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The rise and fall of the U.S. office market.

More than 40 percent of all the office space ever constructed in the U.S. was built during the past 10 years, due to a series of trends that converged in the late 1970s and 1980s.

This era was marked by an internationalized economy and abundant capital, which fueled one of the biggest booms in U.S. real estate history. Commercial real estate, as a result, was one of the hottest businesses of the decade.

But the boom has ended; let there be no question about it. It seems that every day a new headline reads: "Bank Failure Linked to Real Estate Debt," "Construction Starts Down For Third Quarter," "Improving Your Odds...., "Breathing New Life into...." It is clear by now that the 1990s will be remembered in a very different way.

The opportunities for commercial real estate investment and development in the U.S. are rapidly changing. Those factors that merged to produce the huge boom in the past 10 years will not be present for the next 10. What, then, is the outlook? Now that the rush is over, is there still any gold to be found?

Cognetics, Inc. a research firm based in Cambridge, Massachusetts, has been following the growth and decline patterns of the real estate market for quite some time. The firm recently completed two reports for the National Association of Industrial and Office Parks (NAIOP), the association for commercial real estate development, that provide quantified answers to these questions about what the outlook holds in store. Most recent is the report, "America's Future Office Space Needs: Preparing for the Year 2000." Using a unique forecasting capability based on studies of the actual growth trends of more than 8.3 million businesses, Cognetics has calculated past-versus-future demand for office and industrial space. Comparison of the results--by space type and by location--tells us a good deal about the realistic opportunities for commercial real estate investment and development through the year 2000. And perhaps more importantly, close consideration of the factors underlying the boom of the 1980s tells us a great deal about why it will not be repeated in the remainder of this century.

The bottom line is that the need for construction (including rehabilitation) of office and industrial space will decrease substantially in the next 10 years versus what it has been during the last 10. Not only will the overall rate of demand be lower; it will also be unevenly spread. Unlike the relatively universal demand of the 1980s, the demand of the 1990s will be limited to certain types and qualities of space and specific locations. But because those places and types of space will, in many cases, be very different from the ones most in demand in the 1980s, past performance will be a very poor predictor of future health. And because the factors that will define high versus-low-opportunity are neither simple nor obvious--and in many cases will have almost no direct relationship to real ewtate--new levels of information and sophistication will be required. In short, a new level of market intelligence regarding each area's scarcest resource--its tenants--will be a key element for success in the office market of the 1990s.

Market trends

To understand why the boom will not repeat, we must understand how it was created. Among the key trends are:

* absorption into the labor force of both the " baby-boom" generation and unprecedented numbers of working women;

* significant changes in the U.S. industry mix;

* major advances in business and office technology;

* increasing levels of international trade;

* skyrocketing rates of entrepreneurial activity.

Accompanying these major trends have been a number of subsidiary effects, including new roles for smaller businesses (often in unexpected industries), shifts in preference for particular types of geographic location and changes in the degree of competitiveness of U.S. industries.

To see how these diverse, and apparently unrelated, trends can have a tremendous impact on real estate demand, let's focus on one of the most powerful of them: the demographics of the baby boom.

The baby boom produced one of the sharpest increases in U.S. population growth evern experienced; the growth rate peaked at more than 20 percent in the early 1960s. But the boom was followed by a bust, and today, U.S. population growth is at its lowest level since the Great Depression.

In order to absorb the great mass of new baby-boom workers into the labor force, the economy had to produce substantial job growth. Not only that, but once the baby boomers--women, as well as men--became employed, they moved quickly into relatively high-paying jobs and became prodigious consumers, furthering the expansionary trend. Thus, this single, unique demographic effect can be cited as a primary catalyst for unprecedented economic growth in the U.S. during the 1970s and 1980s.

By comparison, there will be very few new workers to absorb into the economy in the 1990s. The growth in the U.S. labor force will drop from a high of 2.4 percent per year in the 1970s to only 1.1 percent per year in the 1990s. Absent a major change in immigration policy, there will be few new jobs to create, simply because virtually every American who wants to is already working.

While the baby boom was a major catalyst for economic growth in general, major shifts in the U.S. industry mix also affected the office market. As seen in Chart 1, the percent of the U.S. labor force employed in white-collar occupations has increased consistently--and dramatically--since the turn of the century. Whereas only 30 percent of Americans held white-collar positions at the outbreak of World War II, nearly 60 percent do today. But again, the trend has reached its peak. During the 1990s, white-collar employment will actually decline slightly as a percent of all U.S. jobs.

Construction demand drops

Demand for construction of commercial real estate will mirror the behavior of the economy, slowing down from the pace of the past 10 years. Even incorporating a conservative set of assumptions, the overall growth in need for construction of all three major types of space (primary office, factory and other industrial) will decline by an average of 45 percent versus the past 10 years--roughly in proportion to the rate of slowdown in total economic growth.

Furthermore, types of office commercial space will not be needed equally. The overall decrease in total construction demand masks declines that range from 9 percent to 93 percent for particular types of commercial space. And, as Chart 2 shows, it is the types of space that were most heavily constructed in the past 10 years that will be the least needed in the decade to come. In the most extreme case, the need for construction of new, primary office space will plummet to less than 10 percent of actual 1980-to-1990 construction levels. Less dramatically, the need for construction of factory space will fall to approximately two-thirds of recent past levels while need for other indutrial space (including bulk distribution and flex/R&D/service center) will hold fairly steady at more than 90 percent of 1980-to-1990 construction levels.

