Economic Letter 2001-27; October 5,
2001
Natural Vacancy Rates in Commercial Real Estate Markets
Regional Report. The Regional Report appears
on an occasional basis. It is prepared under the auspices of the Financial
and Regional Analysis Section of the FRBSF's Economic Research Department.
With the slowing economy, vacancy rates in commercial real estate markets
have risen sharply over the last two quarters. Nowhere is this more evident
than in the Twelfth District, where vacancy rates in the key high-tech
markets (San Francisco, San Jose, and Seattle) have increased four-fold
since the fourth quarter of 2000. The sharpest increase in the country
over this period was in San Francisco, where vacancy rates rose from 1.7%
in 2000 Q4 to 10.3% in 2001 Q2; this also was one of the sharpest two-quarter
increases observed at any time over the past twenty years.
We tend to believe that an increase in vacancy rates is bad news for
property owners. If the vacant space has been created by tenants' business
failures, then it is likely that owners will have to lower rents in order
to re-lease the space. Of course, increases in the vacancy rate could
very well be good news for tenants and for the overall economy if an unnaturally
low amount of available space is choking economic growth. To analyze the
economic impact of changes in the vacancy rate it is necessary to have
a reference point for what might represent an equilibrium vacancy rate.
In this Economic Letter, I describe a useful benchmark—the so-called
"natural vacancy rate"—and show how current vacancy rates compare to
their benchmark rates.
Trends and levels in vacancy rates
Figure 1 plots vacancy rates for six major commercial real
estate markets in the Twelfth District. Two features stand out clearly.
First, all six markets show signs of cyclical influences. Vacancy rates
were extremely high in the late 1980s and early 1990s, as markets across
the country weakened in the wake of what, with perfect hindsight, appears
to be a period of significant overbuilding. Emerging from the 1991 recession,
vacancy rates declined to extremely low levels by historical standards.
While these markets have not moved in perfect unison over this period,
it seems clear that they all have some exposure to common factors.
Figure 1
Second, while different markets display roughly the same movements over
time, the levels of vacancy rates appear to be quite different across
different markets. These differences are so persistent that they must
reflect some underlying structural differences in the markets themselves.
Thus, it becomes clear that the economic implications of a 10% vacancy
rate for San Francisco could be very different from the economic implications
of a 10% vacancy rate for a city such as Phoenix.
The natural vacancy rate
The theory of the natural vacancy rate acknowledges the reality that
real estate markets are characterized by frictions that tend to impede
the process of market clearing (in a frictionless economy, the requirement
that supply equals demand implies that vacancy rates should be zero).
Real estate markets, in fact, are very decentralized so that it can be
difficult at times to match a particular office space with the most appropriate
tenant. Landlords, of course, wish to lease to tenants who are most willing
to pay for their particular space and will set rents so that not all tenants
will find the lease attractive. Thus, even in equilibrium we should expect
to observe some empty space (see Wheaton 1988).
Exactly how much empty space is "natural" for a market depends on how
responsive (elastic) demand and supply are to economic shocks. On the
demand side, suppose, for example, that tenants are relatively insensitive
to changes in rents. This might occur because location is important for
the tenant (law firms need to be close to the courts, high-tech firms
tend to cluster in regions with research universities). All other things
held constant, we might expect vacancy rates to be low in this type market
because tenants are basically "price takers," meaning that the expected
return to searching for cheaper space is low.
On the supply side, suppose that it is very easy for developers to bring
new space to market after an increase in demand, perhaps because there
are few zoning complications or because there is an abundance of open
land on which to build new structures. Again, holding all other features
of the economy constant, we would expect that vacancy rates would tend
to be high in this type of market. Favorable economic developments, such
as high employment growth, would lead to increased demand for new space.
Fast response by developers building ahead of the employment growth would
tend to keep the vacancy rate higher than in a more constrained market.
When estimating the natural vacancy rate for a market, researchers are
presented with the problem that only actual vacancy rates are observed.
The natural rate must be inferred from the history of actual vacancy rates.
