Real Estate Crisis? It Depends on Supply

Casey Mulligan Economix March 16, 2011

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Casey B. Mulligan is an economics professor at the University of Chicago.

Real estate's future can often be understood by closely watching the supply of residential and commercial buildings.

In early 2009, employment and gross domestic product were dropping sharply, and real estate values had plummeted from their highs in 2006. The housing market was already in crisis, so it felt right to expect the commercial real estate market to follow.

Nouriel Roubini predicted, "More than 700 banks could fail as a result of their exposure to commercial real estate." Elizabeth Warren later reported, "There is a commercial real estate crisis on the horizon."

And journalists frequently referred to a looming commercial real estate crisis. But none of this commentary noted how the supply situation in commercial real estate was drastically different than it was in housing.

By 2008, it was clear that too many homes were built for the market to bear. But the four-to-five-year boom in housing construction had taken resources away from commercial building, holding down the inventory of structures that would be available for business use.

With commercial structures in relatively short supply, I concluded in early 2009 that there would probably not be a commercial real estate crisis creating waves of bank failures.

My conclusion was greeted with much skepticism (one example was Salon's article on "The NYT’s Chicago Economist: Wrong Again," insisting that warning of a commercial real estate meltdown was part of "reliable economy-watching"). Paul Krugman also weighed in.

More than two years have passed, and we no longer hear much about the once-imminent crisis.

Professor Roubini still thinks that a commercial real estate crisis is ahead. Others said the crisis was averted. Either way, it is now recognized that the relatively low supply of commercial real estate made a big difference.

In order to assess the likelihood that the housing sector double dips "“ that is, has another crisis something like the one in 2008 "“ it helps to look at the supply.

The black line in the chart below shows an index of housing inventory per person at the end of each year from 1990 to 2011 (with housing inventory measured as square footage, adjusted for quality; 2011 is a forecast). Housing supply almost always increases faster than population, but the housing boom of 2002-6 stood out compared with the other years in terms of the relative rate of housing construction.

By 2007, housing supply was well above the trend of the 1990s (before the housing boom). If you think that a rational market would have more or less followed that 1990s trend, then the excess supply in 2007 meant that housing prices had to come down.

Of course, housing prices did come down a lot in 2007 and 2008, and the housing supply stopped growing. By the end of 2010 "“ the second-to-last observation shown in the chart "“ housing supply had fully returned to the trend of the 1990s.

Because the pace of housing construction continues to be slow, it looks as if housing supply will be significantly below trend by the end of this year.

These supply results tell us something about the future of housing prices. Those prices depend on demand, too, but as long as housing demand is near or above the preboom trend, it looks as though housing prices are low enough already.

Part of the inventories of housing and commercial property sit vacant, but those vacancies are largely part of a slow economic recovery and the difficult task of dividing property losses from previous years among homeowners, landlords, banks and commercial tenants.

With the slow pace of new construction, neither the housing nor commercial real estate markets can any longer be characterized as having supply that significantly exceeds the fundamentals of demand.

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