Amid predictions that the housing market may finally be on the road to recovery, non-residential construction shows signs of weakening
As the housing market goes, so eventually goes non-residential construction, say industry economists. With the value of U.S. construction expected to fall for the third year in a row (Fig. 1), major downturns are predicted for the vertical markets that have carried the slumping housing sector over the last few years. Even sacred cash cows, such as health care, education, and manufacturing, won't be able to avoid the slowdown caused by the credit crunch brought on by the effects of the subprime mortgage crisis. Portending the economic climate to come in the next year and possibly beyond, in July and August the U.S. Census Bureau reported first-time declines in private non-residential construction spending, with only a slight comeback in September (1.3%).
“Non-residential construction in general, we have to remember, always follows residential,” says Lee Smither, managing director of the management consulting group for FMI Corp., Raleigh, N.C. “It generally lags behind by about 12 to 18 months.”
In its 2009 forecast, FMI is expecting a 12.5% plunge in non-residential spending, led by a 30% decline in lodging, a 22% drop in office, and a 21% drop in commercial. Predicting total U.S. construction spending for 2009 to top out at $963.3 billion, an overall decline of 7.4% (click here to see Table 1), the firm is not alone in its dire predictions.
Of its 16 non-residential construction categories, the U.S. Dept. of Commerce is expecting seven to decline in 2009, with a 25% plunge in commercial, a 22% decline in lodging, and an 18% dip in office (click here to see Table 2), dragging down total construction put-in-place to $985.9 billion for a 7.5% decline. Portland Cement Association (PCA), Skokie, Ill., is envisioning a 23.1% drop in non-residential construction put-in-place. Loss leaders include hotels and motels with a 33.4% belly flop, other commercial with a 28.9% decline, and industrial with a 27.7% dive. PCA's outlook for 2009 is predicting a 13.9% decrease in total construction put-in-place for 2009 (click here to see Table 3). McGraw-Hill Construction, New York, is anticipating a 9.7% decline in non-residential project starts contract value (a leading indicator of construction put-in-place) and another 9% dip in non-building project starts contract value, led by a 31.6% drop in manufacturing and a 30% drop in electric utilities. With total project starts contract value to decrease by 7.4%, the company expects total U.S. construction starts contract value to equal $514.6 billion (click here to see Table 4). “By whatever broad measure of the industry that you look at, it's clearly in retrenchment,” says Robert Murray, chief economist for McGraw-Hill.
Only Reed Construction Data, Norcross, Ga., is anticipating a somewhat level non-residential market, with an increase of 1.2% (Fig. 2), and a total construction increase of 0.7% in 2009 (Fig. 3). “You can see the steady uptick from early 2006 and into 2008 has now ended and is going to slip off a little bit because of the strong start this year — a 12% gain in non-residential construction spending — falling to about a 1% to 2% gain in 2009 and picking back up very slightly in 2010,” says Jim Haughey, chief economist, Reed Construction Data.
Reed is anticipating activity levels — the number of square feet under construction — in non-residential construction to experience a decline in the high single digits for two or three quarters (or longer for some types of projects) into the early part of next year. “But compared to housing, where the decline was approaching 60%, this is rather mild,” Haughey says.
All markets down
From the onset of better economic conditions, according to Edward Sullivan, chief economist for PCA, the non-residential construction market typically takes 18 months to rebound. Therefore, it could be several years before the non-residential vertical markets recover. One of the hardest hit sectors will be retail. In 2006 and 2007, this segment derived demand from the housing market and is now reflecting its meltdown. Predictions for a decline range from 10% to 30% for construction put-in-place and starts. “Store construction has taken the biggest hit,” Sullivan says.
According to Suzanne Mulvee, senior real estate economist for Property and Portfolio Research, Boston, the volume of transactions has dropped across all property types, but particularly for stores. “The transaction volume is off year-to-date by as much as 70% in the retail market,” she says. “The deals just aren't getting done.”
However, at this time, inventory isn't as high as it was at the onset of other economic hard times. “Commercial avoided the surge it experienced in the prior decade,” says Murray, who maintains there's still a competitive retail landscape. “The decline won't be as severe as previous corrections.”
The other part of commercial construction, office, will also take a hit in the coming year, but it will most likely be contained to various geographic regions. “Vacancy rates in downtown areas will be pretty high,” says Hank M. Harris, president and managing director, FMI Corp. “Some suburbs are following, but we think the suburbs will probably bounce back faster than the urban markets. But all of them can be expected to go down for a while before they start to resurge.”
