Over the past two years, the seesaw that is the construction industry economy was kept level by a thriving non-residential sector. Industry analysis performed in 2006 predicted that in 2007 a red-hot non-residential sector with double-digit gains would again balance the overall construction economy, allowing time for a much-needed correction in the inventory of the overbuilt single-family housing market. Hopes for an impending turnaround in single-family housing, however, were dashed as news of the crisis in the sub-prime mortgage broke mid-year. As a result, last year's predictions of moderate overall increases in the construction industry economy proved woefully incorrect. “Every time we think we've hit bottom, another shoe drops,” says Kermit Baker, chief economist, The American Institute of Architects (AIA), Washington, D.C. “It's increasingly possible the housing recession could bloom into a full economic downturn.”

Despite recent Federal Reserve Board action to cut interest rates and a federal program to freeze sub-prime mortgage rates, most industry forecasters have integrated the consequences of tighter lending standards and increased foreclosures, delinquencies, and bankruptcies into their revised 2007 forecasts. In fact, some economists predict the bad apple that is the sub-prime mortgage crisis will continue to spoil the rest of the barrel well into 2008. However, some projections for next year reveal a lesser degree of doom and gloom, forecasting a softer landing for the general economy, a minimal slowdown in non-residential markets, and, finally, a recovery period for the residential sector after it bottoms out in 2008.

The corrections

Before any economists could complete their forecasts for 2008, projections for 2007 had to be amended to reflect current concerns, such as the Federal Reserve Board's dilemma between inflation and recession, fraud in the sub-prime mortgage market, a weakening dollar, unprecedented prices per barrel for oil, job loss, and a decline in consumer confidence. As a result, projections for 2007 took a nosedive, with single-family housing having the fastest descent.

In a correction to its 2007 forecast, McGraw-Hill Construction, New York, changed a modest 4.8% decline in the dollar volume of single-family housing starts to a whopping 25.1% decline. Almost entirely a result of this decline in single-family housing, the total dollar volume of overall construction starts was corrected from a 0.6% decrease to an 8.2% decrease. For 2008, the firm is expecting a further 3.1% decline in single-family housing starts, which, combined with a 1.6% decline in non-residential, gives 2008 the second dollar decline — at 2% — in the market since 1991 (click here to see Table 1) .

“The stable construction cycle has hit a speed bump,” says Robert Murray, vice president, Economic Affairs, McGraw-Hill Construction. “We are seeing a turndown in activity, not just in construction starts but in spending as well.”

Still, there's a chance for a soft-landing scenario for the economy in 2008, according to Murray. Although the single-family housing market is in a collapse, other markets are showing growth. “The Cinderella at the ball is single-family housing,” he says. “As a result of the credit crunch — the biggest threat to the construction industry going into 2008 — there will be a dampening of the commercial sector, but you'll keep your viable projects. In non-residential building, we seem to have learned the lessons from the past.”

Jim Haughey, chief economist, Reed Construction Data, Norcross, Ga., admits the sub-prime mortgage crisis delivered a jolt to construction and real estate, but his firm is claiming that the ramifications, which have been limited to the residential economy, are mostly over. “Economic support for construction is good but not great,” Haughey says. “Moving forward, there will be lingering effects in real estate and residential construction, but not much for commercial or institutional. The only segment that's shrinking is the new residential sector.”

Haughey's firm corrected its 2007 prediction of a 1.8% decrease in residential spending (not including the remodeling sector) to a huge 20.4% drop in residential construction spending. However, because of its faith in the health of the non-residential sector, the company was able to minimize the correction to its prediction of a 5.9% increase in U.S. total construction spending in 2007 to a modest 1.2% decrease (click here to see Table 2). Reed Construction Data's forecast is predicting a 7.3% increase in U.S. total construction spending for 2008, with new housing construction back in the black with a 2.1% increase.

A 6% decrease in single-family construction put-in-place was recently changed to a 28% drop by FMI Corp., Raleigh, N.C. This led to a change in its 2007 total construction forecast from a 2.2% increase to a 4.8% decrease. For 2008, the company is predicting a mere 1.0% decline in single-family housing, a 5.2% increase in total non-residential, and a 1.9% increase in total construction (click here to see Table 3). “We are probably on the optimistic side of the forecasting business, but we don't see current events impacting the economy, which should continue to be strong,” says Heather Jones, construction economist, FMI Corp. “If we are wrong on that, we are wrong on everything else.”

