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Can “The 2003 Problem” Happen in the U.S.?

We are in a weird economic environment.  “Weird” is not the kind of terminology that economists usually throw around, that is the realm of the physics community and the people at Fermilab just west of Chicago with their strange quarks, charmed particles and the like.  With interest rates at the lowest levels in the post-war period and slow economic growth however, the usual relationships in all the economic data can bounce off in unexpected directions.  Looking at a similar intersection of economic variables in Japan following the burst of the 1980s real estate bubble, this intersection drove an unexpected surge in new office construction in Tokyo in 2003.  Can this “2003 Problem” happen here?

Chicago offers not only a laboratory for experiments in physics, but the comparatively easy regulatory environment for new construction makes it a natural laboratory to explore changes in financial variables and their impact on construction.  Looking at the excess office space available on the market today, one might think that there is no need for any ongoing construction.  With financial market conditions well outside of historic norms however, and investors chasing yield like never before, might we see construction activity in Chicago similar to the previous experience in Tokyo?

“Hey you, stop wearing that hat!”  This is what I would hear in the early 1990s walking with my colleague Tim as we made the short walk from Chicago’s Union Station to the campus at UIC where we were both studying economics.  It gets cold in Chicago in winter and while the walk was less than a mile west of the Loop, Tim would wear this giant fur hat to stay warm.  Apparently Tim’s hat was displeasing to one of the numerous homeless men who set up camp in this land west of the West Loop which had many marginal industrial buildings and surface parking lots within a short distance to two major commuter rail hubs, subway lines and freeway infrastructure.

As penniless grad students, we had to tough it out with these walks on cold winter mornings.  This said, it struck me as odd at the time that so many office workers had about the same walk as us each morning in the other direction to the office buildings in the East Loop.  In my naiveté, I thought that someone should just build some office towers in this underutilized portion of the city.  My thinking was that some tenants would be willing to pay a bit more in rent to avoid those morning walks in the winter. 

Fast forward two decades, and office availability rates in Chicago’s West Loop stood at 17.6% at the end of the 2nd quarter.  Given the size of the submarket, this figure translates into roughly 7.6 million square feet of space available for lease.  To put this figure into perspective, over the last four quarters 7.6 million square feet of new space was delivered nationally.  Given this magnitude of available space, one might think that new office towers in the West Loop will only be seen far into the future.  Recently though, some projects seem to be moving forward.

The River Point project in the West Loop recently moved out of the planning stages with Ivanhoé Cambridge joining Hines on a project which will add 850,000 square feet of modern office space to the submarket.  There are other large projects in the planning phase that could move forward in the near-term as well including 301 South Wacker, 222 West Randolph, Wolf Point and 625 West Adams.  Looking at market fundamentals alone, one might think that this roughly 3.2 million square feet of planned projects could not move forward with economic fundamentals still weak, but the experience in Tokyo shows otherwise.

In Tokyo, after years of malaise following the burst of the real estate bubble in the 1980s, new office construction came back strongly in 2003 despite weak fundamentals in the economy.  In this year, 40 new office projects were delivered in Tokyo in an event known as the 2003 Problem.  Leasing market conditions could not drive such a move in new construction; in a rent to replacement cost metric the numerator still was nowhere near the previous peak.  The denominator though had moved quite a lot.

Our research colleagues in Japan note that the real estate boom in the 1980s drove land prices up to artificial highs.  Land values plummeted for most of the 1990s falling anywhere from 80 to 90% by 2003.  Ongoing deflationary conditions in the Japanese economy impacted the denominator more than the numerator in the rent to replacement cost metric and a number of investors came to the conclusion that new construction was the best use of investment capital in the Japanese real estate market. 

Is this process underway in Chicago today?  Looking at the factors driving the denominator in the rent to replacement cost measure, there is not enough evidence to conclusively say yes.

