Some things are obvious, but they just don’t click until someone else points it out to you. That happened to me when I picked up Monday’s Wall Street Journal and read The Outlook article by Eliot Brown on page 2. This article discussed the impact of the current drop in office construction on future rents and it really made a lot of sense to me. Brown states that according to McGraw-Hill Construction, 2011 had the lowest level of new office construction starts since 1960. Yes, that’s 1960, as in 50 years ago. Now, I don’t remember that, but I do remember all the “see through” skyscrapers in downtown Dallas and Houston in the early 1980’s, and it took the economy a long time to fill all those vacant office buildings. And we all remember the years of low rents resulting from the overbuilding.
But, then, as the economy picks up steam, and more jobs created, the vacancies drop, and rents start going up. It just makes sense. It’s a case of supply and demand. As Brown points out: “Developers and lenders don’t like to build until demand is strong. Rents must be high, vacancies low. But once those fundamentals fall into place, it takes years for building to be constructed. In the meantime, job growth leads to higher demand for space, which pushes rents higher.” An example of this happened in Manhattan when the slowdown in construction following the 2001 recession caused rents to jump more than 30% between mid-2006 and mid-2007, according to the firm of Cassidy Turley.
So this is surely a conundrum. How can developers build the office towers of the future when the current vacancy numbers are so low, and lenders are unwilling to gamble on the timing of a recovery? Banks used to fund construction projects without requiring the developer to have tenants lined up. Now, however, few banks will agree to fund a project unless the developer has preleased a significant amount of the projected space. And, as we know, right now, few tenants are in the market to commit to future space at higher rents. It’s a case of the chicken and the egg.
While history shows that office rents rise dramatically after periods of high vacancies, no one wants to gamble that history will repeat itself. But if I were a commercial developer right now, I would start looking for the funding to develop new office space to be ready by 2015 or so, because that’s about when the rents should be going through the roof. Who out there is willing to be the chicken? Or perhaps the egg?