According to Skokie, Ill.-based Portland Cement Association's (PCA) prognosis, FMI's forecast is well off the mark. Ed Sullivan, staff vice president and chief economist, PCA, warns that the sub-prime mortgage crisis has bled through to the real sectors of the economy and will have a long period of adjustment. “The threat to the economy is not a housing issue,” he says. “It's a credit issue — an issue of how we financed housing and consumer spending.”

Speaking at the PCA Economic Forecast in October, Sullivan corrected PCA's 2007 construction forecast from an initial 1.8% decrease to a 3.9% decline and is projecting a further 3.7% change downward for 2008 (click here to see Table 4). “We had expected the non-residential market to keep the momentum, but that's no longer the case,” Sullivan says.

Although the fundamentals of the U.S. economy in general currently are sound — relatively low rates for inflation, interest, and unemployment — Sullivan's PCA forecast advises construction firms to take a more conservative approach toward near-term strategic planning. “There's no question that we are starting from a very good position,” Sullivan says. “But I wonder, if you look back at all the good news, is this analysis backward-looking? Does it account for the hurdles that lie ahead for the economy?”

Bottoms up

The biggest hurdle to the construction industry economy may be the continuing downturn in the housing market. “In two short years we went from record highs to an industry upheaval,” AIA's Baker says. “Home building is in the midst of a significant downturn, and it's going to get worse before it gets better.”

Of primary concern is the glut of single-family houses currently on the market. Housing production has slowed significantly, but only recently (Fig. 1). The decline in single-family housing starts first appeared in 2006, with an 18% drop, from its peak of 1.6 million units started in 2005 (Fig. 2). “Builders waited too long to respond to the inventory of unsold homes,” Baker says. “They were unused to pulling back in good economic times.”

Pulled forward in 2004-05 by record-low mortgage rates and unprecedented price appreciation, demand was at an all-time high. As prices softened, investors and second-home buyers exited the market, and inventories of vacant for-sale homes grew. In addition, borrowers defaulting on sub-prime mortgages have only added to the inventory. The teaser rates for many adjustable-rate mortgages — totaling as much as $425 billion — are scheduled to expire soon, meaning that initial interest rates of 6% or less will be reset at 12% or higher. This has already led to 400,000 delinquencies and defaults in 2006 and, barring any further federal government action, may lead to an estimated 1.2 million delinquencies and defaults in 2007.

Real estate assessments estimate there is a surplus of more than 4 million new and existing homes for sale. “Inventory continues to be a problem,” says Bernie Markstein, vice president, Forecasting & Analysis, National Association of Homebuilders (NAHB), Washington, D.C. “Until we see demand stabilize, we can't expect to see a turnaround”.

Reed Construction Data's Haughey is optimistic that growth in home demand will come from a still-expanding economy but doesn't shy away from mentioning how surplus inventory in the South and West will be corrected. “Whole new subdivisions are waiting to be torn down,” he says. “There are houses sitting empty.”

However, teardowns aren't an easy solution on a local level. Most municipalities resort to teardowns only to prevent vandalism and additional declines in real estate values. The added number of vacant houses in areas hardest hit by the single-family housing slump could force municipalities, already strapped from a decline in revenue because of a decrease in building permits, further into debt to cover the expense of demolition.

Reporter Jeff Coryell has been covering the negative effect of the sub-prime mortgage crisis on the Cleveland area. “There has been a strong tendency among those denying the scope and impact of the mortgage foreclosure crisis, and the attendant credit crunch and slump in the housing market, to speak of the problem only in terms of harm to individual homeowner-borrowers,” he says. “This crisis is hurting whole neighborhoods and the municipalities that contain them as well.”

Through a conversation with Cuyahoga County, Ohio, Treasurer Jim Rokakis, Coryell reports that Cleveland currently has a demolition budget of $6 million. To fully correct the housing crisis, it would need a $100 million budget over the next two years.

Other forecasts are skeptical about the market's ability to curb the number of houses on the market. “About half the inventory on the market has to be cut,” Sullivan says. “Based on current sales, you need to cut 2 million homes out of inventory.”

Sullivan predicts that the sales pace is not going to improve enough over the next year to draw down inventories, especially when adding in the number of houses forced onto the market by foreclosures. “You will not get a recovery in single-family starts next year,” he says. “And if job growth slows, it could take longer.”

With high inventory numbers comes a downward pressure on prices. Sullivan's PCA is predicting a 6% drop in prices this year and another 6% in 2008. Yet, with the downward trend in prices and reasonable mortgage rates, it's still difficult for some borrowers to find the money they need to buy. “Lending standards have tightened considerably,” Sullivan says. “Even in the context of better affordability, these standards will act as a restraint on selling inventory.”

