December 13, 2013

Newmark Grubb Knight Frank

Friday Market Insight

Will the Discipline Last?

  The disciplined addition of new office and industrial space over the past several years has funneled a good chunk of demand into existing properties, which has helped the market recover. As a percentage of the existing inventory, office and industrial construction stood at 1.1% and 0.5%, respectively, at the end of the third quarter. This remains a fraction of the levels at the peak of the last expansion cycle in the third quarter of 2007 when construction topped out at 2.8% for office and 1.4% for industrial. Office construction activity is strongest in – of all places – Pittsburgh, where The Tower at PNC Plaza, an 800,000-square-foot downtown project that will be occupied by PNC, helped push the ratio to 3.8%. On the industrial side, San Antonio leads with construction totaling 2.4% of inventory, followed by California’s Inland Empire at 2.0%.

Construction levels are much lower than the industry’s prior two expansion cycles. In the period leading up to the 2001 recession, office construction peaked at 3.6% of inventory while industrial peaked at 2.1%.
The 1990-91 recession was preceded by a massive cycle of office overbuilding triggered by tax legislation in 1981 and 1986, which loosened and subsequently tightened the tax advantages available to real estate investors, setting off an ill-considered construction and lending boom that spawned the savings and loan crisis. It was the era of opulent, granite-clad towers delivered empty to the market. Texas fared worse than average due to reckless lending by many of its financial institutions compounded by an oil bust in the mid-1980s. Houston, with its lack of zoning, turned into the poster child for the boom-gone-bust and was punished accordingly by a generation of institutional investors who red-lined that market. Fast-forward to 2013 when Houston is near the top of investors’ buy lists.
The overbuilding of the 1980s haunted the commercial real estate industry, tarnishing its reputation as an asset class suitable for conservative investors while leaving a residue of concern that the industry was chronically prone to similar episodes. But lenders and developers have been more restrained since then, which has played a large role in restoring the industry’s credibility among investors. Will that restraint hold? In New York, longtime observers are wondering whether demand will catch up with projects in the pipeline. In Washington, D.C., the market has softened as a moderate construction cycle ran headlong into tenant downsizing related to government cutbacks. But these examples are like ripples from a stiff breeze on a lake compared with the tsunami of overbuilding a quarter century ago.
Next year will bring another surplus of demand over supply, reducing vacancy rates and pushing rents higher. The longer term prognosis is favorable, too, as lenders and their regulators exercise more vigilance overall in the wake of the 2008-2009 financial crisis and Great Recession.
Robert Bach   Director of Research - Americas  312.698.6754

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