Like retail, the office market was more cautious in its recent boom time, so the recession won't be as bad as the correction in 2001. “It got killed in 2001, but may not be hurt as much this time through,” Mulvee says.
According to Mulvee, the 2001 office recession was led by tech companies that leased space well ahead of hiring. “This time through, we're seeing companies with real products, and up until a week ago, real profits. They weren't leasing space ahead of their hiring. We think there's going to be less glut in the office market this time through.”
Surprisingly, institutional buildings, such as education and health care, are also expected to decline in 2009. Predictions for decreases range between 2% and 6%. “There's a short-term blip here, mainly because of funding and budget problems in a lot of these institutions,” Harris says. “Health care is going to go down only temporarily, but the market's got a good strong prognosis to it in the long haul.”
As for education, the credit freeze on the bond market makes it a wait-and-see situation, according to Murray. Although spending for K-12 schools is on the decline, the long-term outlook for high schools and universities seems optimistic. Many states in recent years have passed school construction bond measures, especially Texas and California. In addition, major universities have increased capital spending plans. Financial aid difficulties may end up affecting dormitory building, however.
Forecasts for manufacturing are split. McGraw-Hill Construction is predicting a 31.6% plunge in 2009, preceded by a record 69% gain. “Manufacturing buildings will plunge 32% in dollars after an exceptional 2008 that was lifted by the start of several massive oil refinery expansion projects,” Murray says. “Investment in new plants will be restrained by tight credit and diminished capacity utilization in a slow economy.”
With a 4% increase on its books, FMI disagrees with this dismal view of the market's future. Although the manufacturing market will feel the impact of the weakening economy, it still has the potential for a revival in the United States. “After years of off-shoring most of our manufacturing capacity, we are in the process of bringing some of it back,” Harris says. “There are some industries, like steel, that because of pent-up needs have been able to bounce back strongly in the United States. We think that's got some short-term health to it. For other industries, like food and beverage processing, they're impervious to economics. People have to eat and drink.”
Ironically, the cause of the decline in non-residential spending — the housing recession — may be on its way back up in the next few years. Many forecasts are predicting a bottom to be hit at the end of this year or early in 2009, followed by a mild rebound. Reed Construction Data is expecting a 26.2% decrease in housing starts for 2008, to be followed by an 8.6% increase in 2009 (Fig. 4), with construction spending following suit shortly after. “The single-family market has largely cleaned up most of the problems,” Haughey says. “Builders are starting fewer homes than they're selling and are now just waiting for realtors to unload the existing homes that are on the market. Even though housing started this whole problem several years ago, it's going to do better than the rest of the construction markets for the next few years and even better than the rest of the economy, even though it won't get back to where it was.”
David Seiders, chief economist for the National Association of Home Builders (NAHB), Washington, D.C., isn't expecting an increase in new single-family home sales until the end of 2009, and a substantial rebound in new-home starts until the end of 2010. “There is some pent-up demand building,” he concedes.
In addition, the $7,500, 15-year interest-free loan for first-time home buyers included in this summer's housing rescue legislation should spur housing demand in the coming months. Yet, Seiders remains realistic. NAHB calls for housing starts to post their fourth year in a row of double-digit declines, with another 16.2% drop in 2009 (Fig. 5 on page 36). “Momentum is still definitely downward,” he says.
Others are also fairly pessimistic about a near-term residential market turnaround. “For single-family housing, declines are continuing and showing no sign of an upturn,” Murray says. “Home prices are continuing to drop, 20% so far this year, and we expect another 10% decline through the first half of 2009. Then, things should level off.”
McGraw-Hill is predicting a 36% decline in single-family starts for 2008, compared to a 2% decline in 2009. FMI is predicting a 10% decrease in single-family housing construction put-in-place for 2009, and PCA is expecting an 18.1% decrease.
“Although production has declined dramatically, we haven't begun to work off excess inventory,” says Kermit Baker, chief economist at The American Institute of Architects, Washington, D.C. “With falling demand, high inventory levels are not declining.”
However, according to Baker, once the recession ends, housing should snap back fairly quickly. “The industry has a history of returning to the 15% to 30% range in the first quarter of recovery and even stronger in the later quarters,” he says.
The excess inventory of single-family homes is also causing problems for the multi-family housing market. “The most immediate impact on the apartment market is the competitive supply in the form of vacant homes: for-sale product that is sitting out there and competing with landlords for tenants,” Mulvee says. “With the shadow inventory, we think that the apartment market demand is going to struggle a little bit in the near term.”
