The Pinnacle of Irrationality

By MICHAEL GOTTLIEB California Real Estate Journal Editor That the Burj Dubai was renamed the Burj Khalifa just as the latest "world's tallest building" was unveiled last month hardly came as a surprise. It doesn't take a team of economists to figure out that it makes good fiscal sense to honor the person - Sheik Khalifa bi Zayed, ruler of Abu Dhabi - who rescued your country from bankruptcy. That the record 2,717-foot-tall Burj Khalifa, with more than 160 stories of commercial and residential space, was built at all appears to be an inevitability. For much of the past century, the topping out of record-setting commercial buildings has coincided with the topping out of the economy. The skyscraper index, which was first identified by economist Andrew Lawrence in 1999, revealed a correlation between the construction of the world's tallest building and the business cycle. The "unhealthy 100 year correlation," as Lawrence described it, is noteworthy with examples including the Panic of 1907 coinciding with the completion of the 612-foot Singer Building in 1908 and the Metropolitan Life Building in 1908; the Great Depression with the completion of 40 Wall Tower in 1929, the Chrysler Building in 1930 and the Empire State Building in 1931; 1970s stagflation with the World Trade Center completed in 1973 and the Sears Tower completed in 1974; and the East Asian Crisis and the completion of the 1,483-foot Petronas Towers in Kuala Lumpur. Generally, according to a 2005 analysis by Mark Thornton, a senior fellow at the Mises Institute, skyscraper projects are announced and construction is begun during the late phase of the boom in the business cycle when the economy is growing and unemployment is low. But the causal factors behind the correlation between skyscrapers records falling along with global GDP are more direct. "The skyscraper is considered an art form," Thornton wrote, "but its construction is essentially a business that must pay heed to incentives and constraints and therefore skyscraper construction can be expected to closely follow even small changes in relative prices." Now I won't try to explain the Austrian school of economics or Cantillion effects, but three factors have been identified for the close correlation between record building heights and economies heading lower. First is the effect that low interest rates have on the value of land and the cost of capital. When interest rates are low, land is more valuable, especially in major metropolitan central business districts. As land costs rise, owners seek more capital-intensive structures to achieve profitability. Second, a lower cost of capital encourages businesses to grow, become more capital-intensive and more specialized requiring more office space, which supports higher rents and building more office buildings. Third, the technology of building construction changes to keep pace with demand, delivering new systems to use space more efficiently. These factors, along with government meddling in the economy and banks' ability to stimulate the economy by increasing the supply of lendable funds, produce speculative bubbles when combined with the tendency during boom times for the parties involved in the development processes to disregard the traditional basis for land values and base their project economics on what they predict people will be willing to pay. Does any of this sound familiar? It is hard to ignore how these factors aligned to contribute to the latest recession - Thornton wrote it would be "odd for an industry to reduce the price of its product to sell more loans to less desirable customers and thereby put the assets of banks at greater risk" - that so few people recognized at the time. And you don't have to look to Dubai and the now closed and largely vacant burj or perhaps China in 2014 when the 2,073-foot-tall Shanghai Tower will be completed as fears of an Chinese asset bubble rise for signs of this cycle repeating. Just look at the record 1 million-plus-square-foot industrial warehouses in the High Desert region or the tallest new residential towers in Orange County to see how cheap financing, irrational demand expectations and new technologies helped feed the speculation that altered skylines throughout California. The next time a record falls in real estate, you might want to take a hard look at your investment portfolio. ********** © 2010 Daily Journal Corporation. All rights reserved.