectations embodied in the moderate construction activity. Thus,
these signals can suggest which states' economies are less likely to live up to expectations, but

by themselves they cannot predict accurately
where serious real estate problems will occur.

A look at Texas
Many view Texas as the prototype of a real estate
collapse, complete with "see-through" office
buildings, declining property values, and failed
financial institutions. A commonly held view is
that the Texas economy was booming until oil
prices declined sharply early in 1986. This impression, however, is not completely accurate.
The Texas economy was growing at a healthy,
but not spectacular pace during the early 1980s.
During 1984 and 1985, population growth in
Texas was still 50 percent higher than the national average, but this represented a slowdown
from prior years. In 1985, moreover, employment
in Texas grew at a 2.6 percent rate, which was
healthy but less than the 2.9 percent growth seen
nationally.
In this environment, signs of overbuilding
emerged. First, the three Texas cities for which
Coldwell Banker calculated vacancy rates in
1985 all earned the dubious distinction of being
in the "Top Ten" nationally. Their vacancy rates
ranged from 22 to 27% percent, high even compared with the 19 percent nationwide vacancy
rate in 1985. Moreover, construction accounted
for 6.7 percent of all Texas jobs in 1985. This was
significantly higher than the 4% percent national
share, suggesting that construction activity may
have been stronger than the state's more moderate economic climate could support.
At the same time, however, home-building activity was not out of line with population growth
in Texas. During the 1982-85 period, two housing
permits were issued for every three new residents
in the state, a rate of home building very close to
the national average. In sum, there were some
signs of vulnerability by 1985 which, when
coupled with the significant slowing in the state's
avera!! growth rate, ca!!ed for caution.

Arizona
The situation prior to the downturn in Arizona
was quite different from that in Texas. Until 1986,

FRBSF
when construction activity peaked, Arizona's
economy was growing at an incredible pace.
Employment grew by 10 percent in 1984 and by
eight percent in 1985, and population growth was
consistently double or triple the national rate, In
keeping with this growth, Arizona's real estate
markets boomed, although home building activity was not out of line with the state's population growth. From 1983 through 1986, three
housing permits were issued for every five new
residents, a rate that actually was somewhat
lower than the national average, In contrast,
commercial markets appeared vulnerable,
with Phoenix's office vacancy rate at a very
high 27112 percent.
The most distinctive characteristic of Arizona's
boom, however, was the important role construction played in fueling overall growth. Construction employment grew by more than 20 percent
in both 1983 and 1984. By 1986, construction
employment accounted for 8112 percent of Arizona's jobs, almost tv/ice the┬Ěnational average.
With construction activity growing more rapidly
than the overall economy, Arizona's real estate
markets were vulnerable to even a modest slowing in overall growth. This occurred in 1987,
when total employment growth slowed to a stillhealthy two percent pace. That same year, construction employment began its sharp decline,
falling by seven percent. But even as construction activity has fallen and loan losses have
mounted, Arizona has continued to post overall
growth. Thus, Arizona's real estate problems have
occurred against the backdrop of a fundamentally healthy economy, in which real estate
activity for a time outpaced even this fastgrowing state's ability to absorb it.

New England
New England offers yet another scenario for a
real estate downturn. The New England states
posted strong growth during the early to mid1980s, due largely to success in the hightechnology and defense sectors. But in 1985,
manufacturing employment started to decline,
falling by a total of 13 percent between 1984
and 1989. Yet the economy as a whole continued
to do quite well.
The signs of vul nerability that preceded the
downturns in Texas and Arizona were absent in
New England. Construction accounted for five

percent of total employment, only slightly higher
than the national average, and office vacancy
rates in New England cities were considerably
lower than the national average.
Nevertheless, one sign of vulnerability did
exist. From 1985 to 1988, more than one housing
permit was issued for each new resident in the
region. This suggests that builders' collective
expectations about future population growth may
have been unrealistically optimistic. Thus, after
economic growth in New England began to slow,
it took several years for the construction and real
estate sectors to adjust to the new reality of
slower economic growth and reduced demand
for housing.

