Commercial Real Estate Couldn't Have Resisted The Bubble

Earlier, Megan revisited the topic of her column in January's edition of The Atlantic and pondered why everyone apparently "got stupid at once" during the real estate boom. I'd like to suggest an answer: commercial real estate might not have had any choice. I'd suggest that the boom began in residential real estate, and economics dictates that commercial real estate was doomed to follow its path.

Let's start with the chart Megan mentions from Krugman:


I interpret this graph as showing that the party got started in the residential sector. It wasn't until the end of 2002 that commercial real estate started showing significant appreciation, exceeding its pre 2001-2 recession level. The way I see it, the commercial real estate boom lagged the residential boom. If you move the red graph back about 8-12 months, it would practically sit on top of the blue one.

Let's think about the two kinds of commercial real estate, that leased to residents and that utilized by businesses. I think both roads lead to the same result: unavoidable irrational appreciation thanks to the residential market.

Scenario 1: Commercial Real Estate Based On Rental Units

Home prices begin to increase. Since homes and residential rentals are substitute economic goods, when the price for one increases, the demand of the other increases, leading to its price rising as well. Thus, rental prices began to rise with housing prices. That would have led to (fully rational) appraisals of these commercial real estate properties rising, since the associated rental cash flows would be higher.

What if landlords had balked at the appreciation of their rentals? First, they wouldn't. If you can get a higher rent price as a landlord, then that's what you do. It would be stupid not to. And as rental prices rose, demand for housing probably began to increase further. A delightful little vicious cycle ensues, as demand for homes and demand for rentals seesaw, leading to higher and higher prices for each.

Scenario 2: Commercial Real Estate Based On Business Inhabitants

So you've got home prices increasing. You've also got residential rents increasing. On some level, real estate is real estate. What's to stop commercial developers from abandoning office buildings and constructing more apartment buildings if that space becomes more valuable? Very little.

Indeed, the building where I rent my apartment is managed by a commercial real estate developer that had traditionally specialized in creating office space for companies, but got into the residential game when it thought it could be more lucrative a few years ago. My building remains its only residential property, as the party was over by the time its foray into the space was completed. Of course, in cities you also saw old factories and office space commonly converted into residences.

So commercial builders had two options: charge office tenants more or focus on residences instead. Again, these turn out to be substitute goods from the developer standpoint. The increase in the price of office space per square foot should follow any increase in the price of residential space per square foot. As the profit potential in the residential space increases, the supply begins to fall behind demand in the office/factory space sector, eventually leading to its price appreciating as well and more construction.

Moreover, the economy was roaring on all cylinders during this time period, so businesses could stomach increased commercial real estate prices. As banks got used to relaxing standards for residential real estate, they did the same for commercial real estate. And unlike in the residential space, banks and investors wouldn't needed to be worried about businesses speculating on commercial real estate or trying to flip their factories or office headquarters like with residential real estate.

Like Megan, I think a whole lot of irrational expectations were a big part of the equation. But I can still kind of see an argument for commercial real estate having been a sort of casualty of the residential real estate boom. I don't think you can make economic sense of a world where there's an incredible boom in residential real estate but not in commercial real estate. And the graph above indicates that housing is, indeed, where the growth began. Commercial real estate was forced to follow, and I can't see how it could have escaped that fate -- no matter how rational commercial mortgage originators or borrowers might have been. This, by the way, makes it a little harder to dismiss the theory that that Fannie/Freddie/CRA started the runaway real estate train.