Office buildings ; Real property ; Property tax

Randall J. Pozdena

English

Research Papers in Economics

FRBSF WEEKLY LETTER
October 17, 1986
Office Building Boom and Bust
Recent trends in the market for office space have
worried holders of commercial mortgages and
equity investments in office buildings. According
to the Coldwell Banker real estate firm, the aver-
age vacancy rate in downtown office buildings
in the United States at the end of 1985 stood at
about 15 percent- more than triple the rate in
1982. In some areas ofthe country as much as
one-third of the available office space is vacant
and effective lease rates have tumbled sharply.
The purpose ofthis Letter is to discuss the eco-
nomics underlying these trends and to provide
some insights into the likely future behavior of
this market.
Economics of office investment
Office space is a major component of business
capital. In 1985, the value of investment in
office buildings was approximately $30 billion,
or more than 10 percent of total business fixed
investment. As with other productive capital, the
demand for office space is a derived demand.
That is, it depends upon the economic health of
businesses that use office space in their produc-
tive activities.
Office space also has qualities that make it simi-
lar to a durable good. As with other durable
goods, the price at which office space is made
available - through purchase or lease - is
determined primarily by the interaction of
demand with pre-existing supply. Investment in
office space (i.e., new construction) is stimulated
when prices or lease rates exceed the break-
even level for new office facilities.
Nevertheless, the market for office space differs
from that of other durable or capital goods mar-
kets in a number of important respects. First,
unlike capital equipment, office space cannot be
moved between regions. The result is that
vacancy rates, lease rates, investment in office
buildings, and other dimensions of the market
vary considerably among regions. As of Decem-
ber 1985, for example, downtown office
vacancy rates were as low as 7 percent in
Boston and Manhattan and over 20 percent in
Houston, New Orleans, and Oklahoma City.
Within major western cities, downtown San
Francisco and Seattle had vacancy rates near the
national average (at 13 and 15 percent, respec-
tively) whereas Portland, San Diego, and San
Jose were experiencing downtown vacancy rates
of 20 percent or more (according to Coldwell
Banker data).
Second, quite long lags exist in the process of
adding to the existing stock ofoffice space. The
delays are due to the lengthy zoning, planning,
and construction processes involved. In addi-
tion, it is very costly to abort construction proj-
ects underway because of penalty features in
construction contracts, demolition costs, and
discouragement by city planning officials.
As a result, current construction ofoffice space
is best explained (in a statistical sense) by earlier
(and local) economic conditions. In Chart 1, for
example, the ranking ofthe rates ofchange of
employment in a cross-section of cities corre-
sponds quite closely to that ofthe percent
change in office space that occurred two years
later.
Booms and Busts?
Long lags in office construction make it neces-
sary for office property developers to forecast the
demand for their product in the distant future. In
particular, when current effective lease rates rise
above the level that would make new invest-
ment profitable, they must assess whetherthe
rise in rates represents a transient (temporary
and likely to be reversed) or permanent increase
in regional demand for office space. Ofcourse,
investment in response to transient price move-
ments will prove unprofitable.
Some analysts argue that investors in office
buildings have difficulty distinguishing between
permanent and transient changes in market con-
ditions. If much "tightness" in the office market
proves to be transient - as is likely - a boom
and bust cycle in investment and lease rates
would result. A transient increase in lease rates
would lead investors to expand the existing
stock ofoffice space; when demand retreats,
lease rates will be depressed below their pre-
investment levels and investment wouldthenFABSF
dry up until the new space is absorbed and
another transient period of "tightness" occurs.
Economist John Hekman has pointed out that
there is little evidence of unstable cycles in
office building activity (that is, cycles that are
increasingly exaggerated). However, long invest-
