In past recessions, real estate development and construction have played an important role in leading an eventual recovery. It doesn’t seem to be happening this time around. Why not?
At the risk of oversimplification, the economics of real estate development can be summed up in two words: product demand. There’s nothing complicated here; it’s straight out of Adam Smith. In real estate, product is classified in two general categories – residential and commercial.
Residential product takes many forms: large, medium, and small single family detached (SFD), and attached product such as duplexes, triplexes, 4-plexes, townhouses, coach and carriage homes, and low-, mid-, and high-rise. Commercial product exists as office, retail, industrial, multifamily, hospitality, or a combination of these known as mixed-use.
New residential construction isn’t financially viable because many areas of the country are glutted with several months of inventory due to:
· Speculation and easy mortgage money in the first part of this decade that drove homebuilders to oversupply the market,
· The subsequent plunge in property values resulted in home values dropping below the balances of the mortgages encumbering them, leading to massive defaults and foreclosures,
· Currently, some 7 million homeowners are more than 90 days behind on their mortgage payments, and this eventually will add even more residential product to the mix.
Many of these residential properties are available for less than their replacement costs. As long as there is a large inventory of properties and pricing remains low, new residential development will remain depressed.
Outside of a few metropolitan areas such as Washington, D.C. and New York City, development of commercial real estate (CRE) likewise remains depressed. This principally is because of three factors.
1. First, there was an element of oversupply, just as was the case with residential product. Commercial developers, investors, and wannabe developers saw the burgeoning growth of residential and incorrectly assumed all these new rooftops would be occupied and the occupants would need office, retail, industrial, and entertainment facilities.
2. Second, plentiful and cheap mortgage money made it possible to develop projects for which there is little or no demand and that never should have been built.
3. Finally, the effects of the recession have caused firms and individuals to reduce the size of their operations or shutter them completely. This has resulted in much greater vacancy rates, lower rent structures, and greater expenditures or allowances for tenant improvements, among other things. These factors have driven income for these properties lower, which, in turn drove their values down.
The debt on many of these commercial properties exceeds the value of the properties. Many of these mortgages already have begun to mature, and will continue to do so over the next few years. Mortgage money for refinancing and new construction is very scarce because lenders have so much distressed debt on their books that their balance sheets are in poor shape.
Consequently, there is very little demand for new development. In good economic times, the development industry employs hundreds of thousands of people, perhaps millions. It’s not just construction and building trade workers. It includes all manner of consultants from an array of disciplines such as architects, planners and designers, market researchers, landscape architects, engineers, surveyors, attorneys, material suppliers, environmental, traffic, and entitlement specialists as well as office staff at all these entities, just to name a few.
Many of these people remain among the unemployed, and their salaries no longer trickle down through the overall economy.
The bottom line is that it will take some time for the inventory in residential and commercial to be absorbed. It will take time for lenders to restore health to their balance sheets. Until these things happen, it would be foolish to expect the real estate development industry to be able to contribute significantly, as in past recessions, to an economic recovery.
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