Looking back at the sector's boom-bust nearly two decades ago offers insight into today's situation.

Brye Steeves

English

Research Papers in Economics

12 WINTER 2009 • TEN 13 WINTER 2009 • TEN
ueder Construction, a full-service 
contractor  that  does  concrete   
work,  carpentry,  masonry, 
steel  erection  and  more  in  the 
commercial market, isn’t laying off employees. 
“We’ve had more work under contract now 
than we ever had,” says von Gillern. 
Such  activity  in  the  commercial  sector 
may seem surprising in light of the residential 
market’s state, but he says the majority of the 
projects his firm does, which include schools, 
medical facilities and churches, is doing better 
than retail––a sector of commercial real estate 
seeing  high  vacancy  rates  from  overbuilding 
a  few  years  ago  when  financing  terms  were 
looser and overall economic conditions were 
stronger.
“Everybody’s  worried,”  von  Gillern  says, 
but he thinks the commercial real estate sector 
will ultimately fare better than the residential 
real estate market, which was the first domino 
to fall in the current global financial crisis.
During  the  summer  of  2007  when  the 
market  for  securities  backed  by  subprime 
mortgages  collapsed,  uncertainty  and  fear 
resulted in illiquidity for any asset linked to 
subprime mortgages. Over time, the liquidity 
problems  spread  to  other  financial  markets 
and severely affected some banks and securities 
firms. In real estate, home values have dwindled 
and foreclosure rates have soared. Commercial 
properties are feeling the effects of the subprime 
housing lending meltdown, too.
“There  is  some  concern  about  the  U.S. 
commercial real estate market and the impact it 
may have on financial markets and institutions,” 
says  Alan  Garner,  professor  of  economics  at 
Avila  University  and  former  assistant  vice 
Measuring up
During this global economic downturn, Brad von Gillern has been   
getting some pretty heavy questions from his crews at Lueder Construction 
Company in Omaha.
“Am I going to have a job?”
Though some of the 65 or so employees are delaying retirement and the 
company’s competition with other general contractors is heightened, von 
Gillern answers that question with certainty: “Yes.”
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Commercial real estate comparable to early ,90s14 WINTER 2009 • TEN
president and economist at the Federal Reserve 
Bank of Kansas City.
This sector has slowed recently, and Garner 
says many effects are evident, including:
•	An	 increase	 in	 the	 interest	 rate	 on	
commercial  mortgage-backed  securities   
compared to the interest rate on the safe haven 
of U.S. Treasury securities;
•	Declining	prices	for	commercial	properties;
•	Reduced	lending	from	financial	institutions;	
•	A	slowdown	in	commercial	construction	
activity and reduction in related jobs.
“Historically,  commercial  real  estate  has 
been subject to booms and busts,” Garner says. 
“Looking back may provide clues to how this 
current situation will play out.”
Not long ago 
In  his  research,  Garner  compared  the 
current economic situation to the real estate 
bust in the early 1990s when the construction 
boom in the 1980s created a huge oversupply   
of  commercial  space  and  reduced  the 
availability  of  funds  loaned  to  small  and   
mid-sized businesses.
In  some  respects,  according  to  Garner, 
commercial  real  estate  is  less  worrisome 
today than it was in the ,80s and early ,90s. 
This type of construction is a smaller share of 
economic activity, and buildings’ vacancy rates 
are lower. But, the economy is still vulnerable 
to any weakening in this sector, which would 
add  to  the  problems  from  the  housing  and   
energy sectors.
But  on  the  financial  side,  Garner  says 
commercial real estate may be more worrisome 
today.  A  major  difference  from  the  early 
,90s is the increase of commercial real estate 
securitization,  which  may  expose  developers 
and  investors  to  financial  disruptions  that 
originate  outside  the  commercial  real  estate 
sector.  Another  significant  similarity  is  that 
commercial banks currently have a large direct 
exposure to commercial real estate loans.   
In commercial and multifamily real estate, 
construction  booms  and  busts  may  reflect 
employment, market conditions and the like, 
but some factors that encourage overbuilding 
may be more specific to real estate. For example, 
long lag times and high expenses of a project 
may  push  a  project  forward  even  if  there  is 
evidence that market conditions are weakening. 
Also, real estate lenders may assess a proposed 
development  based  on  the  current  or  recent 
performance  of  the  real  estate  sector  rather 
than a realistic forecast of future prospects.
Garner  says  large  fluctuations  in 
commercial  construction  are  not  surprising 
from a historical perspective. Indeed, activity 
more than doubled from 1979 to 1985, and 
multifamily  construction  permits  increased 
nearly 50 percent during this same time.
This boom was the result of many factors. 
Demand for office space expanded as a result 
of  economic,  structural  and  demographic 
changes––employment grew as more women 
entered  the  workforce  and  jobs  shifted  to 
services  from  goods.  Changes  in  federal  tax 
laws  gave  commercial  real  estate  developers 
greater  profits  by  lowering  personal  income 
and capital gains tax rates. Real estate lending 
by commercial banks grew strongly during this 
period because it was expected to be profitable. 
Savings institutions, such as savings and loans 
and  mutual  savings  banks,  also  played  an 
important role in this boom and bust when 
they were allowed to expand into commercial 
real estate lending.
“By  the  late  ,80s,  supply  surpassed 
demand,” Garner says, “and the consequences 
to the economy were becoming apparent.”
As a result of high vacancy rates and new tax 
law changes that reduced the after-tax return, 
commercial  and  multifamily  construction 
Components of U.S. private construction in 2007
Multifamily
4 percent
Other residential structures
25 percent
Commercial