ment gestation periods and uncertainty about
the permanence of changes in officespace
demand make it likely that violent boom and
bust cycles will continue to be a common fea-
ture ofthe office building market. (At the peak of
the current cycle, for example, annual office
space completions totaled 800 percentofthe
completion levels in the 1979 trough.)
Uncertainty and lease and vacancy rates
A number offeatures ofthe office market can be
seen as attempts by the market to accommodate
uncertainty. One is the prevalence of long-term
leases. A long-term lease gives lessees protection
against upward movements in market lease rates
and the lessor protection against downward
movements over the life ofthe lease.
The role of uncertainty also is evident in the
behavior ofvacancy rates. Increasing vacancy
rates should exert downward pressure on lease
rates to the extent that vacancy is an indication
of excess supply. Such a general relationship
can be observed statistically (indicated by the
solid line in Chart 2) in historical data. However,
therelationship is a rather weak onethat sug-
gests that vacant office space may serve another
purpose in an uncertain world: bykeeping a
portion of office space vacant, a landlord pre-
serves theoption totake advantage of a sudden
increase in market lease rates. The greater the
uncertainty about future demand conditions, the
greater is the "optionvalue" ofvacant office
space, everything else being equal.
Thus, a high vacancy rate might be consistent
with rapid increases in lease rates in markets
characterized by high levels ofuncertainty, and
loW vacancy rates with low lease rate inflation
in markets less pervaded by uncertainty. Statisti-
calanalysis performed at this Bank supports
these ideas. For example, more of thewide vari-
ation in the behavior ofleaserates and vacancy
rates observed in Chart 2 can be explained by
taking into account the degree of pastvariation
in lease rates, which may indicate the level of
uncerta.inty...
Origins of the current boom and bust
The behavior ofthe office market between the
1970s and today illustrates the difficulty faced
by those in the office building market when fore-
casting economic and public policy conditions.
In the mid- and late-1970s, rising inflation
expectations and the resulting desire by inves-
tors to hold inflation-resistant assets stimulated
investment in real assets of all types - including
commercial real estate.
Changes in the tax treatment of real estate-
already considered by many investors to be a
tax-favored investment - also increased the
attractiveness of investment in office property.
Changes in tax law in 1981 and 1984 signifi-
cantly reduced (to only 15 or 19 years) the num-
ber of years over which commercial real estate
could be depreciated, and thereby reduced
break-even lease rates on new investments and
stimulated office expansion. Since the "paper"
losses generated by such liberal depreciation
policies could be used to offset taxable income
from other sources, the changes also attracted
investorseager to shelter other income from tax.
To propagate the tax advantages ofcommercial
real estate investment, limited partnerships and
other forms of syndicated real estate ownership
grew in importance. These ownership devices
permitted relatively passive investors to take
advantage ofthe shelter from taxation afforded
by the paper losses that the investments dis-
played in their early years.
The result was one.of the biggest "booms" in
office development in the nation's history. Since
1981, average annual office building comple-
tions in 34 U.s. cities have totaled over 30 mil~
ion square feet, versus an average of only 12
million square feetin the previous 20 years and
an average of less than 20 million in the last
boomin the early 1970s; In western office mar-
kets, the greatest percentage increase in office
space inventory occurred in Los Angeles and
Portland, where over halfof the space in 1985
did not exist before 1981.
Outlook and conclusions
The conditions underlying the office investment
boom of the early 1980s have changed abruptly
and probably exaggerated the cycle in a cycle-
prone industry. Expectations of rising inflation,
which had proVided part ofthe stimulus, haveLegend
• Employment (1981-1983)
ill Office Space (1983·1985)
Chart 2
Office Vacancy and Lease Rate Trends
""' 40 <0
'" Austin ;:;;
<0 • Seattle ~
2 Raleigh'
Boston
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• Milwaukee
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"
Baltimore
'" Phoenix '" Philadelphia
