This article is Part I of a series on business creation and California’s housing market. Stay tuned for Part II, which will focus on how the high cost of housing may negatively impact business creation.

Business creation’s link with real estate

Yes, we are aware this is a real estate journal, written for California real estate professionals. Business creation is easily linked to the success of the commercial real estate market, but the connection between this and the housing market is more tangential. So why are we devoting an entire article series to business creation?

New business formation is responsible for much of the job growth that takes place in our state. Jobs are responsible for providing residents with the paychecks needed to make rental and mortgage payments, as well as the ability to save up for down payments.

A recent example of how intricately these two economic factors are related is the 2008 financial crisis and ensuing recession. The combined impact of falling home values, foreclosures and job loss snowballed into the worst economic crisis our nation experienced since the Great Depression, from which many are still recovering nearly a decade later.

Could our state’s economy be recovering at a faster pace? Is something holding back business creation? Does California’s reputation for an unfriendly business climate have anything to do with it? We explore these questions below.

Editor’s note — A firm or a company is a legal business, which may consist of one or more separate establishments. An establishment exists in a single location, whereas a firm can exist in a single location or many locations, depending on the number of establishments it owns. In this article, business is synonymous with firm.

Net business formation in California: a history

Chart update 12/05/16

Total firms in California618,800608,400600,500
Net rate of new firm formation+1.7%+1.3%+1.7%

The chart above shows the total number of firms in California at the end of each year from 1977-2014, the most recent year this data is available. It also shows the net rate of firm creation. In other words, the rate of creation alone is much higher than the chart suggests — the growth rate is easily over 10% most years — but when accounting for the “death” rate of firms, the net rate of growth is the lower percentage of 1.7% in 2014 shown above.

Reasons for a firm exit include going out of business, merging with another company and, yes, leaving the state. Is this evidence of California’s unfriendly business climate? Actually, no. Less than 1% of all firm exits are due to businesses leaving for other states. Further, a similar rate of domestic firm exits is seen in most other states, according to the Los Angeles Times.

Of the 618,800 firms existing in California in 2014, 20% were 6-10 years old, followed by 13% that were 11-15 years of age and 11% that were at least 26 years old. 55,400 firms — 9% of all firms — were established during 2014, though between one-in-five and one-in-four of these businesses tend to die during the first year of formation. 12,100 firms were lost in 2014 that were formed in the previous year.

Given the rapid increase in home prices during the Millennium Boom, one might suppose other sectors of the economy were also booming at this time. But firm creation was flat from the late-1990s through 2005, with the net business growth rate hovering around 1.5% most years. Further, job creation in California was gradual and consistent during the Millennium Boom, echoed in the level pace of firm creation.

Editor’s note — As we now know, the level rate of job growth during the Millennium Boom was one indication among many that the housing boom was not supported by real estate fundamentals, but by risky lending practices.

The exception to California’s positive firm formation trend occurred during the recession, when net business formation was negative.

During the initial years of economic recovery, job creation picked up beginning in 2010, while 2012 was the first year when firm creation exceeded the number of firms closing in California since before the Great Recession. This indicates previously existing firms able to weather the recession first hired more employees — or more likely, re-hired employees they had to lay off during the recession — in response to the recovery. The economy needed a couple more years to regain solid footing before entrepreneurs felt comfortable enough investing money in new business.

Business formation’s impact on the economy

The Economist notes firm creation has been down compared to before the recession, not just in the U.S. but across the globe. They link the decreased pace of growth to the slowdown in worker productivity. The thinking goes: more established businesses have less need for efficiency than new businesses.

New firms by necessity need to be innovative and squeeze as many skills and talents (and sometimes hours) out of their employees in order to become viable businesses. On the other hand, older businesses have more leeway when it comes to productivity. They have less reason to innovate or think creatively, since their product is established. Established businesses are in the business of protection — not production of new ideas or products. Of course, the downside of this dynamic becomes apparent when the product or method becomes obsolete while other newcomers innovate (think: Blockbuster vis-a-vis Netflix, Radioshack and Amazon, etc.).

When new businesses are slow to form, overall worker productivity also slows. This means workers contribute less gross domestic product (GDP) per hour worked, which is detrimental to economic growth. This is particularly felt in national GDP growth, which has slowed to an average growth rate of 1% per year in 2009-2016, despite the ongoing recovery. Not coincidentally, California doesn’t have the same problem of low GDP, which we’ll talk more about below.

Low worker productivity misleads people into thinking the economy is better off than it actually is. For instance, even though nationwide unemployment is currently at its lowest since before the 2008 recession, other employment measures — such as GDP, labor force participation and the Labor Market Index — are down. Low worker productivity and slow business creation are partly to blame for the mismatch.

Therefore, a job created by a new firm tends to be worth more economically than a job created by an existing firm. The good news for California is it has the fourth-highest job creation rate stemming from new business establishments, according to Beacon Economics.

The impact on real estate

When a business forms, the positives for real estate include:

  • new space leased, good for commercial real estate; and
  • more local jobs, good for residents who now have access to a wider range of employment and income needed to meet higher housing payments, good for home sales.

When firms go out of business or new businesses are slow to form, as in a recession, the negative impacts are significant. The absorption rate for commercial real estate goes negative, meaning more space becomes available than occupied in a given time period. Vacancies rise and new construction falters. On the housing side, home sales slow and values decline. Current homeowners fall underwater on their mortgages, owing more than their home is worth. Foreclosures and short sales occur at high rates, which drag home values down further.

When all of this occurs, big businesses often turn to the government to bail them out, counting on stimulus to reverse the vicious cycle.

Flash-forward to 2017. What can our state do today, in our present economic expansion, to ensure new firm creation continues to rise, securing a healthy, more stable real estate market?

One obstacle to new firm formation is California’s negative image around its “unfriendly” business culture.

But whether California is business friendly or not is mostly a subjective matter, which depends on the metric used. For instance, the Los Angeles Times notes analysts who place California low on business friendly indices use yardsticks like minimum wage, corporate tax rates and taxes for high-income individuals. All of these are high in California, which leads these analysts to label our state as unfriendly to business.

As a testament to California’s unfriendly business practices, Beacon Economics observes new establishment creation slowed from a 17% average annual rate in the mid-1970s to 12% prior to the 2008 recession. But they go on to note the same trend is seen in other more “business friendly” states across the nation. So the reason for the decline likely has little to do with the business climate here in California.

Further, when viewing our business environment through another lens, like state GDP growth, the number of small business start-ups and how secure the state’s infrastructure is, California scores extremely well. The Kauffman Index ranks California third in the nation for start-up density, and 11th for start-up growth (in terms of hiring). When one uses these metrics to gauge business climate, California is seen as a business friendly state.

Thus, business climate remains in the eye of the beholder.

Might business formation increase if California lowered taxes and the minimum wage? It’s possible. But under its current laws, does California currently have the highest GDP growth in the nation? Yes, it does.

Stay tuned for Part II of this article series, which will focus on how the high cost of housing may negatively impact business creation.