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Consensus Construction Forecast
A steeper than projected downturn this year will lay the groundwork for growth by the second half of next year
by Kermit Baker, Hon. AIA
AIA Chief Economist
As we entered 2010, the AIA Consensus Construction Forecast Panel was downbeat on the prospects for the year, projecting a 13% decline in spending (inflation adjusted) for nonresidential building projects. Halfway through the year, prospects have deteriorated, with the current consensus predicting a 20% decline this year. The worst economic downturn in several generations, a fragile financial sector, excess commercial space, and unease in the international economy all share the blame for the current situation.
However, the international economic outlook should produce construction opportunities this year, and domestic opportunities should begin to present themselves next year. Since it began to recover last summer, the U.S. economy has steadily improved, though it has seen a few speed bumps. The European debt crisis roiled the stock market this spring, and the ongoing problems with the Gulf oil cleanup will have an as yet undetermined short-term impact on our economy through the loss of jobs and income, and a longer-term impact on oil prices. Most economists feel that these twin problems are not enough to send our economy back into recession. Our economy likely grew about 3% in the second quarter (inflation adjusted and annualized), and likely will grow at about the same rate for 2010 as a whole. While this is close to the typical growth rate for the U.S. economy over the long-run, it is disappointing for the first year of a recovery where we generally see a more substantial surge.
Economic growth, however, will not accelerate until the employment situation sees a significant improvement. Through the first half of the year, only 880,000 payroll positions have been added and a disappointingly small share have been private sector jobs. The construction sector continues to be a major drag on the economy, as payrolls in this industry have declined by 114,000 so far this year.
Regional recovery somewhat uneven
Energy, manufacturing, and agriculture recently have been some of the strongest sectors in the economy, which has helped some regions of the country more than others. According to a Federal Reserve Board (FRB) report in regional economic conditions as of late May and summarized below, economic activity continued to improve across all twelve Federal Reserve Districts, although many districts described the pace of growth as “modest.” Consumer spending and tourism activity generally increased. Business spending also rose, on net, with employment and capital spending edging up but inventory investment slowing.
By sector, nonfinancial services, manufacturing, and transportation continued to gradually improve. Residential real estate activity in many districts was buoyed by the April deadline for the homebuyer tax credit. Commercial real estate remained weak, although some districts reported an increase in leasing. Financial activity was little changed on balance, although a few districts noted a modest increase in lending. Spring planting was generally ahead of the normal pace, while conditions in the natural resource sectors varied across the districts. Prices of final goods and services were largely stable as higher input costs were not being passed along to customers and wage pressures continued to be minimal.
Respondents to the FRB survey reported some improvement in residential construction activity but little improvement for nonresidential buildings. Most districts noted an increase in home sales and construction prior to the April 30 deadline for the homebuyer tax credit, with contacts in many of these districts also indicating a corresponding slowing in activity in May. Tight credit, the elevated inventory of homes available for sale, and the “shadow inventory” of foreclosed properties on banks’ balance sheets held back residential development in the New York, Cleveland, Atlanta, and Chicago. Commercial real estate activity generally remained weak. Office, industrial, and retail vacancy rates continued to drift upward in many districts putting downward pressure on rents. However, lower rents were said to have led to an increase in leasing activity in New York, Philadelphia, Richmond, Kansas City, Dallas, and San Francisco. The elevated inventory of existing properties for sale or rent continued to weigh on new private nonresidential construction. However, stronger industrial demand was noted in several districts. Public construction increased in Philadelphia, Cleveland, and Chicago, but slowed in Minneapolis.
The FRB report pointed to slow improvement in other key sectors of the U.S. economy:
Business Spending. Capital spending was slightly higher in a number of districts, although several indicated that continuing caution on the part of firms and tight credit availability were limiting expenditures. The manufacturing, transportation, and energy industries accounted for most of the increase in spending on plant and equipment.
Nonfinancial Services. Nonfinancial service activity was slightly improved. Several districts highlighted some strength in demand for professional technical services, such as software and information technology, engineering, and other scientific trades. In contrast, sluggishness remained in accounting, legal, marketing, media, and construction services. Demand for business support services was more mixed.
Manufacturing and Transportation. Manufacturing and transportation activity continued gradually to improve across all twelve districts. Most reported further increases in factory production, shipments, and new orders. Higher residential construction increased demand for construction equipment and materials in the Philadelphia, Richmond, Chicago, Dallas, and San Francisco.
Banking and Finance. Financial activity was little changed on balance. Commercial and industrial lending by banks remained weak in most districts, although Philadelphia, Chicago, Dallas, and San Francisco noted business loan demand was firming. Consumer lending weakened in most districts. In contrast, real estate lending increased even though standards on these loans remained tighter than on other loans, particularly for commercial mortgages. Loan quality was indicated to be stabilizing or gradually improving in most districts, but remained an issue for banks with large exposures to real estate. Contacts in some districts cited concerns over the potential impact of the European fiscal crisis on financial and business conditions, and reported a corresponding increase in uncertainty and financial market volatility.
Employment, Wages, and Prices. Labor market conditions improved slightly with permanent employment levels edging up in most districts. In addition, many districts again noted an increase in temporary hires. By industry, manufacturing was the most often cited source of employment gains (both temporary and permanent). Prices of final goods and services were largely unchanged in most districts as higher input costs were not being passed along to customers and wage pressures continued to be minimal. Steel prices in many districts moved higher, as did lumber and food prices, while energy prices generally declined. Several districts noted tighter commodity supply conditions.
Nonresidential construction fundamentals still weak
The overall improvement in the economy has not yet turned around the nonresidential construction sector. Commercial property values nationally have fallen more than 40% from their mid-2007 high through the first quarter of this year, according to the Commercial Property Transactions Price Index develop by the MIT Center for Real Estate. Declines have moderated significantly since the middle of last year. Until values recover, however, the risk of commercial mortgage defaults remains a serious concern and limits the demand for new construction activity since lower-priced existing facilities are generally considered a more attractive investment than building new ones.
The AIA’s Architecture Billings Index (ABI) suggests that a construction recovery is still a ways away. The May reading for the ABI was still showing a decline in design activity, and historically a construction recovery hasn’t occurred until 9 to 12 months after design billings begin to grow. Tight lending standards continue to create problems for new nonresidential projects. The Federal Reserve Board’s Senior Loan Officer Survey on Bank Lending Practices still points to restrictive lending conditions for commercial real estate loans. The April 2010 survey indicated that most banks kept their lending standards unchanged in the first quarter, while a small share further tightened terms on loans to businesses.
In spite of weak construction levels, weak demand is still pushing up vacancy rates. Reis, Inc., a real estate research firm, recently reported that U.S. office vacancy rates rose in the second quarter this year, and were approaching 18%. National office vacancy rates were below 13% as recently as mid-2007.
Our construction forecast panel expects the weakness in the construction sector to continue well into 2011. Overall, they see nonresidential construction spending declining by just over 20% this year, with declines running close to 30% in the commercial sector, over 20% for manufacturing facilities, and even 12% for institutional buildings.
Next year is projected to finally show some relief in the construction sector. The consensus for overall spending growth in nonresidential buildings is just over 3%, with more than 5% in the commercial sector, a 2% decline in manufacturing facilities, and 4% growth for institutional buildings. In the commercial sector, retail and hotel facilities are expected to see the strongest growth, while health care and amusement and recreation facilities are the consensus for the best performers on the institutional side.