Moderating economic growth triggers construction forecast downgrade for 2017 and 2018
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Entering 2017, construction forecasters were quite optimistic about the near-term outlook for the industry. Not only was 2016 ending up with strong construction spending numbers—6 percent across the entire nonresidential building sector, paced by more than 10 percent in the commercial categories—but 2017 was expected to be the year that federal fiscal policy would provide even more momentum for this market. Tax reform and financial deregulation were going to unleash investment capital, and the repeal and replacement of the Affordable Care Act was going to reduce financial burdens on small businesses. To top it off, a trillion-dollar infrastructure program over the coming decade would directly undergird strong construction growth for the foreseeable future.
However, as of the mid-year 2017 update, the grounds of this euphoria are evaporating. Our economy has seen only about 2 percent growth (when annualized) over the first half of the year, and key elements of the Trump administration’s legislative agenda have made almost no progress. Both consumer sentiment as measured by the University of Michigan Consumer Sentiment Index, and business confidence as measured by the Conference Board’s CEO business confidence survey, are currently at levels below those entering 2017.
Construction spending so far in 2017 has been fairly disappointing. Commercial/industrial construction spending has increased just under 7 percent through the first five months of the year relative to the same period in 2016, as compared to over 10 percent growth for 2016 overall. While some slowdown was anticipated for 2017, it was expected to be offset by acceleration in the institutional sector. However, year-to date growth in spending for institutional buildings is at only 3 percent, up from the 1.6 percent of 2016 but well below expectations when the year began.
As a result, the AIA Consensus Construction Forecast panel is predicting slower growth for the construction industry for the remainder of 2017 and through 2018. Overall spending for nonresidential buildings in 2017 is projected at just under 4 percent, compared to the 5.6 percent forecast at the end of 2016. The commercial market is expected to perform largely as anticipated, with growth now forecast at 8.8 percent for the year, up from a projection of 8.3 percent entering 2017. However, both the industrial and institutional sectors have been marked down considerably. Industrial construction is currently projected to decline almost 7 percent, compared to a projected modest increase six months ago. Institutional construction now is seen as increasing 3.5 percent, compared to the 5.7 percent figure entering 2017.
Construction spending so far in 2017 has been fairly disappointing.
The slower estimated growth for 2017 is expected to continue through 2018. Overall spending growth is currently projected by the Consensus Forecast panel at 3.6 percent for next year, down modestly from the 4.9 percent forecast entering this year. Commercial construction is expected to perform closest to prior expectations, with the 4.0 percent expected growth in spending for 2018 down less than 0.5 percentage points from the late-2016 forecast. Industrial construction is now likely to see very modest 1.1 percent growth next year, down from the prior expectations of 3.3 percent, while the institutional outlook has dropped from the 5.8 percent forecast of six months ago to 4.1 percent with the current projections.
Factors affecting the construction outlook
The recent slowdown in construction spending activity, and the scaled-back forecasts for the next 18 months, are the result of a combination several factors, some dealing with the broader U.S. economy, some dealing with general construction industry fundamentals, and some dealing with weakness in specific construction sectors.
1. Slowdown in the US economy: While few analysts feel that there is much of a risk of an economy-wide recession anytime soon, likewise few see much likelihood of a significant acceleration in growth. The consensus is that our economy will grow in the 2.0 percent to 2.5 percent range through the end of 2018. The Federal Reserve Board is in the midst of an interest-rate tightening cycle, which will serve to limit economic growth. The national unemployment rate is very low, indicating that businesses will continue to have trouble recruiting new workers. The stock market is at record levels, generally signifying healthy profits at US companies. While true, a significant share are these profits are coming from foreign activity, so stock prices are not a simple reflection of the health of the domestic US economy.