Researchers, therefore, have sought to estimate the natural rate by relying
on the intuition that a natural rate is a level to which vacancies revert
after a shock. Accordingly, much work has focused on developing time series
models of the vacancy rate that allow for this reversion to a natural
rate. In an influential article, Voith and Crone (1988) propose a model
where vacancy rates are assumed to be susceptible to local shocks (for
example, the defense industry downsizing in Los Angeles in the early 1990s)
and to aggregate level shocks (for example, changes in interest rates).
As the literature on the natural vacancy rate has developed, it has become
typical to assume that the natural vacancy rate varies over time and that
vacancies are allowed to adjust slowly to the natural rate.
Estimates of the natural rate using the Voith and Crone (1988) specification
are shown below in Table 1 for the six Twelfth District metropolitan areas
already discussed as well as for two major commercial real estate markets
outside the District.
Table 1
Natural Vacancy Rates, 2001.Q2
| |
Estimated natural vacancy rate
|
Actual vacancy rate
|
|
Boston
|
7.2
|
8.7
|
|
Houston
|
17.0
|
13.6
|
|
Los Angeles
|
12.2
|
14.1
|
|
Phoenix
|
15.0
|
16.9
|
|
Portland
|
10.9
|
9.9
|
|
Salt Lake City
|
13.3
|
15.3
|
|
San Francisco
|
7.9
|
10.3
|
|
Seattle
|
10.9
|
9.4
|
The results show a great deal of dispersion in the natural vacancy rate
across different metropolitan areas. One pattern that emerges is that
supply constraints are important in explaining the cross-sectional differences
in vacancies. Cities with lower estimated natural vacancy rates, such
as Boston and San Francisco, face geographical limitations on new construction
in the central business district; San Francisco, in particular, is almost
completely surrounded by water. In the language of the analysis presented
earlier, these cities are characterized by extremely inelastic supply
curves. Quite possibly, tenants in Boston and San Francisco also have
inelastic demand, since there is little incentive to search or wait for
new space to come to market.
In contrast, cities with higher estimated natural vacancy rates, such
as Houston and Phoenix, face fewer geographic limitations. Both cities
have an abundance of flat land on which to build new structures. In the
case of Houston, an extremely liberal approach to zoning also lowers the
costs faced by developers in constructing new buildings.
Comparing the estimated natural vacancy rates to the actual vacancy rates
in this panel of markets affords yet another perspective on recent developments
beyond simply noting that vacancy rates are higher (or lower) than last
quarter or higher (or lower) than average. In most Twelfth District cities,
current vacancy rates are close to or above the estimated natural rate.
Thus, the observed increases in vacancies should be interpreted as more
than just easings of tight market conditions. We would expect these developments
to lead to less new construction and lower rents. The San Francisco market,
in particular, appears to have suffered disproportionately in the slowing
economy. Figure 2 plots the natural and actual vacancy rates for this
market. While conditions there were extremely tight during the dot-com
boom, the ensuing dot-com bust coincided with an actual vacancy rate almost
2.5 percentage points above the estimated natural rate. Interestingly,
the one major exception to this pattern is Seattle, where the current
rate of 9.4% is slightly below the estimated natural rate of 10.9%. This
is notable because Seattle has often been thought of as having a vulnerable
office market because of the relatively large amount of new construction
currently taking place. The natural rate estimates provide some justification
for the new construction, at least up to this point.
Figure 2
Conclusion
The slowing of the overall economy and the specific problems in the tech
sector have led to rising office vacancy rates. While vacancy rates generally
remain well below the highs of the early 1990s, they have pushed above
the natural vacancy rates in several metropolitan areas in the Twelfth
District. A fully developed theory of landlord and tenant behavior would
predict that vacancies in those areas should begin to ease back towards
their natural levels; we should see rents drop and plans for new construction
postponed. How quickly this easing will come about, of course, will depend
on a number of factors, such as the amount of new construction already
in the pipeline and the persistence of the shock to demand.
John Krainer
Economist
References
Voith, R., and T. Crone. 1988. "National Vacancy Rates and the Persistence
of Shocks in U.S. Office Markets." AREUEA Journal 16, pp. 437-458.
Wheaton, W. 1990. "Vacancy, Search, and Prices in a Housing Market Matching
Model." Journal of Political Economy 61, pp. 1,270-1,292.
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