Will We have a Commercial Real Estate Crisis?

Casey Mulligan thinks probably not. From his New York Times piece:

For months now, experts have been predicting that commercial real estate will be “the other shoe to drop.” But in fact, non-residential building fell far behind housing construction during the housing boom. This shortage of commercial buildings relative to housing suggests that a commercial real estate crisis will not occur, or that at worst it will occur with much less severity than did the housing crash.

Here is the chart purporting to support this argument:

(Click on image for a larger version in a new window)

The error Dr. Mulligan makes is the belief that the housing bubble and future CRE performance was/is primarily a function of inventory. The chart suggests housing prices have collapsed because too many residential structures were built. That’s like saying Citibank’s stock price has collapsed because too many shares have been issued. Home prices have dropped because the financing that people used to buy homes at an inflated price is no longer available, not because there are more homes than people are willing to occupy. To the extent CRE inventories were tight, values were inflated, which won’t help us now if the deals were leveraged based on the higher values.

For example, look at Miami, a residential bubble market. The graph below shows the number residential permits issued in relation to the number of new jobs created on a rolling 12 month basis. The secondary axis is the OFHEO Housing Price Index year over year change.

(Click on image for a larger version in a new window)

Home price increases began decelerating in late 2005, but at the time Miami was creating twice as many jobs as new units, so if anything the market was undersupplied. Something else was clearly dragging prices down, and in retrospect we know it was the withdrawal of aggressive lending parameters.

Now, of course, most markets are losing jobs, and most markets are still adding units (and commercial real estate) as projects work there way through the development pipeline. We won’t see a recovery until the employment situation turns around.

What does this mean for CRE? We don’t know for sure how many deals were done with aggressive underwriting during the peak years, but we know there were quite a few and so we can expect some decline in values related to the withdrawal of aggressive leverage similar to what’s happened in the residential market. We also know that CRE is sensitive to employment trends, and those are very negative. The CRE situation may not become as bad as residential, but if it doesn’t it will be because the underwriting was better and employment improves. It won’t be because there was a lack of inventory.

Is Overbuilding Responsible for Excess Housing Inventory?

The President of the National Association of Home Builders says “The excess housing inventory in today’s market is the result of unprecedented foreclosures, not overbuilding.” Paul Jackson, Housing Wire, suggests this statement “borders on the certifiably insane ." I may be certifiably insane, but I think the NAHB position is closer to the truth.

Obviously, we have excess inventory. The amount is subject to debate, but arguments can be made for between 1.75 to 4 million excess units (see this Calculated Risk post, for example). Obviously, many of the excess homes are newly completed builder inventory. You can read the story behind the pictured subdivision here.  So, in a sense builders are responsible for at least a portion of the excess inventory. They built it, it’s empty, end of story.

But, of course, it’s not that simple. There are a lot of people who are living in substandard housing, in apartments, with their parents, with roommates, etc. who would be delighted to be living in these “excess” units. The problem is much of the excess is located in places people don’t want to live or can’t find jobs (read, for example, these depressing posts about Detroit in The Big Picture and The Weekly Standard). And, much of the excess is not affordable even at today’s depressed prices to the people who want the units.

I think Miami is a good example of what actually occurred. Here is a chart of residential permits issued in Miami between 1999 and November, 2008:

(click on images to open larger versions in a new window)

On it’s own, this is about as clear a case as you can get of overbuilding – permits obviously spiked between 2004 and 2006, which nicely dovetails with the peak of the subprime craziness. But, consider employment growth in Miami during the same period:

At the same time permits were peaking at around 45K per year, Miami was adding jobs at 100K a year. Can you really say builders were overbuilding when there are twice as many people with new jobs as units being added to supply? If anything, the numbers imply a housing shortage in the peak period. Here is a chart showing the ratio between new jobs and residential permits:

From mid-2002 through 2007 Miami was adding more jobs than housing units, and for most of this period it was adding around two jobs for every new housing unit. This was not an overbuilt market during that period.

In contrast, here is an equivalent chart for Houston:

Housing prices have held up relatively well in Houston, and most people do not consider it to have been one of the bubble markets. But, note Miami had substantially more jobs added per new unit than Houston did during this period. The data suggest Houston was relatively overbuilt compared to Miami.

In fact, the data suggest that maybe part of the problem in the bubble markets was builders didn’t build fast enough to keep pace with the demand created by new jobs (you can see similar charts for Los Angeles, San Diego, Las Vegas, and many more markets here). I’m not ready to go so far as to suggest they should have done so – had lenders stuck to reasonable underwriting standards more of that demand would have shifted to the rental market and we would have seen higher rents and less vacancy in that segment, which I think we all agree in hindsight would have been better than putting people in houses they couldn’t afford.