2. Construction industry concerns: While rising interest rates will have a longer-term dampening effect on construction, rising materials costs are a more immediate concern. After years of overcapacity and weak demand for many construction commodities, there has been a reversal of this trend recently. Over the past year, oil-related products (diesel fuel, asphalt) have been rising at a 20 percent pace, metals (steel, copper, aluminum) at a 10 percent pace, and other basic building commodities (cement, gypsum board, lumber and plywood) at a high single-digit pace. This past June, an AIA survey asked architecture firms if higher material costs were affecting their practice. Most firms indicated that they have seen noticeable changes in material costs. Of these firms, a third indicated that these increases were a serious problem, and an additional 45 percent reported that they were somewhat serious. In response to this situation, architecture firms and their clients have resorted to a variety of measures, including scaling back the scope or size of projects, redesigning projects, or even putting projects on hold or dropping them entirely.
Labor is another ongoing problem affecting the industry. With the unemployment rate in the construction industry falling from around 20 percent in 2010 to much closer to the overall unemployment rate in our economy at present, there are limited options for attracting labor into the industry. A particular concern is that immigrant labor accounts for close to 30 percent of the construction labor force, with most of these being Hispanics, and the recent focus on immigration could limit the availability of this labor pool.
3. Vulnerable construction sectors: All major construction sectors currently face a range of challenges, but the outlook for construction spending over the next several quarters relies heavily on the performance of four key sectors: retail; industrial; education, and healthcare.
- Retail: E-commerce is typically blamed for the weakness in brick-and-mortar retail facilities. There have been numerous store closings in recent years, particularly among major department store chains. However, closer analysis points to much of the weakness being concentrated in exurban and rural locations that have seen population losses recently. Additionally, many traditional e-commerce companies (for example Amazon and Apple) are pursuing an omnichannel strategy for retailing, creating more demand for retail space. Retail facilities will no doubt face a challenging future, but the seriousness of this challenge at present may be overstated.
- Industrial: the manufacturing sector in our economy has suffered greatly from foreign competition, but somewhat ironically the challenges to retail facilities may offer opportunities for manufacturing. The rise of e-commerce means that production needs to be closer to the ultimate consumer, and that the logistic systems need to be much more efficient. This is beginning to show up in increased demand for shorter-cycle domestic production facilities, as well as more sophisticated decentralized warehousing and distribution centers.
- Education: The construction of education facilities has faced challenges of local government’s fiscal situation, often resulting from the decline of property values during the last recession, and therefore declining property taxes to fund these new facilities. Now that property values have recovered in many markets across the country, issues around basic demographics are at the forefront. The peak year for births for the large millennial generation was 1990, and since the leading edge of this generation has largely completed its formal education, demand for facilities at all education levels nationally has been declining. For example, there were 120,000 fewer births nationally in 2000 than there were in 1990; 180,000 fewer in 2010, and 200,000 fewer in 2015. Education will continue to be a healthy construction market, but growth opportunities are hampered by demographic trends.
- Healthcare: Like education, healthcare demand is heavily influenced by demographics. In this instance, it is the other end of the demographic spectrum, namely the over age 65 population. Demographics for this age group are extremely strong. What isn’t strong is the political environment supporting health care policy. Until current health care policy is settled, there will be continued hesitancy in investing in this sector.
The outlook for construction
Prospects for the construction industry have weakened just a bit with developments over the first half of the year. The AIA Consensus Forecast projects annual growth in the 3.5 percent to 4.0 percent range for the remainder of 2017 as well as for 2018, with a slower growing commercial/industrial market, and an institutional sector facing several challenges.
However, a somewhat more optimistic view is coming from architecture firms. Average Architecture Billings Index (ABI) scores for the first half of 2017 exceeded average scores for both 2015 and 2016. While this could be viewed as architecture firms merely working down their backlog from a few stronger years, that doesn’t appear to be the case. Index scores for both new project inquiries and new design contracts were stronger on average in the first half of 2017 than in 2015 and 2016, and as a result firm backlogs have been growing, not shrinking. By sector, the strongest ABI numbers through the first half of the year have been coming from institutional firms, so we may finally see some progress in coming quarters in the institutional construction sector.
Kermit Baker, Hon. AIA, is the AIA’s Chief Economist and part of the AIA Economics and Market Research Group, which provides AIA members with insights and analysis of the economic factors that shape the business of architecture.
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