How safe is commercial real estate investing? Are we over-building or is this the sweet spot?
The Cost of new construction is now very high, as land prices, construction materials and labor costs have risen substantially; and they are very unlikely to decline. One of the basic measures of a building’s value is ‘what would it cost to replace it?’ And then, you must adjust for age, obsolete and outdated features and location. The current cost for new construction of office buildings, for example, exceeds $250 per square foot of building area. Interior finishes for special purposes, like a medical office building, add more to the cost. Older and less desirable buildings may sell for half that cost. However, when older buildings become nearly fully occupied, say above 90%, then, businesses that need to expand, relocate to better areas for their business, or need to open up additional locations run out of options for new locations, so then they must build.
The reasons for demand for additional space are relatively basic. For example; 1. The business is expanding and cannot take on more physical space in their present location. One of my clients desired to double the size of his space and also wanted to build equity in his location, so he is relocating to a newly constructed building he has developed himself; thus, doubling his space and also creating additional tenant space that will help pay for the building and add to his wealth over time. 2. The present location no longer serves their clientele or employees and finding a more suitable location is necessary. IRC faced this in 2008, when we moved from the office building on Loop 410 where we had been for 35 years, to our present location, which is much more accessible for our employees and clients and allowed us to upgrade our facilities. 3. The business needs to open additional locations to serve new parts of the city. Just drive Culebra Road outside Loop 1604. This area is only in the early stages of the Far West expansion which will add 60,000 new homes to San Antonio, and that means lots of new customers.
When old space is filled up, then new construction is necessary. More expensive new construction, means higher rents to pay for the higher costs. Then, this also increases rents in older buildings because space is becoming more valuable. In a city with a healthy economy, adding 1 to 3% to the inventory of commercial space each year is normal. However, there can be a catch-up effect when building slows or stops, as it did from 2008 to 2012, that is, we must build an above average amount, once investors and businesses regain their confidence.
Mark Dotzour, Chief Economist for the Real Estate Center at Texas A&M, says, “although pricing is now very near – if not above – last cycle’s peak, CRE is far from bubble territory. Instead, valuations on average are well supported by current fundamentals and in-place cash flows.” So, right now, I think new construction is a sign of health for our growing economy.