TheWesH
Real estate activity and construction currently
are booming in many parts of the West. The hot
markets previously seen in the San Francisco and
Los Angeles areas are cooling now, while inland
areas are reporting boom conditions. ~~evada
continues to post phenomenal growth. Activity
in Washington remains strong. For each of these
regions, some cooling is inevitable, but it is legitimate to ask whether boom times have made
these economies particularly vulnerable to the
kinds of serious real estate problems that have
occurred elsewhere.
Between the end of 1987 and Spring of 1989,
California saw a dramatic surge in home-buying
activity, home prices, and construction activity,
Nevertheless, there is no evidence that this
frenzy of activity has created the kind of vulnerability that would increase the odds of serious
real estate problems in California. Construction
employment remains only 5.2 percent of total
employment, just slightly higher than the national
average and low enough to suggest that California's economy is not excessively constructiondependent. And home-building activity in
California actually has been less intense relative
to population growth than it has been nationally.
During the 1985-1989 period, less than one housing permit was issued for every two people
added to the population.
Moreover, of the ten California metropolitan
areas surveyed regularly by Coldwell 'Banker,
only four have office vacancy rates higher than
the national average. And in three of those four
cities, vacancies are only slightly higher than the

19.9 percent national average. Only Bakersfield,
with a 26.3 percent rate, seems vulnerable at
present.
These figures suggest that, at least on the statewide level, current real estate market conditions
do not make California especially vulnerable to a
real estate downturn. However, this does not preclude the possibility that some areas within the
state may have imbalances in their real estate
mark~ts.

for 7.5 percent of total employment in Nevada
during 1989.
The apparent contradiction between a high level
of dependence on construction activity on the
one hand, and residential and office markets that
do not appear to be overbuilt on the other hand,
may be explained by the pace of casino building.
Several large new casinos are being built in Las
Vegas, raising concerns about whether the gaming market will be large enough to make these
projects profitable as they come on line.

Washington and Nevada
Washington (particularly the Seattle area) has
been booming for the past few years, and real
estate markets have been very hot for most of
the past year. Nevertheless, none of the measures
of vulnerability is high at present. During the
1986-89 period, only one housing permit was
issued for every two new residents. Seattle's office
vacancy rate is well below the national average,
at 15 percent, and construction employment
currently accounts for only 5.2 percent of total
employment.
Thus, in Washington, as in California, the recent
robust construction and real estate activity has
not been out of line with general economic activity, suggesting that real estate markets probably will be able to adjust to slower economic
growth without collapsing.
Although Nevada's boom has not received as
much media attention as California's has, in
most respects Nevada's story has been much
more dramatic. Nevada has been the fastestgrowing state in the U.S. for the past three years,
with employment growth averaging 6.8 percent
per year during that period.
This incredibly robust growth may seem like a
perfect setup for a real estate collapse, but many
of the statistics are encouraging. Las Vegas' 10.6
percent office vacancy rate is the second lowest
among the metropolitan areas tracked by Coldwell Banker. The ratio of housing permits to new
residents was three to five during the 1986 to
1989 period, somewhat below the national
average. Among the measures of vulnerability
examined in this Letter, the only worrisome one
is construction employment, which accounted

At any rate, Nevada's growth rate is likely to slow
from the unsustainably rapid six to seven percent
pace of the last few years. In an economy where
construction is such an important component of
the state's economy, building activity will bear
more than its share of the adjustment to slower
economic growth. This suggests that Nevada is
more vulnerable to a real estate downturn than
either California or Washington is, although the
signals examined here are less ominous than they
were for Texas or Arizona.

Encouraging signals, on balance
The analysis presented here shows that in some
regions that have eXDerienced serious real estate
problems, there were signs of vulnerability before
the onset of those problems. Construction activity was robust enough that continued rapid
growth would have been necessary in order to
absorb the new space.
At present, neither California nor Washington
show signs of this kind of vulnerability. This suggests that severe regional recessions (which most
forecasters do not anticipate) would be necessary
to create serious real estate problems in these
states. In Nevada, office vacancy rates and the
rate of home-building relative to population
growth suggest that the region's construction
boom is well within the economy's ability to
absorb the new space. However, the high level
of dependence on construction activity does
suggest that a relatively sharp slowdown in
construction activity may be necessary when the
pace of general economic activity begins to slow.

Carolyn Sherwood-Call
Economist

Opinions expressed in this newsietter do not necessariiy refiect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120