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

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

Although commercial real estate has always been cyclical in nature, the 1980s and early 1990s stand out as a major episode of overbuilding. For example, booming construction during the early 1980s 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 1980s building boom and discusses the real and financial consequences of the subsequent real estate bust for broader economic activity.

Commercial 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 16 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. Booms and busts in commercial and multifamily building may partly reflect aggregate fluctuations in output, employment, and financial market conditions. But some factors that encourage overbuilding also may be more specific to the real estate sector. For example, because it may take several years from the start to the finish of a commercial development project, economic conditions may be quite different when a project is completed than when it was first undertaken (Browne and Case). The long time lags and large sums the developers spend to plan a project may create a bias to go forward with a project even if there is evidence that market conditions are weakening. Moreover, real estate lenders may sometimes be guilty of assessing the creditworthiness of a proposed development on the basis of current or recent past performance of the commercial real estate sector rather than a realistic projection of future prospects. Large fluctuations in commercial construction are, therefore, not surprising from a historical perspective.

Overbuilding in the 1980s

The overbuilding of commercial and multifamily real estate in the 1980s is notable even for this highly cyclical industry. Commercial construction activity increased substantially in the first half of the 1980s, more than doubling from 1979 to 1985 (Table 1). Although some of this growth can be attributed to an increase in the overall price level and growth of the real economy, commercial construction climbed sharply as a share of GDP from 1979 to 1985. Supporting the strong construction in the early 1980s, office vacancy rates were low, although vacancy rates rose substantially by the second half of the 1980s. Multifamily construction also boomed in the first half of the 1980s, with building permits rising nearly 50 percent from 1979 to 1985.

Commercial construction boomed in the 1980s due to many factors. For example, the demand for office space expanded due to economic, structural, and demographic changes. At the same time, federal tax laws gave commercial real estate developers greater profits, while lending institutions, including savings and loans, were making large fees for financing the projects.

Economic and demographic factors increased the demand for commercial space and multifamily housing in the late 1970s and early 1980s. For example, employment grew strongly in this period as the baby-boom generation continued to enter the work force and the labor force participation rate of women rose. The mix of jobs shifted more toward service production and away from goods production. As a result, growth in the number of people working in offices exceeded 4 percent annually in the late 1970s and remained rapid through most of the 1980s (FDIC). Strong growth in the demand for office space was thus a key factor behind the commercial construction boom. But by the late 1980s, with office vacancy rates rising, growth in the supply of office space surpassed growth in demand.

Although all major geographic areas of the country participated to some degree in the construction boom, regional differences in the size and timing of the boom were notable. Economic conditions in the late 1970s were particularly strong in energy-producing regions, such as Texas and Oklahoma. A boom in energy-related construction in the early 1980s eventually led to sharp increases in office vacancy rates in such energy centers as Houston and Oklahoma City, a little ahead of the rest of the country. The construction boom came somewhat later in New England and other Northeastern states, driven partly by the expansion of the computer industry in the Boston area and strong financial sector and defense-related hiring throughout the Northeast. California also experienced a major construction boom through much of the 1980s, reflecting rapid population growth, a surge of defense-related manufacturing during the first half of the 1980s, and expanding international trade with Pacific Rim nations.

Besides strong economic growth, major changes in federal tax laws contributed to the commercial construction boom in the first half of the 1980s. The Economic Recovery Tax Act of 1981 (ERTA) lowered personal income and capital gains tax rates. Another provision of ERTA was an accelerated cost recovery system that greatly shortened the period over which commercial real estate could be depreciated. Faster depreciation produced higher after-tax returns on commercial real estate projects, encouraging real estate development through tax-oriented limited partnerships.

Fiscal policymakers eventually concluded that ERTA provided too much of an incentive to invest in real estate development projects. The Tax Reform Act of 1986 (TRA) curtailed tax-oriented real estate partnerships by making it impossible for taxpayers to offset ordinary income with tax losses generated by "passive" investments, such as commercial real estate. In addition, TRA eliminated the accelerated cost recovery system, thus lengthening the period over which commercial structures were depreciated and reducing their after-tax returns. As a result, investors became less willing to purchase existing commercial properties in the late 1980s and early 1990s, contributing to the softening in real estate prices (FDIC). …

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