Those Empty Spaces Won't Fill Up Any Time SoonChristopher Farrell
Location, location, location, goes the old saw, is all that matters in the real estate business. Pick the right location, and even an idiot can turn out to be a real estate genius. But location isn't helping much these days. Commercial real estate from London to Sydney is in the throes of a depression. And the slump, following on the heels of the unprecedented real estate boom of the 1980s, still has further to go. In many of the world's leading cities, real estate values could keep falling for years to come.
Just how did the commercial real estate mother lode of the last decade turn into the fool's gold of the 1990s? In the 1970s and '80s, growing international trade created an enormous need for more office space in the world's metropolitan centers. The demand was especially strong from financial services, which expanded rapidly, along with international bank lending and the surge in bond, equity, and foreign exchange trading. And banks were eager real estate lenders, as they grew leery of lending to Third World countries and lost many corporate customers to the securities markets. From 1980 to 1991, commercial real estate loans as a percentage of all loans grew from 10% to 17% in the U.S., from 7% to 12% in Britain, and from 11% to 17% in Japan.
IN REVERSE. But these days, the drive for office space has shifted into reverse. Brutal global competition in services is forcing U.S., European, and Japanese white-collar industries to slash costs and shed workers. Like manufacturers before them, banks, insurance companies, and law firms alike are struggling to slim down. The result: a dramatic drop-off in the need for office space, and with it, the emptying of offices around the world. From 1980 to mid-1992 the office-vacancy rate jumped from 2.9% to 17% in Manhattan, from 2% to 20% in the City of London, and from 1.8% to over 13% in downtown Toronto. "There will be little new demand during the decade of the 1990s," says David G. Shulman, head of real estate research at Salomon Brothers Inc. "And that is why real estate values are falling globally."
The trigger for the real estate bust was the international stock market crash of October, 1987, which marked the beginning of a worldwide retrenchment in financial services. The downturn accelerated as economies around the world went into a slump. In New York City, for instance, finance, insurance, and real estate employment (FIRE) rose by 32.6% from 1977 to 1987. But FIRE jobs have fallen by more than 10% since the October crash--even though the stock market is near record levels and the financial markets are bubbling. In London, FIRE employment made a round trip: from 126,800 in 1981 to a peak of 158,600 in 1988 and back down to 127,800 in 1991. In Japan, securities employment is down 10% since its 1991 peak.
SQUEEZED. And the forecast is for anemic growth in financial-service jobs, even after economic recovery takes hold. For example, the growth rate in office employment in the U.S., including FIRE, lawyers, accountants, and consultants, was 4.3% annually from 1984 to 1989, calculates A. Gary Shilling, head of his own economic consulting firm. But pressure to improve productivity will keep office-job growth to a 2% annual rate from 1992 to 1997, he estimates. Over the same time period, Shilling expects that cost-conscious employers will cut office space per employee from 195 sq. ft. in 1989 to 182 sq. ft. Add it all together, and it could take about 13 years to bring the current national office vacancy rate of 19% down to a traditional 5%. Using a slightly different model, Bjorn Hanson, chairman of real estate for Coopers & Lybrand, says it could take a dozen years to get the U.S. office market back to normal.
Of course, different cities and regions in the U.S. will bounce back at different times. For instance, after adjusting for local market conditions, Shilling calculates that it could take as many as 19 years to work off New York City's vacancy rate, 13 years in Los Angeles, and 10 years in Boston. And rents will ratchet lower as office leases expire. From 1987 to the first half of 1992, for example, rents in Manhattan dropped from $42 per sq. ft. to $23, according to the Yarmouth Group, real estate investment advisers.
The picture is equally grim for London real estate, which is mired in the worst depression since World War II. The most recent casualty is Olympia & York Developments Ltd.'s Canary Wharf office project in London's East End, which went into receivership in May. The vacancy rate in the City of London is currently 20%, and an additional 2.6 million sq. ft. of office space are coming on the market over the next six months, says Paul Orchard-Lisle, senior partner at property consultants Healey & Baker. "Some of the buildings put up in the late '80s won't get occupied," he adds. Indeed, from 1991 to 1994, FIRE employment in the City of London could fall by 8%, forecasts Stephen Waterman, project manager at PMA, a London-based property consulting firm. He expects other office employment, such as legal services, to shrink by 9% at the same time.
Zurich's real estate market is also ina shambles. Office prices have been halved since U.S. and Japanese financiers began cutting back their operations in the city about 18 months ago. Rental rates since the beginning of the year in the most desirable downtown business addresses are off by one-third, from $63 per sq. ft. to $42. It would take a three-year economic boom to sop up the city's empty office space, says Rene Casserini, a top manager at Interswiss Fonds, a real estate broker in Zurich. "But that boom isn't coming," he adds.
TIME LAG. In Paris, despite a 4% vacancy rate, rental rates on prime office space are down about 10% from their 1990 peak. Rents could fall by 20% more as 1.6 million sq. ft. come on market over the next two years.
And in Japan, Tokyo's vacancy rate currently averages 5% citywide. However, the vacancies on buildings that were completed during the first half of this year are about 20%, and asking rents on these buildings are down by about 10%. The Japan Real Estate Economy Institute estimates that property values are now down by some 40% in Tokyo.
Tokyo's market is set to drop even further. Some 60 million sq. ft. of new office space is coming on stream over the next two years, but demand amounts to 20 million sq. ft., says Graeme McDonald, a senior analyst at James Capel Pacific Ltd. "With a two-year time lag between changes in the economy and any impact on commercial property, we are only in the initial stages of the downturn," says McDonald.
Naturally, not every market is in the tank. In sharp contrast to the rest of Europe, commercial real estate values in Germany are strong. They have been largely propped up by regulatory limits on real estate lending as well as by restrictive zoning. And in Hong Kong, after plummeting some 40% since 1989, office-rental prices are heading back up again. The economy of neighboring Guangdong Province in China is growing at a 15% annual clip, and almost all the trade goes through Hong Kong.
Of course, a rebound in the economies of the industrialized world is bound to help the commercial real estate markets. Still, heat will be on European, Asian, and North American service companies to boost their productivity in a world of freer trade and more open capital markets. And that means that the glut of commercial real estate is not about to disappear any time soon.