EconSouth (Second Quarter 2003)


Regional Focus

Corporate downsizing has taken a toll on office landlords across the Southeast. But the overabundance of office space, created by significant job losses and overbuilding, has been particularly severe in Atlanta, the region’s largest commercial real estate market.

During the mid- and late 1990s, the Southeast set the pace for the nation regarding commercial real estate development and investment. The boom was most evident in Atlanta, where technology, telecommunications and the area’s traditional base of blue chip companies expanded over an extended period of time — from before the 1996 Summer Olympics through 2000.

Even in early 2001, the outlook for Atlanta’s commercial real estate market was generally favorable. The office vacancy rate was a healthy 11.6 percent during the first quarter. Certainly, the stock market was in decline and dot-com businesses were faltering. But some major companies such as WorldCom (now MCI) and Mirant were still in expansion mode, and investors remained eager to bankroll new office projects.

During 2001 and 2002, construction cranes were a frequent sight on Atlanta’s ever-evolving skyline as speculative projects moved from concept to steel and glass reality. In early 2003, some three million square feet of new office properties were under construction in the Atlanta area. (See the sidebar) for a look at commercial real estate conditions elsewhere in the Southeast.)

Atlanta: Total Employment, 1990Q1 vs. 2001Q2 Recession
Regional Chart
Note: This chart compares the impact in the Atlanta area of recessions that began in 1990 and 2001, measured in terms of employment. The blue line shows the downturn and recovery of 1990–93. The red line shows the 2001–2003 downturn and recovery; the data for 2003 are projections.
Sources:; Torto Wheaton Research, Spring 2003 Outlook

“Phantom” vacancy haunts market
Many developers were counting on a continuation of Atlanta’s strong job growth. In early 2001, however, the Atlanta job-creation machine suddenly cranked into reverse. According to the Bureau of Labor Statistics, after netting no fewer than 55,000 jobs each year between 1993 and 2000, Atlanta’s payrolls grew by only 10,000 in 2001 and declined by 16,000 in 2002 (see the chart).

The result: Atlanta today is awash in vacant office space. For example, in 2002 Houston-based developer Hines completed One Overton Park, a 380,000-square-foot office tower built speculatively to accommodate an anticipated expansion of corporate tenants in northwest Atlanta. As of early 2003, One Overton Park is more than 80 percent empty. Even signature buildings such as One Atlantic Center in midtown Atlanta have large vacancies, and major new projects in the area such as Atlantic Station (6.5 million square feet of office space) and the 41-story Symphony Center are in early phases of development with pre-leased tenants.

As the office supply has increased, so has the vacancy rate in the Atlanta area, which has surged nearly 11 percentage points in two years to more than 22 percent as of the first quarter of 2003. Moreover, many real estate professionals believe that number is deceptively low given the undetermined amount of “phantom vacancy” — a large volume of subleased office space that has opened up as a result of corporate downsizing. If such phantom vacancies are factored in, the city’s actual office vacancy rate is probably closer to 30 percent.

“I’m worried about Atlanta,” said Raymond Torto, a principal with Torto Wheaton Research in Boston. “There has been a tremendous development spigot in recent years, and it’s affected virtually all property types.”

How out of balance is the supply of real estate in Atlanta? Even without considering the phantom subleased space, the market confronts some daunting arithmetic. Currently, some 25 million square feet of vacant space exists. The market needs to absorb 10 million square feet to get that number back to a healthy level of about 12 percent to 13 percent vacancy.

Assuming the most optimistic scenario — in which Atlanta’s economy kicks into high gear later in 2003 and reports the same rate of job growth that it delivered during the late-1990 boom years — Torto projects the market will return to balance in about seven quarters, or sometime in 2005. If growth is slower — a prospect that Torto and others believe is more likely — the office vacancy rate could remain above 20 percent well beyond 2006.

Charlie Croker vs. Bernie Ebbers
Atlanta has an impressive track record of growth, and some signs are positive when looking ahead. Newell Rubbermaid recently announced it would relocate its headquarters from Freeport, Ill., to Atlanta’s northern suburbs. The company is planning to lease or build about 300,000 square feet in north Fulton County as the new home for some 350 corporate staff.

