Is Commercial Real Estate Reliving the 1980s and Early 1990s?

By Garner, C. Alan | Economic Review - Federal Reserve Bank of Kansas City, Third Quarter 2008 | Go to article overview

Is Commercial Real Estate Reliving the 1980s and Early 1990s?


Garner, C. Alan, Economic Review - Federal Reserve Bank of Kansas City


Concern has been rising about the health of the U.S. commercial real estate market and any impact it may have on financial markets and institutions. It is too early to judge the full extent of any problems, but commercial real estate financing has been shaken by the financial market tiirmoil associated with recent residential mortgage defaults. The spreads of commercial mortgage-backed securities have widened relative to Treasury securities, and recent reports suggest that prices for many commercial properties are declining. In addition to the direct effects on construction activity, large commercial real estate losses by financial institutions might dampen broad-based economic growth by causing banks to cut back on commercial, industrial, and household lending.

One way to gain perspective on the current commercial real estate market is to look back at historical experience. A natural comparison is with the 1980s and early 1990s. In the 1980s, commercial construction boomed, resulting in a massive oversupply of commercial space and creating serious financial problems for many depository institutions and real estate investors. Many analysts believe these problems helped cause a broader credit crunch in the early 1 990s, which reduced the availability of funds to small and middle-sized businesses and slowed overall economic growth.

How is the current economic and financial situation in commercial real estate similar to and different from the conditions leading up to the real estate bust in the late 1980s and early 1990s? The first section of this article will describe the earlier episode and identify contributing economic and financial factors. The second section will consider how current commercial real estate fundamentals are similar to and different from the earlier episode. The recent commercial construction boom was not as large as in the 1980s, suggesting excess supplies of commercial space may not grow as large. The third section will examine the curtent size and distribution of financial risks relative to the earlier episode. A major difference from the early 1990s - increased commercial real estate securitization - may expose developers and investors to shocks originating outside the commercial real estate sector. A major similarity is that commercial banks currently have a large direct exposure to commercial real estate loans.

I. WHAT HAPPENED IN THE 1980s AND EARLY 1990s?

Although commercial real estate has always been cyclical in nature, the 1 980s and early 1 990s stand out as a major episode of overbuilding. For example, booming construction during the early 1 980s eventually caused large increases in office vacancy rates in the late 1980s and early 1990s. The resulting losses on real estate loans in turn caused a surge in failures by banks and savings institutions. After a brief overview of the commercial construction sector, this section describes the causes and extent of the 1 980s building boom and discusses the real and financial consequences of the subsequent real estate bust for broader economic activity.

Com mereiai construction

The commercial construction sector includes a wide range of property types. In this article, this sector is defined as office buildings, retail structures, warehouses, and privately owned healthcare facilities. By this definition, investment in commercial structures accounted for about 1 6 percent of all private investment in structures in 2007 (Chart 1). Construction of multifamily housing (apartments and some townhouses) will also be examined in comparing the 1980s and early 1990s with the present because the financing of multifamily structures is similar to commercial real estate financing. Investment in multifamily residential structures, was about 4 percent of private structures investment in 2007. Because of their similarities, this article will sometimes examine the combined behavior of the commercial and multifamily categories.1

Commercial real estate has historically been subject to booms and busts. …

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