Houston in the 1980s was a city of vacant office towers. Even as the oil boom turned to glut and the economy sank, real estate developers doubled the size of the office market from 1980 to 1986, according to commercial real estate performance tracker Reis.
Now Houston is undergoing another boom in office construction as Texas experiences a shale energy revolution and leads the nation in job growth. For banks that help finance the $5 trillion U.S. commercial real estate market, and for the investors who purchase commercial mortgage-backed securities, this trend may raise the question of whether an economic boom could end in another commercial real estate bust.
This time its different are famous last words for an economist. But evidence accumulated over the last two decades shows that the U.S. office property marketa sector that predictably boomed and busted every 15 years or so prior to 1991has become a model of a disciplined, well-functioning real estate market. This positive change appears to be largely the result of increased transparency and discipline brought about by capital markets and stock exchange-listed equity real estate investment trusts, or equity REITs. The office market in the era of listed equity REITs provides a prime example of how a well-structured, securitized real estate market, by moderating construction boom and bust tendencies, can generate positive spillover benefits to the economy at large.
Although overbuilding of the housing market in the years leading up to the 2008 financial crisis is widely recognized, fewer people are aware that commercial real estate remained remarkably unaffected by overbuilding. That remains the case today. The commercial real estate that suffered during the crisis did so because businesses hit hard by the recession went under or fell behind on their loansnot because there were too many buildings.
My research indicates that much of the difference between commercial real estate and residential housing can be attributed to the influence of equity REITs. Since the early 1990s, the market share of office properties owned by publicly traded equity REITs has increased by more than tenfold. Unlike private real estate players, REITs receive instantaneous feedback on operating and investment plans as their share prices rise or fall on corporate announcements. My research indicates that the information signals REITs provide to the overall market appear to have tempered commercial real estate boom and bust cycles.
The office property sector until fairly recently was a classic boom-and-bust market characterized by periods of significant overbuilding. During the go-go 1980s, completions of new office construction averaged over 7% of total inventory per year and peaked at nearly 10% in added annual square footage before the collapse of the U.S. commercial real estate market in 1989-90.
Since the early 1990s, however, the publicly listed equity REIT market has grown from an equity market capitalization of $13 billion in 1991 to a capitalization of $670 billion in 2013. This growth provided a new indicator of commercial real estate supply and demand and changed the calculus driving new construction in the marketplace. From 1991 to 2013, new office completions as a percentage of inventory averaged just 1.4%, with a peak in 1999 of 3.8%. As a percentage of existing stock, new office completions averaged a modest range of 1%-2% from 2002 to 2008. The supply of new commercial real estate increased even more gradually during the sluggish economic recovery, which also appears to have dampened swings in vacancy rates in recent years.
Key market players now pay close attention to REITs before allocating more capital to commercial property markets. For example, when new office construction occurs in Washington, D.C., and share prices of REITs that hold office property there react negatively to this information, it sends a signal to construction lenders, among others, that further new supply of office space may negatively impact rents going forward. This in turn may constrain additional construction lending.
In contrast, private ownership markets generally provide critical information with a greater time lag, implying that capital misallocations can persist for longer periods of time. The transparency, financial reporting, price discovery and structural factors provided by public capital markets and listed real estate securities serve to defeat distortions associated with opaque private markets that historically have culminated in prolonged busts.
As publicly traded REITs now provide a marker that private real estate owners and developers can use to tailor their development activity to market demand, they also provide banks with an indicator to make more informed lending decisions. These informed decisions, in turn, help moderate the supply of credit to prevent market bubbles and the economic damage they can produce. The listed equity REIT industry thus provides a valuable warninglike one of those flashing road signs that indicate when the speed limit is being exceededfor all who choose to pay attention to it.
Timothy Riddiough is a professor in the Department of Real Estate and Urban Land Economics at the University of Wisconsin School of Business. This article is based on research by Prof. Riddiough and two colleagues that appeared in the Journal of Portfolio Management.