NAHB's Markstein agrees. “Mortgage rates are not the problem,” he says. “Tightening lending standards are the problem. They're a drag on the housing market. Some banks and lenders are requiring 30% down. That's essentially saying, ‘Don't talk to us.”

The markets that attracted the most speculators will likely be the slowest to recover (click here to see Table 5). States like Florida and California may not see recovery until 2010. “The boom in prices was far more concentrated than people thought,” says Mark Vitner, director and senior economist, Wachovia Bank, Charlotte, N.C. Wachovia is predicting three or four more quarters of residential decline before the market begins to moderate. “This time, what's brought down housing is that prices have run ahead of people's ability to buy houses.”

Ironically, the good news for the single-family housing market is that it may finally hit rock bottom in 2008. “It's darkest before the dawn,” says Markstein. “We're looking at a little more trouble ahead, but by Q3 of next year, we're expecting a mild rebound.”

Despite a weakening in the share of the project cost homeowners will get back on remodeling, that sector will continue to help the housing market recover. Aging homes — most around 30 years old — and high homeowner equity levels are being translated into home remodeling spending. “Remodeling doesn't get ahead of itself like home building — some parts are doing reasonably well,” says Baker, who estimates only a slight decline in spending on home improvement projects, from $298 billion in 2006 to $291 billion in 2007.

In the last few years, remodeling has been constrained to the high-end projects, but in the next year will be spread across the price spectrum. In particular, mid-range projects — defined in terms of quality of products used — will overtake upscale projects in share of cost recovered in 2007 for major kitchen and bath remodels, roof and window replacement, and deck additions.

Jurisdictions limiting development in prime locations is also a large driver of the remodeling sector. “There's more of a demand for remodeling and rehab in large markets, such as Boston,” says Suzanne Mulvee, senior real estate economist, Property and Portfolio Research, Boston. “These are markets that are overpriced and have space constraints, so the price of rehab is worth it.”

Taking a surprising turn for the worse, multi-family housing is on the decline. Projections for decreases range from 6% to 8.1%. Fighting its own overbuilt inventory, multi-housing is taking a beating in many construction forecasts. Condo conversions will be hit harder than apartments. “We haven't made as much of an adjustment there,” Markstein says. “There's no question we've got too much.”

A slowing housing market isn't good for multi-family housing, says Mulvee. “It doesn't translate,” she says. “If the economy slips, then there are no jobs and no renters.”

Vitner disagrees, maintaining that the apartment business is benefiting from the housing slump. Tightening lending standards and rising foreclosures are boosting demand for rental apartments. In addition, Vitner says that apartment rents are in the midst of a solid uptrend, totaling $16.7 per square foot in the first quarter of 2007 and moving up from there.

According to Mulvee, some of the money that was going into real estate may make a hasty retreat back to the stock market. “It's more expensive for developers to go through on financing,” she says. “The cost of debt has increased quite dramatically.”

Spill over

Although the decline in new residential construction accounts for the decline in the overall construction total for starts and spending, the consensus for the non-residential sector is that the days of double-digit growth are over. However, most economists concur this is a temporary slowdown, even if they don't agree on which sectors will remain viable. “Think of it more as a pause — a plateau building peak,” Haughey says.

Tighter credit conditions are not just constrained to mortgage markets, says Sullivan. Developers may be required to bring more equity to the table because of the spill over from the mortgage credit problems in the residential sector and the decline in demand for building space in areas suffering from the collapse of the housing market. For example, retail sales are solid except for neighborhood developments built out in anticipation of residential growth.

For 2008, the key to non-residential building is moderation, in both growth rates and structure size. Although many big box stores are going forward with construction, their prospects are mixed, says Murray. Wal-Mart, for example, recently announced plans to scale back expansion. “There's a move to smaller venues,” says Murray, estimating that store construction will increase 11% in 2007 with a 7% drop in 2008. In addition, retail is pairing up with entertainment venues in “lifestyle centers,” which usually also contain a grocery component.

Institutional square footage has gone down although spending goes up, says Haughey. Prisons are also getting more numerous but smaller, and older schools are being replaced. As a result, the education trend goes against the usual population predictors. Starts are higher in wealthy areas with declining enrollment than in poorer states with a rapidly growing enrollment. Funds for public institutions will come from double-digit gains from early 2004 into 2006 in state and local tax receipts, investment earnings, donations, bond issues, and fee income. However, these sources, dependent on a strong economy, may ebb over the next year.

