Thursday, December 28, 2006

Bends Laffer Curve - Not Very Funny

The Laffer Curve is a theoretical construct that states generally that there exists some optimal revenue-maximizing tax rate for our government, somewhere between 0% and 100%. At 0%, obviously they collect nothing, and at 100% there is no "theoretical" incentive to work (or one hell of an incentive to hide your income) and there is also $0 in revenue. So the Laffer Curve is an inverted "U" shape, with $0 in revenue (plotted on the Y-axis) at 0% and 100% tax rates (plotted on the X-axis), and some local maximum somewhere in the middle that maximizes income.

There's been quite a bit on this blog, it's predecessor, as well as The Bulletin about businesses (mainly downtown) being closed down, ostensibly due to large increases in rent. Duncan McGeary talks about the lease rates diconnecting from reality on his blog, The Best Minimum Wage Job A Guy Ever Had.

Finally, it can probably be stated with little risk that Bend has experienced one of the largest population growth & wealth bubbles in its history, with a flood of people & money coming to this area in just the past 5 years.

So, what does the Laffer Curve, high lease rates, and big growth recently for Bend have to do with each other? It's my opinion that Bend commercial lease rates launched on a steep trajectory higher originating from a number of factors, a primary one being eyepopping growth, that may well have pushed per sq/ft rates past the point of profit maximization for commercial property owners.

Think of it like this: There exists some theoretical lease rate that maximizes the entirety of commercial properties downtown revenue, what it is, is debatable. But cumulatively (assume) there is some blended rate that maximizes the income for these properties. And it exhibits Laffer curve-type behavior; it is maximized somewhere between 0% of the "surplus" (profit) of these businesses and 100%. Charge nothing, and you get nothing, but charge 100% of a business owners surplus, and you eradicate any incentive to stay open.

As an aside: I do realize that there are "lifestyle" businesses, where the owner derives some sort of "psychic benefits" from operating their business, and the economics are of little importance, and some persons like this will operate their business at a loss for extended periods. There are also owners (maybe including Duncan), who take far smaller than economically maximized paychecks for the pleasure of doing "what they want". And then there are simply people who are ignorant of their economic gains over the relevant planning period. All these factors can push lease rates beyond an economically determined profit maximization point, and keep it there. And there is probably evidence that this is happening in some measure in downtown Bend.

I think that the large increases in lease rates currently in Bend are the simple projecting forward of large past rate increases. Demand for the space has certainly gone up with population booming in Deschutes County, while supply has stayed largely contained (until recently, when building height restrictions were lifted). This has resulted in a boom-led increase in lease rates, and with that, a boom in commercial property prices.

But I think the boom is slowing, if not busting. This makes current lease rates "optimistic", and probably to the right of the concave downward "Laffer Curve" for Bend downtown property. In fact, if a "bust" of Bends hyperboom really happens with full force, the natural slowing of economic activity, a dramatic slowing in lifestyle subsidies, and a dramatic decrease in economic incentives to continue working marginally profitable stores (a spouse unwilling to continue subsidizing a money loser, for example) could combine to lead to an explosion in vacancy rates downtown, and a commensurate plunge in lease rates.

I don't think the hyper-optimistic rates of $2.50/ft (+ net lease charges) are sustainable downtown. Of course leases rollover over years, so the effect may be delayed, but there seems to be strong evidence that commercial property owners are confiscating a share of the surplus created by downtown business that is far to the right of optimal, and will lead to a drastic reduction in total revenue. Businesses in Bend simply do not make enough to support current lease rates.

Once this sinks in, there will be a sharp adjustment in Bend commercial property values, downward exacerbating the bust. As I've written before, commercial property exists for no other reason than to make their owners money, and when the money stops these properties fall hard. And once the manifestations of a bust are clearly visible ("For Lease" signs all over), it's even harder to convince new lessees to sign up. Busts are hard to... well, bust.

I am not a bleeding heart liberal, left-wing nut socialist, or anything of the sort. I am a profit maximizer to the core, and think these building owners should maximize their income. But it is my firm belief that they have gone too far in lease rate increases, and they are far past the point of profit maximizing on the "Laffer Curve" for Bend commercial property. I think owners who are not grasping all they believe they can possibly charge in an economic environment gone soft are pursuing an enlightened path. Lessors charging $2.50/ft or more will find their space empty, as there just aren't that many businesses here that can absorb that sort of lease rate and survive.

5 comments:

Paul-doh! said...

I think the whole "Laffer Curve" idea also applies to Bend Realtor incomes: After listing all the Phase 2 homes around me in the $350's for 6 months without a sale, a new Realtor marked them down to $299K, and sold 5-6 units in a heartbeat.

There is demand here... it's just not pie-in-the-sky anymore. Once Realtors grasp this idea that lower prices (from here) will maximize their income, they will abandon their delusions of 25% annual price increases. The last Realtors in my neighborhood operated under this delusion... and made $0 (actually they probably lost quite a bit, with marketing & HR factored in).

Anonymous said...

this post is so dull that, after reading it, i wanted to claw my eyes out.
keep 'em coming!

Anonymous said...

"this post is so dull that, after reading it, i wanted to claw my eyes out."

ditto

IHateToBurstYourBubble said...

Interesting. When I read something boring, I just stop reading. I try not to render myself permanently blind, as I usual regret it later that day. Hopefully the next piece is less dull. I don't want anyone to resort to self immolation!

As Lloyd put so eloquently in Dumb & Dumber:

"Now don't you go dyin' on me!"

Anonymous said...

haha couldn't resist posting this here from Ferris Bueller:

In 1930, the Republican-controlled House of Representatives, in an effort to alleviate the effects of the... Anyone? Anyone?... the Great Depression, passed the... Anyone? Anyone? The tariff bill? The Hawley-Smoot Tariff Act? Which, anyone? Raised or lowered?... raised tariffs, in an effort to collect more revenue for the federal government. Did it work? Anyone? Anyone know the effects? It did not work, and the United States sank deeper into the Great Depression. Today we have a similar debate over this. Anyone know what this is? Class? Anyone? Anyone? Anyone seen this before? The Laffer Curve. Anyone know what this says? It says that at this point on the revenue curve, you will get exactly the same amount of revenue as at this point. This is very controversial. Does anyone know what Vice President Bush called this in 1980? Anyone? Something-d-o-o economics. "Voodoo" economics.