Money runs out, and construction comes to an abrupt halt.
This happens from time to time in real estate development projects, but it is happening more than ever this year. The combined effect of a lending crunch, budget cuts, high energy prices, and a collapse in the real estate market make it unusually difficult to get commercial real estate development projects finished. It can take eight years to plan and build an office building or shopping center. Thousands of projects have been called off before construction began. But other projects ran out of money after construction was underway, leaving a partial building sitting awkwardly for months, potentially for years, waiting for new financing to be arranged, or perhaps waiting for a new owner to buy out and redesign the project.
Thousands of commercial real estate development projects have come to be owned by banks. In some cases, the bank foreclosed on a project after construction delays and overruns left the developer out of cash and unable to refinance. In others, the bank and the developer agreed to call off a project after they realized it was no longer economically viable.
It’s a problem for banks, which don’t really want to be in the business of owning real estate. The partially finished buildings are a special problem. In banking terms, they are high-value assets with very low liquidity and no earnings.
The Fed is trying to figure out what it can do about the half-finished commercial real estate development projects that banks already own, or may end up owning over the next two years. One thought is to devise a special kind of financing instrument so that the half-built buildings can be completed quickly. But the Fed does not want to take this approach too far in a real estate market that is already seeing high vacancy rates and falling rents.
Most of the country is seeing commercial real estate more than 10 percent vacant, with rates more like 20 percent in most large city centers. With so much excess space already, it might be better for the real estate market if many of the incomplete buildings could be mothballed for five to ten years, and the construction completed only when the space might be needed. Adding more buildings to an already overbuilt commercial real estate market could further depress rents and put more pressure on building owners and developers.
By some estimates, most of the cities in the United States have more than enough commercial space for the next 10 years. Some local politicians have been calling for a moratorium on new downtown construction until the market gets back into balance. Instead of a moratorium, restrictions on lending for commercial real estate development might be a more flexible approach. A rule preventing banks from lending more than 80 percent of the value of a project, in areas that are already overbuilt, would go a long way toward limiting the kind of real estate speculation that puts banks and developers at risk.