With its premier airport, highway system, low corporate tax rate, wide variety of housing options and low cost of living in comparison to California and the Northeast Corridor, Atlanta is an attractive location for major corporations. But how the area will fare in the next 12 to 18 months is the subject of some concern.

Regional Focus Callout

“Atlanta is home to a number of industries that are in downsizing mode,” said John Robertson, assistant vice president and team leader for the Atlanta Fed’s regional research group. Because of the city’s heavy concentration of technology and travel-related industries, which were particularly hard hit in the latest recession, Robertson forecasts that Atlanta’s recovery will probably lag that of the rest of the nation.

Developers are accustomed to boom and bust, particularly in high-profile markets such as Atlanta. Some of the biggest players in today’s real estate market survived the painful shakeout of the mid-1970s, and most were around to experience the demanding years from 1989 through 1991.

How is the present market different from these difficult past episodes? It’s too early to write a book about it, but it’s likely the story will be different from Tom Wolfe’s A Man in Full, a 1998 novel about the fall of high-living Atlanta developer Charlie Croker in the early 1990s. In Wolfe’s story, the fictitious Croker battles lenders for control of his largely vacant real estate buildings in Atlanta. Eventually, he loses control of his real estate — along with his “trophy wife” and lavish lifestyle.

Perhaps a better symbol for today’s battered real estate market is Bernard Ebbers. While he was chairman of WorldCom, the company was accused of inflating its financial performance and stock price. After the story broke about WorldCom’s actual performance, the company declared bankruptcy and laid off thousands of workers. In the process, large chunks of empty office space became available, much of which was located at the company’s Mississippi headquarters and major regional offices such as Atlanta.

The drop in demand for space has been painful for developers, who say they were responding only to what appeared to be a legitimate need for office supply. “We didn’t overbuild the market — we overleased it,” said Tad Leithead, senior vice president of Cousins Properties in Atlanta. “The problem was an unrealistic expectation among tenants for the amount of space that they would need.”

Picture of Building
Regional Focus Callout

Recovering from a “perfect storm”
Much of the development has been funded through publicly traded real estate investment trusts (REITs). For its part, the banking industry has probably mitigated the excess space problem somewhat by tightening underwriting standards. Savings and loans are not a major factor in the market as they were in the 1980s, and tax-driven deals are less of a problem now than they were before the IRS code was revised in 1986. Today, underwriters typically refuse to lend more than 70 percent of the value of the project, compared with 100 percent 15 years ago.

But even with stricter guidelines, the real estate market may be in a difficult position. How could this happen? Leithead describes an unforeseen “perfect storm” that struck the Atlanta economy with particular vengeance. A convergence of multiple forces took the area by surprise, pounding the area’s office, industrial and multifamily real estate sectors while leaving the residential market (at least for now) relatively unscathed.

Elements of this storm include

  • The collapse of demand from dot-com tenants. Firms such as eTour leased hundreds of thousands of square feet in Atlanta. Many of these companies are now out of business or significantly downsized.
  • The telecom meltdown. Atlanta was a major center for telecom firms that attracted a great deal of investment during the 1990s. For example, WorldCom left behind a swath of office space in northwest Atlanta after the company declared bankruptcy in 2002.
  • The terrorist attacks of Sept. 11, 2001. Atlanta is a major destination for business travel and conventions, two industries that have been hit hard following the attacks. Cutbacks in the airline industry, particularly Atlanta-based Delta Air Lines, also have hurt the area economy.
  • Corporate layoffs. Major corporations such as Coca-Cola, Cingular Wireless and BellSouth have trimmed payrolls in an effort to sustain profits during a period of sluggish sales growth.

The impact of low interest rates
The Federal Reserve’s low-interest-rate policy has also had a significant impact. Many property owners have coped with the financial strain of falling rentals by refinancing to low-interest, adjustable-rate debt. When short-term rates do begin to rise, however, some property owners may experience renewed pressure to make payments on their loans.