There are some elements of the economic downturn and recovery in the U.S. that rhyme with those seen in Japan in the 1980s and 1990s, rhyme but not match exactly.  While the U.S. has not seen the same degree of a bust in land values as that experienced in Japan, there have certainly been declines.  Data from our friends at Real Capital Analytics suggests that land prices in the U.S. are now anywhere from 30 to 50% lower than at the peak seen in 2007, that said, prices are on the way up.  High quality development sites, particularly in the multi-housing sector, are not sold at fire sale prices any longer.


Aside from land costs, other important metrics in the replacement cost figure include hard costs (ie., the costs for construction materials) and the soft costs of labor, engineering, design and financing.  The team at Turner Construction produces an index of the hard costs included in new projects in terms of construction materials.  In the 2nd quarter of 2012, this index is down roughly 9% from the peak level set in 2008.

A rule-of-thumb metric for the construction of office towers in CBD submarkets in the U.S. is that between land costs, hard costs and soft costs, each contributes a third to overall replacement costs.  In suburban areas this ratio places much less emphasis on land costs but the focus here is on CBD submarkets.  Given the declines seen in hard costs and land costs, replacement costs in total could be anywhere from 13 to 20% lower than those seen at the peak if soft costs were unchanged.  The finance costs of soft costs can also move quite a lot in this environment.

Again, there are some elements of the economic downturn and recovery in the U.S. that rhyme with those seen in Japan in the 1980s and 1990s, and policy actions by key Federal teams are using that experience as a guide.  The quantitative easing that the Federal Reserve Bank has pursued is in fact a program aimed at preventing the decades of malaise experienced by the Japanese.  This action by the Federal Reserve Bank though has other consequences.



As shown in the preceding chart the U.S. is currently in uncharted waters with respect to interest rates that prevail in the economy.  The long run average since 1980 for the Ten Year Treasury is 6.87% with a standard deviation of 3.1.  To put these figures into perspective, if you were to take the 1.83% level of the Ten Year Treasury seen in August of 2012 and pick any random date since January of 1980 , you have a better than 95% chance that the Ten Year Treasury at that date will be higher than the level seen in August.

With a current interest rate environment lower than that seen over 95% of the recent history, investor perceptions of risk and return can change dramatically from those seen in the past.  Rather than let capital sit in low yielding government bonds, some Pension Funds with ongoing targets of 8% returns find themselves re-assessing the degree to which they will take on more risk to hit these targets.  New construction certainly fits the bill there and soft costs can really start to change from such re-assessments.

Key financial aspects of the soft costs of construction include the cost of financing construction loans and developer yields on costs.  The rule-of-thumb historically was that developer yields on costs should be about 10%.  Informal discussions with our Capital Markets professionals suggest that the low interest rate environment is bringing that yield down closer to the 7% range today. 

The cost of the debt itself then should also move to record low levels if, as in normal times, the cost of construction debt moves with the overall interest rate environment.  Again, these are not normal times, risk aversion is quite high today for lenders and construction financing for large office towers is generally not available.

The $300 million development cost for the River Point project is reported to be coming directly from Ivanhoé Cambridge as opposed to a more traditional combination of equity and a construction loan tied to a fair amount of pre-leasing.  Compared to previous metrics, going in all-equity would seem to be a costly way to build an asset.  When building an asset, you want a high rate of return on your equity with a low rate of return on the debt because that is your cheapest capital.  Again though, previous metrics were set in an environment with different type of interest rates, job growth and yield curve.

With all capital cheap today and investors hunting for productive investments, an investor might look at that equity portion of the capital stack and accept a lower rate of return on it than in the past for the right project.  Is it then cheaper to build today than to buy? 

Not necessarily.  The 2012 mid-year Cap Rate Survey from CBRE suggests that stabilized Class A buildings in the Loop would sell for a roughly 6% cap rate in the current environment.  If we underwrite a ten year hold using the rent forecasts from Econometric Advisors one would see a roughly 3.5% per year income growth assuming no major tenant events.  Also taking the Econometric Advisors forecast of a100 basis point increase in cap rates over ten years as we leave this low interest rate environment, and, back of the envelope one could get an 8% IRRs unleveraged assuming no unusual cap ex events.  Add a little leverage to this mix and if you are a pension fund with an 8% return target, and offices in the West Loop could look like an attractive investment option.

