Sunday, January 31, 2016

Supply and Demand Dynamics of Real Estate

Elephant Building
(Elephant Building)

Commercial real estate is subject to the fundamental laws of supply and demand like all other goods markets. Let's look at the specifics driving the commercial real estate markets at the property level.

What Drives Demand for Commercial Real Estate Space?

The demand side depends largely on the type of commercial real estate. I go over each major property type and what drives demand in this post. In a general sense, the economy drives demand for commercial real estate space. As the economy expands / improves, businesses expand and need more employees, creating a need for additional office space. As those new employees move to the area they need a place to live, which increases the demand for homes and apartments. Those businesses might need additional warehouse space, increasing the demand for industrial space.

The opposite is true as well. As the economy suffers, businesses might lay off employees and need less office space. Think of the recession that hit in 2008. Prior to 2008, office parks were full of real estate agencies, mortgage brokers, and banks such as Washington Mutual that were buying loans from the mortgage brokers. As the housing bubble  burst, those companies started to go out of business, people were laid off, office parks suddenly had a lot of vacancy, and people weren't able to pay rent or buy houses. Imagine the huge impact on the commercial real estate industry this had. Landlords started slashing their asking rent to try and increase occupancy, other landlords cut more, and property level cash flow was decimated.

Right now the opposite is happening in real estate. In many markets, there's very little vacancy and landlords are taking advantage of the lack of supply by increasing rents. Apartment rents have been increasing by 10% or more over the last few years in some markets! Increasing rents and high occupancy are improving property level cash flow for most landlords.

What Drives Supply of Commercial Real Estate Space?

The supply side of commercial real estate is a bit trickier. Constructing new buildings is a difficult proposition for several reasons. First, constructing buildings from the ground up is a long process and can span several years in some cases. This means developers can't just build based on current market conditions. They have to forecast into the future to figure out whether or not they should build, meaning they need to be comfortable with the market for several years, not just the current state it's in. A best case scenario for a developer is the market has very low vacancy, has upward pressure on rents, and is projected to experience demand growth for the next several years. If these conditions are met, a developer might go ahead with projects.

Second, there just might not be a place to build. Think of a city like San Francisco. SF is on a tiny peninsula with lots of very steep hills. Nearly every good piece of land has already been developed or built upon. The only way to increase supply is to increase density, or tear down existing buildings and rebuild something new. Increasing density is tricky because it puts strain on the existing infrastructure, neighbors often don't like it, and building vertically becomes difficult and costly. Tearing down buildings is problematic because there's the issue of possibly needing to relocate existing businesses / individuals. Likewise, there might be issues with the zoning on the property.

Third, cities might be against new construction / redevelopment. Anytime a developer wants to change the use of a parcel of land, or increase the density on a parcel of land in a lot of cases, they must go to the city for permission. Some cities are very hesitant to give permits, others are more willing. It's a slow and costly process, at best. At worst, it's slow, costly, and futile.

The morale of the story is that the supply of commercial real estate space is sticky, meaning it doesn't respond instantaneously to market demand. Back to the San Francisco example, there's a huge demand for office space and residential space that's pushing up rents to astronomical levels, but there's just not nearly enough new construction taking place because there's just nowhere to build. It also doesn't help that the city has ridiculous caps on the amount of new construction allowed per year and similar anti-development policies. The demand might never be fully met in a city like SF.

The opposite situation existed in 2008 in many markets. Because commercial real estate was doing so well in the mid 2000's, developers started developing numerous projects. The projects took a couple of years to build and were delivered to the market in 2008 right when the market crashed. You had a perfect storm--the demand side was hit hard while supply shot up, magnifying the effects of the downturn on commercial real estate.


To sum things up, demand is driven by the economy. As the economy improves, real estate market fundamentals improve. Once the fundamentals are strong enough, developers will start new construction projects that will hit the market in a few years. Once the projects finish construction, supply increases and relieves demand pressures.

Whether or not developers are able to build projects depends on many reasons, several are mentioned above. The last important point is that the supply of real estate space is very sticky. Supply will lag demand, or front run demand as it did in 2008, which can cause shocks to the supply-demand-balance.

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