The Southeast’s once-booming multifamily housing sector has had an especially difficult time adjusting (see the sidebar). The lowest mortgage rates in 40 years have bolstered the single-family residential market, enabling first-time home buyers to qualify for mortgages. This trend has prompted an exodus of apartment tenants across the Southeast because even low- and moderate-income residents are able to afford homes of their own.

A surplus of space also has developed in the Atlanta area’s low-profile industrial sector, which is typically less susceptible to real estate cycles. Corporate cutbacks have taken a toll on Atlanta-area warehouses and factories; industrial vacancy rates jumped from 7 percent in early 2001 to more than 17 percent in the first quarter of 2003. Other Southeastern cities report similar patterns with continued consolidation, downsizing and the migration of operations to low-wage labor markets overseas.

Smoother sailing ahead?
The Atlanta real estate market will eventually recover. The question, though, is when and how. Egbert Perry, a member of the Atlanta Fed board of directors and chairman and CEO of Integral Group, an Atlanta firm that develops apartments, envisions an expansion of jobs in the area but nothing spectacular in the foreseeable future. His forecast: “Trickle-along growth, then a slow ramp-up.”

Real estate development is not for the faint of heart, and optimism runs deep in Atlanta. Leithead envisions short-term uncertainty and inertia, followed by a rapid, steady upturn as the area’s corporate executives realize that they need to hire more employees to grow and become more profitable. Once that happens, empty office space will start to fill up. “Irrational exuberance has been replaced by irrational pessimism,” he said. “But the market will even out in the long run.”

Mostly Sunny for Florida Office Market; Other Areas Cope with Overbuilding

Commercial real estate in Florida depends on a broad range of industries — tourism, support services, small businesses and investment from Latin America. Although some of these sectors have faltered, key real estate markets across the state are prospering, with the trend improving in recent quarters.

“Florida has been stronger than the nation because of its service industry focus,” said John Robertson, an officer in the Atlanta Fed’s research department. “There has been a lot of migration into Florida. Our best guess is that this trend will continue.” For a number of years Florida’s population has been growing at twice the rate of the rest of the country, driven significantly by migration from Latin America and by retirees.

Picture of Buildingn

Miami sidesteps overbuilding
Urban and cosmopolitan southeast Florida is an example of this trend. Miami’s reliance on small and medium-sized businesses has worked to the area’s advantage during a period characterized by corporate downsizing. Miami has avoided severe overbuilding because it has not traditionally attracted the big-money investors who have fueled rapid development in other markets such as Atlanta.

In a pattern mirrored elsewhere in Florida, Miami lost a moderate number of jobs in 2001 but began posting job growth in late 2002. Latin American banks and corporations continue to expand, along with law firms, trade consultants and other service organizations. The office vacancy rate for Miami is up from 10 percent in 2001 to more than 15 percent in the first quarter of 2003, but it appears to be leveling out. Demand for space is particularly strong in the downtown and beachfront areas.

Real estate analysts cite a trend toward 24-hour communities, with businesses moving back into historic urban areas and demand on the rise for environments where businesses and residents mingle. Miami, in particular, with its vibrant and colorful nightlife and ethnic diversity, has benefited. At the same time, many of the cookie-cutter office buildings in sprawling suburban locations across the Southeast have struggled.

Autos and health care drive other parts of the region
Other major commercial real estate markets in the Southeast have benefited from job growth in the automotive sector, which has partly offset reductions in relatively low-wage manufacturing fields such as textiles and apparel. Saturn and Nissan have expanded production facilities outside of Nashville. Computer manufacturers Dell and Hewlett-Packard also are absorbing more space in the area.

Nashville has avoided severe overbuilding, but excessive construction has created a modest glut of suburban office/industrial space. The office vacancy rate is close to 16 percent. Also working in Nashville’s favor is a strong medical sector, which is less vulnerable to swings in the economy.

A similar situation applies in Birmingham. The University of Alabama has expanded its Biomedical Research Institute although the Birmingham office market may have suffered a setback with the recent SEC investigation involving Birmingham-based HealthSouth.

