Can economic diversity reduce construction cycle volatility?

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Toby Kropp
Undergraduate student, Leeds School of Business, University of Colorado Boulder

Economic diversity could be one of the defining factors in commercial real estate and apartment construction cycles in Colorado. Economic diversity measures how financial activity is spread across different industries. When employment is spread across all sectors, it is considered economically diverse. The more dependent a local economy is on a few sectors, the more sensitive it becomes to economic shocks. The question is whether the volatility in Colorado’s commercial real estate and apartment construction cycles have been reduced as the Colorado economy has become more diversified.

Brian Lewandowski
Brian Lewandowski
Associate director, Business Research Division, University of Colorado Boulder

Like most states, the composition of Colorado’s employment base has changed dramatically over the past five decades. The state’s employment base grew from about 1 million jobs in 1969 to nearly 3.6 million jobs in 2015. During this period, the state’s economic base shifted from about 25 percent of total jobs in goods-producing sectors to about 14 percent. While the goods-producing industries have accounted for 260,000 additional jobs over this period, the services sectors accounted for about 2.3 million new employment.

Thomas Thibodeau
Academic director, Real Estate Center, University of Colorado Boulder

In 1969, the top five industry sectors in Colorado accounted for nearly 60 percent of the jobs. Government positions led the economic base with nearly 23 percent. By 2015, the top-five industries accounted for less than 50 percent of total employment in Colorado, with government jobs falling to just 13.4 percent of the total. In addition, the retail trade industry was replaced by health care in the top-five employment sectors.

One way to measure economic diversity is through the Herfindahl-Hirschman Index, commonly referred to as HHI, a measurement that collapses the percent of employment in each industry sector to a single number. A lower HHI score is evidence of more diversity, whereas a higher score indicates less economic diversification. The accompanying chart provides the HHI annually for Colorado for the 20 major industry sectors reported by the U.S. Census Bureau over the 1969 through 2015 period.

Between 1969 and 2015, the Colorado economy became substantially more diverse. The HHI was 1,033 in 1969 and, by 2015, the HHI decreased to 722. The HHI chart separates this timeframe into 10-year periods starting in 1969 in order to gain some insight into the rate of change in economic diversification over time. By connecting these points, we can indicate a noticeable change in the slope of the line as each period continued. The majority of state’s economic diversification occurred during the early part of this period, from 1969 to 1979. Since the turn of the century there has not been much change in economic diversity

So, what does all of this mean for the income-producing property construction cycle? The growth in jobs that require bricks and mortar certainly have benefited the commercial real estate business. Colorado added more than 1.2 billion square feet of income-producing property between 1969 and 2015, including apartments, hospitals and other health treatment, hotels and motels, office and bank buildings, stores and restaurants, and warehouses.

The second chart illustrates the annual amount of new construction on a per capita basis (to account for the increase in population) between 1969 and 2015. The chart is divided into the same time periods as the previous HHI graph.

The chart indicates substantial volatility in Colorado’s income property construction cycles with a significant increase in construction activity following tax reform in the early 1980s. The construction activity during this time was generated by altering depreciation rules for income properties from 40-year, straight-line depreciation to the 15-year accelerated cost recovery system. By the mid-1980s there was a significant decrease in construction activity – in part because of reverting back to a longer-life, straight-line depreciation schedule and falling oil prices when $60 a barrel in December of 1985 dropped to $30 a barrel by February 1986. Another significant decrease in the property construction cycle happened between 1988 and 1991 during the savings-and-loan crisis.

Our detailed analysis looked at how Colorado’s economic diversity had potentially affected the commercial real estate and apartment construction cycles. In the end, the data suggests that any benefits associated with increases in economic diversity have been overwhelmed by other factors like economic shocks and significant changes to Federal tax policies from outside the state.

Featured in CREJ’s June Office Properties Quarterly. 

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