Across the national geography, the notion of a new round of building seems rather inconsistent with the disappointing pace of economic and job growth that has become the distinctive feature of the recovery.
Outside of the apartment sector, where fundamentals have strengthened in the context of a moribund housing market, there is ample reason for developers in most markets to hold off on new construction projects until asset prices and space demand show signs of sustainable improvement. The data confirm that, at least for now, construction and related lending remain subdued.
The extraordinary rebound in Manhattan’s trophy office prices is driving the exception, motivating new development that will ultimately capture a disproportionate share of the city’s absorption.
U.S. Development by the Numbers
Balancing construction costs against prevailing asset prices, the national calculus generally favors the buying of assets rather than building. As a result, measures of construction activity outside of the multifamily sector show listless near-term development. Already at extremely low levels, construction employment fell in a majority of states and metro areas between April and May, according to the most current data from the Bureau of Labor Statistics.
As compared to a year earlier, construction employment in May had fallen in 28 states and risen only modestly in areas where it has picked up. The losses were often weighted to commercial construction, but the six-year-old housing crisis continued to exact its toll as well. Weighed down by macroeconomic factors and an overabundance of single-family and condo units, construction recorded it largest May declines in Nevada and Florida.
Year-over-year construction spending was also down, even after controlling for adjustments in input and labor costs. Nationally, private construction spending was 10.3 percent lower in April as compared to a year earlier. Multifamily spending was down 7.6 percent, while office spending was 14 percent lower. Retail construction spending set the bar for the decline among commercial property types, falling 17.5 percent yearly.
With few new projects getting under way, construction loan demand continues to be weak. Similarly, underwriting standards for construction loans remain tight even as they have thawed for stabilized assets. The balance of construction and development loans on bank balance sheets has fallen in kind. From a peak of $631 billion in the first quarter of 2008, construction and development loans on bank balance sheets have fallen by more than 50 percent, to $296 billion as of 2011’s first quarter.
The regulatory pressure facing banks is understandable given the performance of their legacy pools. The default rate on construction loans is currently 16 percent, four times higher than loans for in-place commercial and multifamily properties.
In many cases, what market observers and policymakers have cited as headwinds from bad commercial real estate loans are actually drags from nonperforming construction loans left over from headier days. The near-term prospects for recovering against these loans are dim. For banks with more than $1 billion in assets, net charge-offs against legacy construction loans in the first quarter reached 4.9 percent, roughly five times the rate for commercial and multifamily loans.
Significantly outpacing the national investment trends over the course of the recovery, Manhattan’s trophy office market is also on the cusp of a development boom. Prices are high enough for the best assets that development is an option for the well-capitalized institutional market participant.
As reported by Bloomberg’s David Levitt last month, more than 25 million square feet of new space is currently in the proposal or planning stages or already under construction. If each and every one of these projects comes to fruition, Manhattan’s office vacancy rate will almost certainly rise unless matched by significantly stronger office-using employment growth than we currently project.
But the developers of these projects—ranging from public REITs like Brookfield and Vornado to private developers like Silverstein and Related—are unlikely to bear the brunt of higher vacancy rates. Given the relative age of Manhattan’s Class A inventory, historical trends suggest that tenants will gravitate to the newer properties, with older and functionally obsolete stock suffering the negative impact of tenant migration.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.