Alabama’s automobile manufacturing sector has increased demand for industrial space and has caused a ripple effect, which has helped the market. Five major plants are located within 85 miles of Birmingham (Mercedes, Hyundai, Honda, Fiat and Toyota), and many other businesses have opened in the area to provide parts and services to the auto industry.

During the 1990s, Birmingham’s office space was scarce. But the supply has now caught up with demand. Several downtown office projects, including Concord Center and One Federal Place, were launched in the downtown area in recent years. The result: Birmingham’s office vacancy rate increased from under 6 percent in 1999 to about 10 percent as of early 2003, and it may go a bit higher still.

Commercial real estate will continue to be a major contributor to the Southeast’s economy. It may be a while, however, before enough businesses can be found to fill some of the abundant vacancies. But eventually it’s likely these assets will be utilized to support future growth.

“Bottom Fishers” Drive Southeastern Housing

As the economy in the Southeast has slowed, housing has emerged as a notable area of strength. Brisk residential construction has sustained growth in myriad related fields, from building materials to financial services.

“We continue to be amazed by the strength of the market,” said John Wieland, an Atlanta-based homebuilder and former chairman of the Atlanta Fed’s board of directors. “March (2003) was a record month for us, and April was strong as well. It’s all being fueled by incredibly low (interest) rates.”

Many consumers perceive the 40-year-low mortgage rates as a fleeting opportunity to buy. So-called bottom fishers (people who are motivated to buy or refinance homes because of low interest rates) are rushing into purchasing decisions while rates remain favorable, and the number of people who qualify for mortgages has never been higher.

Picture of Subdivision

For now, buyers have a strong hand, with “some areas reporting a softening in market conditions,” according to the Atlanta District section in the April 2003 Beige Book, an anecdotal report on current economic conditions released eight times a year by the Federal Reserve. “High-end homes remained difficult to sell in most parts of the District.” What’s lacking, at least for now, is substantial job creation or relocation into parts of the region, according to the report.

Perhaps the softest price range for homes is $500,000 to $700,000. “A lot of people who buy in that range have taken it on the chin with investments,” said Phillip Rassel, a vice president with Metrostudy, a residential real estate information service.

The decline in stock wealth has been broad but not catastrophic for a significant number of affluent families with the means to bid $1 million and up for their dream home, Rassel said. As a result, the value of some houses in exclusive neighborhoods continues to appreciate, and the second-home vacation market remains strong in certain locations.

Strength in the housing sector has applied to most parts of the Southeast. New Orleans has recovered from a slump in tourism late in 2001, and home-sale prices increased 7.5 percent during the first nine months of 2002. Sales activity also increased despite weak sales of multifamily dwellings.

Housing permits in 2002 were at or near peak levels in Birmingham, Nashville and Atlanta. And the residential market for Florida has been “exceptionally strong,” said Brad Hunter, director of Metrostudy’s south Florida office. “There’s been a lot of capital flight from Venezuela and Argentina, and people are choosing to put it in the Miami market,” he added.

Given the weak economy and the disparity between residential and commercial real estate, speculation exists about a “housing bubble” that could lead to a sudden decline in home prices and hence in equity.

Typically, this sort of bust would occur after a housing market boom. But that doesn’t appear to be the pattern in the Southeast. Homes have been appreciating steadily at about 7 percent annually, compared with surges of 20 percent or more that prompted past collapses in California and elsewhere. “There hasn’t been the hyperappreciation that lends itself to the bubble that people have been talking about,” Rassel said.

Wieland agrees, adding that the price of building supplies (lumber, concrete and wallboard, for example) has fallen, helping to dampen the cost of housing. “There’s nothing to collapse on sticks and bricks,” he said.

Demand is expected to continue for well-situated homes built with quality construction techniques and materials, said Wieland. Residences that are hastily built on small or poorly located lots are more vulnerable to price correction.

When it comes to housing, the Southeast has inherent advantages. People continue to move south, and longstanding migration trends are unlikely to change because of interest rates. The region’s track record for creating jobs, while it has lagged in the past two years, bodes well for this key driver of today’s economy.

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