Tuesday, October 03, 2006

Why do developers overbuild?

In theory, the market for real estate should be self-correcting. If prices fall and vacancies rise, developers should take these signals as indicators that no more space should be built. If prices rise and vacancies fall, developers should take these signals that more space is needed in the market. This is good theory, but it does not work. We know that developers are prone to building more space than the community can absorb. New space is added to markets that cannot fill up the existing space. So why do developers overbuild?

1. Developers will take any tenants.

Developers are concerned that their own space becomes occupied. It does not matter to them whether the tenants are new to town or are already in town and moving from an existing shopping center to the new one. Equally, developers do not care if the new center satisfies growth in demand only captures demand away from an existing center. If the new shopping center empties out an existing shopping center, this causes blight which is bad for the community. When Wal-Mart opened its supercenter, Food-4-Less closed. Wal-Mart is not satisfying new demand, it is simply capturing demand away from existing stores, leaving us with empty shopping centers.

2. Commercial development takes a long time.

Development is a slow process. A developer may read a signal saying that it is time to build in 2003. By the time the development is ready for occupancy, it is 2006. The market may change in the intervening time, shifting from a market needing new space to a market in surplus with no new spaced needed. The empty office structure in the 1800 block of Wakarusa is an example. The developer began in the belief that the office market would be strong. Instead, the structure has been empty for years because the office market turned soft.

3. Correct actions by individual developers do not add up to correct actions for the market.

Developers act alone. Several developers may read market signals to build. Individually, each is properly reacting to market signals. Collectively, the combined actions of all developers create too much space. We saw this in apartments in 1997. We normally add about 400 apartments per year, but that year we added about 1,200. Each developer was properly responding to market signals, but each wished that the other developers had not built. The resulting surplus hurt the older smaller apartment building owners hardest. It took about 3 years to absorb that surplus.

4. Tenants are more mobile than buildings.

If retail vendors see better opportunities in a different location, they will move when the net benefits of moving outweigh the costs. The commercial real estate left behind cannot be moved. Redevelopment of an outdated building can be costly, usually more costly than building a new structure on the periphery of the city. Redevelopment is tricky and generally has difficulty competing with newer, larger shopping space. The failure of the Downtown 2000 redevelopment plan is an example of this problem. There is simply too much supply for the few tenants seeking stores, and it is hard for expensive downtown redevelopment to compete with life-style centers at the edge of the City.

These conditions lead real estate markets to overbuild resulting in chronic vacancies and deterioration. When the vacancies and deterioration last long enough, blight is the result. Blight not only lowers the value of the surplus properties but it can lower the value of surrounding properties, causing a widespread loss in value. This is costly, ugly, and avoidable.

If a city like Lawrence wants to avoid such losses, it can correct the developers' propensity to overbuild through simple regulation of the flow of new space into the market. The rule is simple, do not allow the developers to build more space than the market can absorb. In retail markets, this means allowing the supply of space to grow only as fast as the growth in retail spending. In housing, this means only letting the supply of new units grow as fast as the growth in population.

Lawrence's failure to follow these rules has brought it to a very unfortunate position. The City has allowed so much retail space to be built that the downtown is being hurt along with several other older existing shopping centers. The City cannot proceed with its redevelopment plans downtown. Older shopping centers cannot attract new tenants. The City has allowed so much housing to be built that it is causing older neighborhoods to lose population and to lose investment needed to renovate older homes.

Lawrence needs to recognize that the real estate market is full of imperfections. Just because a developer wants to build does not mean that it is a good idea. Often the City needs to take the position that the developer must wait until the City can absorb the new development without harm to the remainder of the City.

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