The balance of supply and demand in early 2002

U.S. commercial office, industrial, and research property markets are experiencing paradoxical conditions. The balance of supply and demand for space is extremely unfavorable. Especially in high-tech markets like Silicon Valley, vacancy rates have soared to 15 percent or more in early 2002. Few leases are being signed because almost no firms need more space, and thousands that need less are flooding markets with sublease space. Yet for properties fully leased at good rents, market demand has been strong and property prices rising. The stock prices of real estate investment trusts (REITs) have also been driven upward while the rest of the stock market stagnated.

The main reason for this paradox is that investment yields have recently been so low on stocks and bonds. Therefore, the steady positive yields on real properties that are well occupied or on well-run REITs look very attractive to yield-hungry investors. So they have shifted a lot of money from stocks and bonds into commercial real estate, which often produces yields of 8 to 9 percent. This has stabilized or raised prices on many well-occupied properties in spite of adverse conditions in space markets.

This paradoxical situation only applies to properties well enough occupied to produce steady net incomes, not those with high vacancy rates. This situation is occurring within property markets experiencing unusually low levels of both leasing and sales transactions. Leasing activity is low because so few firms want additional space. Some sales are occurring, but many fewer than in a normally sound market. Buyers are deterred from making offers because of uncertainty about the true value of properties in a market where few leasing transactions establish likely future rent levels. Property owners are deterred from selling by similar uncertainty, and by the fact that many are large corporations that own commercial properties they have been using themselves. Also, institutional owners like pension funds have been reluctant to sell because they don’t know what they would do with the money.

How long will this paradoxical situation last? One way it could end is by the return of strong general prosperity. Yet vacancy rates are now high enough so that even expanding space demand will not create much upward pressure on rents and prices for at least two years, and perhaps longer. This means entrepreneurial owners of older, relatively obsolete buildings with strong occupancy and yields should consider selling them now, before a return of general prosperity sucks yield-hungry money back into stocks and bonds.