A fourth of downtown St. Paul office space is vacant. That information, taken alone, might indicate a real estate cow market. That is not to be confused with a bull market, when all prices rise. It refers to the way commercial property, like the cattle market, can go from boom to bust because decision-makers have imperfect information and fall prey to wishful thinking.
The upshot is that quantity and prices of commercial real estate don’t always respond smoothly to changes in business conditions.
The cattle cycle is simple: Cattle prices start to rise. Producers respond rationally by deciding to produce more. For that, they need more breeding stock. They keep young females for breeding that would otherwise go to slaughter. Old cows that might be culled instead are kept for one more pregnancy.
Holding back breeding stock reduces the number of animals going to slaughter. This pushes prices even higher. More producers then hold back more females, in a self-reinforcing cycle.
Biology is destiny in bovine economics. It takes a year before more calves are born to now-larger breeding herds. Even more time passes before these are weaned, fattened and marketed. More than two years pass before operators’ reactions to higher prices result in higher slaughter numbers. That isn’t the instantaneous response of supply-demand graphs in freshman econ.
But eventually, more fat cattle are marketed. Because so many ranchers expanded their herds simultaneously, the increased flow soon becomes a torrent. Prices plummet. Producers then see little profit and cull their herds heavily. They don’t keep heifers as herd replacements. Both decisions swell slaughter numbers, reinforcing price declines.
Again, a couple of years pass before slaughter numbers drop in response to now lower herd sizes. Beef prices pull out of the cellar and the cycle starts all over again.
Office buildings don’t breed, so the analogy is not perfect. But otherwise, the commercial real estate cycle often is similar.
Rents rise. Many developers foresee profits from new buildings. These, like steers, can’t be turned out overnight. Prices stay high for a few years as developers acquire property, design buildings and construct them. But as with cattlemen, too many people have the same idea at the same time. When all the new space comes on the market, vacancy rates rise and rental rates plummet.
Some developers go broke. Others hunker down and ride out the storm. Some older buildings become parking lots. Eventually, excess space gets absorbed, occupancy and rental rates rise and the cycle begins anew.
There is a twist, however, in St. Paul’s situation. There has not been much private building downtown recently. The state of Minnesota did build a lot of office space, which has drawn tenants from downtown. Moreover, there has been office construction in some suburbs. But developers did not go wild in downtown St. Paul. Thus, current high vacancy rates may be an exception to a usual pattern.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.