Calculating the Overbuilding Equation
During the dismal first half of the 1990s, new commercial real estate development ground to a halt. Construction was absent from the industry for so many years that developers began to think of themselves as property managers.
But mid-decade, as the industry recovered from the turmoil of the early 1990s, a surge in commercial real estate development began to occur. Now that new buildings consistently are being added to the inventory, the question arises: Are we repeating the mistakes of the 1980s by overbuilding?
To answer this question, consider two definitions of overbuilding. Some real estate professionals define overbuilding as creating supply in excess of demand, while others say it is growing the inventory base too quickly. Although similar, these definitions are not the same because they use different benchmarks. The first definition measures overbuilding by comparing supply and demand data while the second measures it by calculating supply change over time.
Demand often is measured in terms of absorption -- an inherently backward-looking calculation because it is based on the difference in occupancy rates between two points in the past. Further, demand tends to be dependent on the state of the overall economy during that time period.
On the other hand, supply is a forward-looking calculation because the current financing cycle of the private-capital markets determines the number of construction starts that will come on line sometime in the future.
Thus, the question of overbuilding may be answered differently depending on which definition is used.
Supply and Demand
A comparison of the relationship between supply and demand from 1980-1989 to supply and demand from 1995-1999 for nonoperating business property types examines whether the first definition of overbuilding is occurring. Using F.W. Dodge construction data, each property type's absorption is divided by its inventory in a given year to determine a percentage that reflects how much new product was absorbed by the inventory. Then the average for each property type is calculated for each time period.
Finally, the averages for the 1990s are divided by the averages for the 1980s to determine if the industry now is creating and absorbing product at the same rate as in the 1980s. If the industry is absorbing more product now than in the 1980s, then overbuilding is not occurring. The average percentage of product absorbed in the 1990s as compared to the 1980s is as follows for the major property segments: 105 percent for the office segment, 157 percent for retail, 84 percent for industrial, and 34 percent for multifamily.
This comparison shows that the average amount of net absorption as a percentage of inventory was greater between 1995 and 1999 than it was in the 1980-1989 period for both the office and retail segments because their percentages exceed 100. This is significant because both of these property types frequently are mentioned as being in danger of overbuilding.
But these calculations may signal a problem for the two remaining property categories. Industrial and multifamily absorbed a significantly lower percentage of inventory in the late 1990s than in the 1980s. For the supply-and-demand relationship, this may indicate an overbuilding problem in these property segments.
Dividing the amount of construction starts for each property type by its inventory in a given year can determine if the industry is overbuilding based on the other definition -- by increasing the inventory base too quickly. This calculation gives a percentage of how much new product was added to the inventory.
First, the average number of construction starts for each property type is calculated for each time period. Then the results of the 1990s are divided by the results of the 1980s. The average percentage of product built in the 1990s as compared to the 1980s is 47 percent for the office segment, 99 percent for retail, 65 percent for industrial, and 46 percent for multifamily.
Clearly, the inventory grew at a much slower rate in the latter 1990s than in the 1980s because the percentages for all property types are under 100. On average, starts in the 1990s increased the inventory in the range of one-half to two-thirds as quickly as in the 1980s. Because no property type has an inventory growth rate for the 1990s that equals that of the 1980s, overbuilding, according to calculations based on construction starts, is not nearly the concern now that it was in the 1980s.
An interesting aspect of these comparisons is that retail inventory is growing at the fastest rate, yet also is the segment that is experiencing the greatest increase in absorption. This would seem to indicate that the demand for new retail space is higher than generally thought and capable of filling most of the new space that recently has been built.
Ultimately, the concern about overbuilding is that owners and developers will be unable to pay property mortgages. This can occur when buildings are financed to the absolute level of tolerance within the pro forma and market demand does not live up to expectations. If supply significantly outstrips demand, which has occurred in a few areas of the country including Dallas' office market, then effective lease rates could decline, also placing existing buildings in jeopardy.
So perhaps another question to ask in conjunction with “Are we overbuilding?” is, “Are we overfinancing?” A major contributing factor to the commercial real estate problems of the 1980s was that newly developed properties often were so highly leveraged. While underwriting standards for development loan-to-value ratios have crept up since 1995, in most cases they still are relatively conservative in comparison to what they were in the 1980s.
The increased quality and timeliness of commercial real estate information has helped to reduce the danger of the kind of broad overbuilding that occurred in the 1980s. As a result, if the U.S. economy remains generally healthy, the severity of the commercial real estate cycle's next wave should be significantly decreased.