Still, is there enough high-quality product to go around at this pricing?  If not, for an investor with a tolerance for higher risks and lower return on equity, the required market rents for a project to pencil out can be far lower than those seen in the past.

This type of rationale is exactly what the Federal Reserve Bank has hoped to achieve through the program of quantitative easing which has helped to bring the long-end of the yield curve down to such low levels.  The traditional monetary policy response of setting the low-end of the yield curve, the Effective Fed Funds Rate to a mere 0.14% since 2008 was clearly not having much of an impact on growth with investors hesitant about future growth opportunities, hoarding cash and not making the investments necessary to spur economic growth.

Still, hesitancy about investment in other asset classes is not the only feature driving investors to consider new construction.  Despite the quantity of empty office space in the West Loop, rents are actually on the rise, particularly so for the high-end of the market.

The following chart shows that average net asking rents for the submarket bottomed out at nineteen dollars and change at the end of 2010.  Since then the average rent has posted a cumulative 5.5% growth through mid-year 2012.  The average space is today asking for net rents of roughly $20.80 per square foot and the face of it, rents at that level might not seem to be enough to justify new construction.  The thing is though, when one is building a new asset, one will be building not to the average rent but the rent at the top of the market. 

Pulling together the rents for the top ten percent of listings in the West Loop, the high end of the office market has seen faster growth in rents since 2010.  This top ten % shown in the preceding chart has seen cumulative growth of 7% since the end of 2010 with a rent premium to the market average climbing from the 20% range up to 25%. 



With just a little more demand this premium would be likely to climb assuming no major changes in the type of space tenants want.  There is some evidence that tech firms prefer the older, funkier space in the East Loop and River North especially, but the financial services and law firm tenants still prefer large floorplates in modern buildings, and if their sense of caution fades as the economy rebounds, this premium could grow quickly.

The implication for investors in the office market from the potential addition of new towers is mixed.  New construction need not be feared as something that will undercut the performance of modern, high quality assets.  In the current market there is clearly a flight to quality with rents growing at a stronger clip in these assets.  Where the challenge may be seen is in older, inefficient assets at the lower end of the market.

It would seem that the impact of new construction would be likely to be borne by particular submarkets.  Many of the older, inefficient assets are in the East Loop far from the major transportation hubs in the West Loop.  Those assets, when originally developed, were close to the major transportation hubs of the Illinois Central and the LaSalle Street Station which when established in the 1850s, served the population base of relatively wealthy white collar workers on the south shore.  In the mid 1900s though, these populations moved to the northern and western suburbs which in turn are serviced by Union Station and the Ogilvie Transportation Center.  Again though, some of the new tech firm tenants in the market are now showing a preference for this funky older space closer to the older transportation hubs.

The 2003 Problem, can it happen here?  Chicago is a great natural laboratory but sometimes experiments that happen in the laboratory cannot be replicated elsewhere.  Some of the factors that drove the 2003 Problem in Tokyo are present in Chicago today but not all and is unlikely that this market, or the U.S. in general will experience the same flood of new office towers.

One of the key features that Chicago has most in common with Tokyo is the large stock of older inefficient assets from which tenants might be poached.  Again, if we use Chicago as a laboratory, not many other markets in the U.S. have this structural issue.  Certainly in Manhattan there are many pre-war buildings and for years now developers have been actively upgrading the quality of the office space in the market as tenants drop out of the low end of the market.  The large stock of older inefficient space from which tenants might be poached is not a condition seen in every large city in the U.S. 

Still, we are in a weird economic environment.  Rather than let capital sit in low yielding government bonds that have negative returns when adding in the impact of inflation, some investors may be more tempted than before to put capital to work in the development of a hard asset.

In my naiveté when I was in school, I thought that someone should just build some office towers in this area west of the West Loop.  The colorful characters who accosted graduate students on the way to campus may well be pushed into other areas as changes in financial market conditions can help make it possible to bring underdeveloped land in these areas more fully into the economy of Chicagoland.​​​

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