The outlook

The office market's outlook for the 1990s can be summarized by four key observations:

* The overall magnitude of growth in demand will be significantly lower than in the 1980s.

* Not all places will share equally.

* In many cases, the places that will do well in the future are quite different from the "hot" markets of the past.

* The degree to which individual locations are, or will become, overbuilt will have a tremendous impact on their viability.

At a most general level (and as previously cited trends would imply), growth in U.S. office employment in the 1990s will fall to just less than half of 1980s' levels. Whereas more than 4.8 million new office jobs were created in the last decade, the tally for the next decade is just less than 2.3 million. As a result, employment-driven demand for new office space will fall to 48 percent of 1980s' levels, or 634 million square feet--much less than what was constructed during the last 10 years in the South Atlantic and Pacific regions alone.

But in today's largely overbuilt market, the need for space and the need for construction of new space are not necessarily the same. A threefold increase in prevailing average vacancy rates during the past 10 years is symptomatic of the problem. Chart 3 indicates the enormity of today's oversupply. More than one billion square feet of unoccupied office space currently exists--more than the total existing stock of the nation's largest (Mid-Atlantic) market. As a consequence, more than half of this country's 273 metropolitan and rural markets could absorb all of their predicted growth in demand for the next 10 years within vacant space that exists today. Much like the credit-card-driven American consumer, the real estate industry has ransomed tomorrow's growth in order to build today.

But at the same time, the U.S. population is on the move, as seen in recently publicized reports from the U.S. Census Department. The upcoming labor shortage virtually ensures that the location preferences of employable people will dictate where businesses can create jobs and grow. As a result, future need for construction of office space will be very unevenly distributed among places (see Table 1). And the areas that will benefit most are those that are traditionally non-indstrial, less expensive and warm. One-third of all employment growth in the 1990s will be located in just three states: California, Florida and Texas.

The South Atlantic region, which attracted only 20 percent of office construction in the 1980s, will account for a third of construction in the 1990s. Perhaps most shocking, the construction need in two of the nation's biggest regions for existing office space (New England and Mid-Atlantic), including the commercial centers of New York, Philadelphia, Hartford, Stamford and Boston, will be lower than in the small-based Mountain region, where there are not many firms relative to the size of the geographic area.

The biggest individual gainers in the 1990s will include many of the markets that "missed out" on the growth of the 1980s, whether because of severa industrial transitions or the effect of the world market for oil. Included here are recovering industrial cities, such as Canton and Erie and oil-patch areas such as Oklahoma City, Houston, Beaumont and Baton Rouge. On the basis of actual amount of office construction demand, Atlanta will lead the nation with a need for more than 10 million square feet.

But the U.S., as a whole, will need to restructure its office-space market. Even the most liberal scenario produces a rate of construction need that is two-thirds lower than the 2.132 billion square feet built in the U.S. in the 1980s.

The two factors that may work to boost office construction demand in the 1990s are:

* the market's ability to tolerate sustained, high vacancy rates, and

* the need for obsolescence-based construction.


Expected Need for Primary Office Construction: Last 10 Years, Next 10 Years, Ratio of Future/Past (Conservative Scenario: 6% Vacancy)
 Area Future Past Past Ratio
New England 3.9 148.8 .03
Middle Atlantic 7.6 368.4 .02
East Northcentral 15.8 259.3 .06
West Northcentral 7.3 136.9 .05
South Atlantic 46.1 444.9 .10
East Southcentral 5.3 79.1 .07
West Southcentral 5.4 302.6 .03
Mountain 13.0 118.0 .11
Pacific 33.4 373.3 .09
United States 137.9 2,132.3 .06
(Square feet in millions)

That is, if the markets are willing and able to sustain vacancy rates that are well above the historical tight markets of 6 percent or 7 percent, then the need for office space construction could rise substantially. If the 1990s vacancy rates continue at the 1980 to 1990 average, for example, construction need would approach 500 million square feet. Similarly, if some existing building are deemed unusable because of obsolescent technology, location or design, replacement construction could be required.

Looking forward

In discussing the requirement for successful commercial real estate investment and development in the 1990s, a final thought is in order: the level of demand is not the only aspect that is going to change. For office as well as industrial space, a changing tenant mix will create new challenges for developers and managers alike. Gone are the days when the prime industrial or office tenants were solely Fortune 500 firms. Today's growth companies are smaller, but are often just as sophisticated and demanding as the previous generation of major tenants.

With this in mind, we can point to three key success factors for commercial real estate investors in the 1990s:

Select your sites very carefully. -- Growth will be highly selective--not only within regions, but within individual metro areas.

Buildings must be managed with great care. -- Tenants will be the commodity of the future and smaller tenants will dominate demand.

Be informed. -- In more competitive marketplace, the best performers will be the best informed.

In the 1990s, success will be a matter of capabilities, not of luck. For the real estate player who select his or her sites carefully, and comes properly equipped, the opportunities will be there.

David Birch is president of Cognetics, Inc., a Cambridge, Massachusetts-based marketing and consulting firm and is a faculty member at the Massachusetts Institute of Technology (MIT). This article is based on the findings from the report "America's Future Office Space Needs: Preparing for the Year 2000," commissioned by NAIOP. The author served as the primary researcher and Price Waterhouse provided the principal research grant for this study.
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Birch, David
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1991
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