According to Murray, warehouses are the one non-residential sector that's getting bigger. There's greater demand for warehouses from global trade. In addition, larger regional facilities are being built by major retailers, and there's a need for updated facilities to handle improved inventory management practices.

The decline in residential growth has also played an important part in the loss of interest in public projects associated with residential areas, particularly water and sewers, as well as private projects that derived demand from the housing market.

Amid questions about the solvency of the highway trust fund and the federal highway bill, Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users (SAFETEA-LU), the U.S. Chamber of Commerce recently reported that the funding shortfall will reach $1 trillion by 2015. Although some states are trying to make up for this with tolls and private funding, others have experienced legislative disapproval. For example, Texas recently passed legislature to impose a moratorium on private equity for two years.

Although the collapse of the I-35 bridge in Minneapolis in August called attention to the run-down state of the nation's infrastructure, many industry experts say the limelight was short lived. “It was an issue that was brought to the forefront, and it quickly dissipated,” Sullivan says. “I have absolutely no extra spending on bridges integrated into the report.”

Although PCA is predicting a 2.1% increase in the value of construction put-in-place for public construction, Sullivan has reservations. “You could get the re-emergence of fiscal pressure in 2009,” he says. “Slowdown in job creation means a state revenue slowdown and state fiscal crisis.”

The biggest differences in forecasts for the 2008 construction economy lie in how industry experts treat the sub-prime mortgage crisis. Some believe the damage to be largely over and confined to the single-family housing market. Others argue that the tighter lending standards brought on by the mortgage crisis will spill over into the non-residential sector. “I have it touching everything,” Sullivan says.

However, even with this major difference of opinion, most projections are predicting a bottoming-out of the residential sector, with a possible recovery by 2009 or 2010. For the non-residential markets, there is slow growth ahead, especially for sectors intrinsically linked to the residential market, such as retail and public projects, especially water and sewer, yet market fundamentals for the non-residential sector remain strong.

The 2008 forecasts allocate the chance of recession between 30% and 45%, yet they all depend upon the economy avoiding a recession, which is the one factor that could cause major corrections to this year's forecasts. Consumer confidence, the price of oil, interest rates, the value of the dollar, and employment and wage rates will all play a part as 2008 unfolds. “There's certainly a lot of uncertainty going around,” Murray says.



Sidebar: A Green Future

By 2010, green buildings are expected to comprise 5% to 10% of U.S. non-residential buildings. Currently, new federal energy legislation with green building provisions is making its way through Congress. The provisions would require new federal buildings to decrease consumption of fossil fuels in stages, with the goal of achieving “carbon neutrality” by 2030. The version of the bill currently in the House would also require private utilities to provide at least 15% of their electricity from renewable sources, such as wind and solar, by 2020.

“We are in the midst of one of the biggest societal shifts since World War II,” says Rick Fedrizzi, president, CEO, and founding chairman, U.S. Green Building Council (USGBC), Washington, D.C. “Then, everyone came together at that one moment. I think we're there today, realizing the energy crisis and the health crisis are all environmentally linked. The green movement addresses this.”

In 2006, it's estimated that 2% of the non-residential buildings in the United States were certified under USGBC's Leadership in Energy and Environmental Design (LEED) credentials. According to the USGBC, there are LEED-certified buildings in at least 25 states and 100 cities in the nation. Currently, USGBC has 11,185 corporate members and 40,471 LEED-accredited professionals. “LEED taught people a language,” Fedrizzi says. “People want this basic knowledge about the boxes we live, work, and play in.”

This could mean a double behavior change for the construction industry. With “green” catching on around the country, the pressure is on to change what it builds as well as how it builds. The building sector is the single largest contributor to carbon dioxide emissions. To make matters worse, the construction industry is No. 1 for landfills. “We know what buildings use: energy, water, waste, CO2,” Fedrizzi says. “But we also know the effect of green buildings, which is 40% less CO2. If you can buy a $1.39 box of animal crackers that can tell you the amount of fat and calories, why can't you do that with a $90-million building?”

Driving green building are the manufacturers that collaborate on technology to associate activity with energy consumption and cost, says Fedrizzi. “There is a collective consciousness equating green with safety and controls.”

This allows owners and developers to look at buildings in a holistic sense. “A $4-per-square-foot investment in building green could net a $58-per-square-foot benefit over 20 years,” Fedrizzi says. “This is immediate and measurable.”

This also gives the private sector the incentives it needs, instead of mandates that direct energy efficiency.