16 percent
Manufacturing
3 percent
Single family
28 percent
Other nonresidential structures
8 percent
Mining
11 percent
Power and  
communication
5 percent Source: U.S. Department of Commerce
IN  the  earLy  ,90s,  looser  financing  and  stronger  economic  conditions  led  to   
overbuilding and high vacancy rates. Current commercial real estate doesn’t seem   
to be overbuilt to the same degree.
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S16 WINTER 2009 • TEN
slowed, but the reduction was too late to stem 
rising vacancies, which had climbed to nearly 
19 percent nationwide by 1992.
“With such an excess of commercial and 
multifamily  space,  rent  and  property  prices 
dropped  and  many  real  estate  developers 
and lenders were hit hard with huge losses,” 
Garner says. “The decline in commercial real 
estate construction helped cause the recession 
in  the  early  1990s.  And,  overbuilding  and 
the  resulting  losses  by  real  estate  lenders 
contributed to a sharp increase in failures of 
financial institutions.”
Current commercial real estate
“It’s  difficult  to  predict  whether  the 
commercial  real  estate  boom-bust  of  the 
late  ,80s  will  be  repeated  today  because  the 
future  supply  and  demand  for  commercial 
space is uncertain,” Garner says. “But there is 
some  evidence  that  suggests  the  commercial 
and multifamily markets may not face excess 
supplies as large as in the early ,90s.”
Demand  during  the  next  few  years  is 
difficult to predict, and as of now, it’s definitely 
down at Millard Lumber in Omaha, says the 
company’s CEO Rick Russell, much of which 
he attributes to consumers’ confidence. Millard 
Lumber offers products and services for both 
residential and commercial projects, with most 
of its business centered on wood frames.
“People  watch  the  news  …  it  bothers 
them,”  Russell  says.  “The  fundamentals  are 
there, but the psychology isn’t.”
He can name a handful of already-financed 
projects  that  have  been  postponed  due  to 
nervousness. Many hope costs will drop––an 
attitude Russell calls “a terrible mistake” when 
prices, for lumber specifically, are at their lowest 
in years.
“Day-to-day,  we’re  trying  to  remain 
positive,”  says  Russell,  who’s  been  in  the 
business  since  the  ,70s.  “There’s  so  much 
uncertainty out there.”
Vacancies in existing structures also are a 
concern, but national office vacancy rates are 
17 WINTER 2009 • TEN
lower now than in the years before the 1990-
91 recession. The national office vacancy rate 
was about 13 percent in early ,08, compared 
with 18 percent in 1989. At 9.4 percent in ,07,   
the industrial vacancy rate for warehouses and   
other  light  industrial  structures  was  about 
the  same  as  in  1989,  though  this  sector 
was  not  as  overbuilt  to  the  same  degree  as   
office buildings. 
Kevin  Nunnink,  chairman  of  Integra 
Realty Resources, which is a nationwide real 
estate valuation and consulting firm, has seen 
a dramatic slowdown in retail leasing, which he 
attributes to low consumer spending affecting 
the retail sector. Nunnink is also a member of 
the board of directors of the Kansas City Fed.
A  major  difference  between  the  earlier 
real estate cycle and the present one is the level 
of real estate securitization, Garner says. For 
commercial real estate, it grew from less than 
2 percent in 1990 to more than 26 percent by 
the end of 2007. For multifamily mortgages, 
securitization  grew  from  11  percent  to  31 
percent during the same time period. 
Securitization has both benefits and costs, 
Garner says. While it can stabilize real estate 
markets by evening out the flow of capital to 
the  commercial  real  estate  sector,  providing 
more effective market discipline of developers, 
and spreading commercial property risk to a 
broader array of investors, securitization also 
can make the market vulnerable to financial 
shocks  that  had  little  effect  on  commercial 
property in the past. 
Garner  says  another  worrisome  trend  is 
that  commercial  and  multifamily  developers 
currently  are  relying  more  on  debt  to 
finance their projects than in the late 1980s. 
Commercial and multifamily mortgages were 
24 percent of nominal output in ,07, up nearly 
4 percentage points from 1988. In addition, 
the prices of commercial property appear to be 
weakening after a period of sharp appreciation 
in the last few years.
On the positive side, while the exposure of 
commercial banks and savings institutions to 
commercial and multifamily real estate loans is 
somewhat higher than in the 1980s, real estate 
lenders may have maintained higher lending 
standards than in the past. 
Whether the commercial real estate sector 
will suffer as much as the residential real estate 
market,  “the  jury’s  still  out,”  Nunnink  says. 
“I  believe  that  if  the  capital  markets  loosen 
up, the impact to commercial real estate will   
be softer.”
Back at Lueder Construction in Omaha, 
only  one  of  the  company’s  pre-construction 
projects––a  fitness  center––has  been  put  on 
hold. Financing for new projects is available, 
although under tighter terms. Lueder is working 
to offset third-party risk from subcontractors it 
uses. And the company president is optimistic.
“We’ve seen it before,” von Gillern says, 
“and we’ve survived it before.”
 
“  ” Day-to-day, we’re trying to remain positive.
COMMENTS/QUESTIONS are welcome  
and should be sent to teneditors@kc.frb.org.
fUrThEr resources
“IS COMMErCIal rEal ESTaTE rElIvINg 
ThE 1980S aNd Early 1990S?”
By c. Alan Garner
KansascityFed.org/TeN
LUeder CoNStrUCtIoN CrewS IN omaha keep busy during the economic slow-
down. the company president attributes this to the type of commercial projects they 
do, such as this church, which have fared better than retail projects.
By BryE STEEvES, seNIor WrITer
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Measuring up: commercial real estate comparable to early '90s

http://www.kansascityfed.org/publicat/ten/pdf/Winter2009/MeasuringUp.pdf

Measuring up: commercial real estate comparable to early '90s

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Research Papers in Economics