" ...J • Norfolk Chicago San Diego . .
"E 10
Gson
'"
Colorado Springs
"
Orlando' c
'" iii
'"'
0 • New York
"
• San Francisco 0> c ·Miami
'" .c ·10 0
E • Los Angeles
"
Denver
" Q; -20
6
0- 10
Los Angeles
Milwaukee
Portland
Chicago
New York
Seattle
Baltimore
Boston
Orange Co.
San·Francisco
Miami
Wash. D.C.
San Diego
Norfolk
Tucson
Houston
Phoenix
Dallas
San Antonio
Austin L_~~~;:=i:::;=:;;=;:::;~~ Orlando
~ ~ ~ 00 00 ro 00
Percent Change
Chart 1
Employment and Change in Office Space
reversed sharply. Employment trends in some
areas also have changed suddenly. In the early
1980s, for example, some of the strongest office
markets could be found in Dallas, Houston, and
other "oil patch" regions where employment
was growing rapidly (see Chart 1). Today, with
the apparently unexpected decline in oil prices,
these markets are among the nation's most
depressed.
In addition, the tax treatment of real estate that
provided some ofthe stimulus to investment will
suffer a sharp reversal under current taxreform
proposals. The 1986 tax bill will, for example,
eliminate the favored treatment of capital gains
and stretch the depreciable life ofcommercial
real estate to 31.5 years from the 19 years per-
mitted under the 1984 Tax Act. In addition, it
will phase out the ability of participants in real
estate syndicates to use paper losses to offset
other current income.
The consequences for the office market will not
be a long-lived "excess" of office space. As the
historical relationship displayed in Chart 2 sug-
gests, office vacancies will exert downward
pressure on lease rates and lead to an increase
in the quantity of office space demanded.
Indeed, lease rate concessions of as much as
one-third are common in new buildings in
Houston. In the nation, square footage per office
worker increased by six percent in 1985 in con-
trast to earlier declines.
The proposed changes in the tax treatment of
real estate do not directly affect thedemand for
office space by tenants, but win reduceinvestor
demand for office buildings at current lease
rates. (The tax proposals will raise theafter4ax
cost ofowning office buildings and thus will
reduce net income at current lease rates.)
Although individual building owners may wish
to restore profitability to their investments by
raising lease rates, they will generally be unable
to do so in competitive markets. Equilibrium
lease rates are determined by the interaction of
tenant demand and the stock of office space,
both of which will remain largely unchanged.
Instead, building prices and landprices probably
will have to fall to re-establish profitability in
office building ownership and investment.
Randallj.Pozdena
Opinionsexpressed in this newsletterdo not necessarily refle.ct theviews of the managementofthe Federal Reserve Bank ofSan
Francisco, orofthe Board ofGovernors of the Federal Reserve System.
Editorialcommentsmay beaddressedtotheeditor(GregoryTong) ortotheauthor...• Fr~copiesofFederal Reservepublications
can beobtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,San Francisco
94120. Phone(415) 974-2246.uo~6u!4S0m 4o~n U069JO 0POI\9U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
SelectedAssets and Liabilities
Large Commercial Banks
Amount
Outstanding
9/24/86
Change
from
9/17/86
Change from 9/25/85
Dollar Percent!
Loans, Leases and Investmentsl 2 201,744 - 857 5,117 2.6
Loans and Leases1 6 181,805 - 886 4,515 2.5
Commercial and Industrial 49,678 - 611 - 1,412 - 2.7
Real estate 67,573 44 2,873 4.4
Loans to Individuals 39,624 286 1,724 4.5
Leases 5,660 27 257 4.7
U.S. Treasury and Agency Securities2 11,567 - 166 - 551 - 4.5
OtherSecurities2 8,372 195 1,152 15.9
Total Deposits 202,759 - 3,488 5,696 2.8
Demand Deposits 50,289 - 2,093 4,632 10.1
Demand Deposits Adjusted3 35,357 - 939 4,223 13.5
OtherTransaction Balances4 16,859 - 540 3,411 25.3
Total Non-Transaction Balances6 135,611 - 854 - 2,346 - 1.7
MoneyMarket Deposit
Accounts-Total 46,326 - 768 1,353 3.0
Time Deposits in Amounts of
$100,000 or more 34,016 - 101 - 4,656 - 12.0
Other Liabilities for Borrowed MoneyS 25,268 - 1,221 32 0.1
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Netborrowed(-)
Period ended
9/22/86
20
27
7
Period ended
9/8/86
38
51
12
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephonetransfers
5 Includes borrowingvia FRB, IT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percentchange

Office building boom and bust

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Office building boom and bust

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