At the peak of the housing market in August 2006, the construction industry employed more than 10 percent of the Inland Empire’s labor force. Today, it employs barely 5 percent. This sharp decline in construction jobs, which was felt in both the residential and commercial sectors, demonstrates how important the real estate market had become to the region’s overall economy in recent years.

The Winter 2010 issue of Inland Empire Outlook focused on residential real estate and reported that even when the value of that market reached its lowest point in late 2009, it showed no signs of a quick rebound. But the downturn in the residential sector provides only a partial picture of the Inland Empire’s real estate market. For a more comprehensive view how real estate affects overall economic activity in the Inland Empire, it is also necessary to consider the commercial real estate sector.

Commercial real estate can be divided into three primary categories—office space, industrial space, and retail and shopping space. Office and industrial real estate, because of their ties to employment, can be viewed as potential drivers of the economy and, to a certain extent, drivers of retail and shopping and residential real estate. As companies return to financial stability and increase their local employment, the improving job market will likely boost residential real estate prices and rising discretionary income among reemployed residents will help restore consumer spending.

Retail Follows Rooftops: Trends in Retail and Shopping Real Estate

Historical data show that residential housing and retail and shopping space are affected by a common set of factors. Fluctuations in retail and shopping space tend to mirror the activity of the residential housing market but generally with a slight lag. Accordingly, it is likely that if residential real estate recovers, retail and shopping space should follow. An examination of historical vacancy rates in retail real estate reveals that this relationship has, indeed, existed in this region.

In March 2002, the region’s retail and shopping vacancy rates were only 1 percent, but starting in the third quarter of 2002, they started to climb. By December 2003, the retail and shopping vacancy rate had more than quadrupled, ending slightly greater than 4 percent. Then, in mid-2006, the residential housing market crashed. Over the next three years, retail and shopping vacancy rates soared and by September of 2009, almost 9 percent of existing retail and shopping space in the Inland Empire lay vacant. These trends show that there is a relationship between residential and retail and shopping real estate in the Inland Empire, and that a recovery in retail real estate is unlikely to appear until the residential housing market has shown clear signs of recovery.

Driving the Economy: Trends in Office and Industrial Real Estate

Vacancy rates for office and industrial real estate in the Inland Empire remained stable between 2000 and the summer of 2007, when both sectors saw vacancy rates skyrocket. The timing of the sudden increase in office and industrial vacancy rates coincided with the collapse of the housing market. In March 2007, office and industrial real estate vacancy rates rose sharply to 8 percent and approximately 6 percent, respectively. These vacancy rates continued to increase over the next two years until June 2009. At that time, they again leveled off but at an all-time high: office real estate had a vacancy rate close to 17 percent and industrial real estate had about a 15 percent vacancy rate.

Although these vacancy rates have reached historic highs, they nevertheless understate the dire condition of commercial real estate in the Inland Empire because they fail to account for the dearth of construction of new commercial space units. While existing office and industrial real estate properties remain vacant, there is very little demand for new development. Over the past year, the amount of rentable building area (RBA) under construction has plummeted to unprecedented lows. Because there is virtually no new industrial real estate construction in the region, recent rates reflect only the vacancy of existing real estate.

The Demise of Commercial Real Estate

The high commercial real estate vacancy rates in the Inland Empire show no signs of decreasing in the coming months. While commercial real estate may have found its bottom, as residential real estate did in late 2009, it will not likely recover quickly. For commercial real estate to have a positive impact on economic activity, a significant increase in occupancy rates would need to be accompanied by an upswing in construction. The low probability of this outcome provides little hope that real estate will spur a broader economic recovery. More generally, it is unlikely that real estate will soon reassert its pre-recession role in driving economic activity in the Inland Empire.