Considering the recent upswing in commercial real estate prices and traded real estate stocks, in what inning is the commercial real estate recovery? Could there be extra innings? Prior to the most recent decline in real estate, downturns in commercial real estate cycles have historically been caused by supply shocks—developers putting up new buildings until they (or their banks) ran out of money. However, the most recent downturn that took place during the 2008 financial crisis was a demand shock. As a country, we didn’t have an overabundance of buildings, we had too few employees needing places to work and not enough consumers needing places to shop.
Employment trends now indicate that demand is recovering (see first chart below). As of June 30, 2014, the number of employees being added annually to nonfarm payrolls has returned to precrisis levels. All of these new employees need places to live, shop and work, which fuels the demand for multiple property types: apartments, retail malls and shopping centers, and office buildings. However, despite an increase in demand, construction of new buildings as a percentage of existing inventory—new supply
—remains muted (as shown in the second chart below). There are exceptions to this supply trend, such as the number of new office buildings in San Francisco and new apartments in Washington D.C., but the takeaway is that the length of the current upturn will likely be determined by how long the economic recovery continues, at least here in the U.S. If the recovery stalls, and employment trends reverse, commercial real estate will no doubt suffer.
Downturns of years past
First, a brief history primer is in order. In the 1970s and 1980s, tax laws allowed for accelerated depreciation of commercial real estate owned by limited
partnerships, so tens of billions of dollars flowed into these vehicles during this period of time. This capital was often combined with very high levels of leverage in order to amplify the tax benefits for limited partners. Additionally, savings and loan officers provided debt capital (credit) to developers who seized the opportunity to build new buildings that often lacked one critical component: tenants. Then came the Tax Reform Act of 1986, which wiped out the accelerated real estate depreciation, and suddenly limited partners and other investors witnessed the vaporization of their investments. Without tax benefits, many partnerships did not have financial reasons to exist and
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Touching Base on the Commercial Real Estate Recovery
Matthew Abbott
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