However, through sheer demographic drivers the apartment market has the potential for a rebound in the same geographic areas that have been hit hardest by the housing recession. According to Mulvee, the children of the Baby Boomers (the Echo Boomers), will soon be graduating college, forming new households, and moving to warmer climates for jobs to cities such as Raleigh N.C., Austin, Texas, and Orlando. “Yes, even Florida's getting younger,” Mulvee says. “These are the markets that will see the biggest influx of new renters, on a percentage basis. On an absolute basis, markets like Los Angeles and New York, which have huge existing populations of young people, they'll see the largest change going forward.”
The one bright side to the decline in construction projects is an easing of demand for construction materials. “The commodity price surge, which was such a problem for construction in the early part of this year, is essentially finished,” Haughey says. “If you had a problem of underestimating the cost of materials for jobs in the last seven or eight months, that's going to go away for several years.”
According to Haughey, construction material prices increased at a 20% pace through July, were unchanged in August, and then increased again at about a 6% pace in September. “The slowing world economy has caused some outright price declines for metals and, through energy, for plastics, and the ebbing U.S. demand and demand from overseas is going to keep construction materials price inflation well below what it was in the early part of this year.”
John Mothersole, principal, Industry Practices, Global Insight, Washington, D.C., says the investor component, or speculation, that helped to inflate prices along with demand, will also decline in 2009. “Trading volume is likely to be less,” he says. “Prices are going to track more closely with the fundamentals of the market.”
According to Mothersole, steel prices have only begun their retreat. “Prices are falling with big reductions to come,” he says.
In addition, scrap, the canary in the coal mine for predicting market changes, will fall to $220 per short ton next year. Finally, copper prices may drop from their all-time highs. “We see a small surplus in 2008 that widens out in 2009, pointing prices lower still,” Mothersole says.
There will be continued erosion in the construction equipment market as well. From 2005 into 2006, the construction equipment market was booming, relying on exports to Asian markets. This was followed by a falloff in 2007. “We expect to see some more falloff with much of the damage coming ahead in foreign sales, partially to Asia,” Haughey says. “It's going to be a slack market, which means if you're buying, better prices.”
More collateral damage from falling markets will be increased competition and higher unemployment rates for engineering and construction firms. When vertical markets are on the decline, competition for projects in the healthy markets increases. “Even if you're a firm that's positioned in the good vertical markets sectors, you can pretty well guarantee that your competition's going to be going up dramatically, because all of these people who are in unhealthy sectors have got to have a place to go,” Harris says. “So everybody, no matter where they're positioned or how they're positioned, is going to feel the net effects of this.”
With fewer projects may come layoffs. “Construction unemployment has almost perfectly mirrored general U.S. unemployment over time, in the ups and downs of the cycles,” says Harris. “It stands to reason that you're certainly going to see our industry's unemployment moving up, which is ironic because most of the firms in this industry have spent the last 10 or 15 years doing everything they can to hang on to talent. Now it's going to be a situation of probably going in reverse on some of that, having to deal with the other side of the coin.”
The numbers for the 2009 construction forecasts depend on the success of recent actions from Congress and the Federal Reserve Board, such as the Federal Housing Relief Bill in July, the $700 billion bank rescue that also included extensions for tax credits for renewable energy sources, and the coordinated cut in interest rates with foreign nations. They also anticipate further fiscal stimulus for investment in construction projects, such as an infrastructure bill supported by the Associated General Contractors of America (AGC), Arlington, Va. Yet, even with continued measures, construction is expected to remain in the red. “The steps taken to help the frozen credit market will work, but with time,” Murray says. “But even before these events, we were dealing with a tough credit market.”
However, a recession is preferable to a state of panic. “We think the genie's going to get put back in the bottle,” Haughey says. “We anticipate that within a month or so credit costs and availability for non-financial firms and consumers will return to where they were back in July and August. Unfortunately, that's not a very pleasing prospect because we were just on the verge of a recession, but the panic will be gone and people can stop talking like it's 1929.”
There is a lesson to be learned from construction's history. “All of us who live long enough are ultimately going to become believers in economic cycles — and economic cycles come and they go,” says Harris. “In the 1970s, for example, some people thought our problems were so large they were going to last forever. Obviously, that's not the case, but we do have some serious challenges ahead of us as an industry right now.” (See Strategies for Hard Times on page 30 for more information).
According to Harris, past recessions took as long in recovery as they did in the making of them. “The down period lasted about as long as the preceding up period,” he says. “So there could be an argument to be made that this recession — from a construction standpoint — could go for a long, long time because the construction markets have been basically bullish for 16 years, at least on a national level.”
However, Harris thinks a prolonged recession is doubtful. “There are so many demand drivers behind so many different forms of construction that it's hard to imagine it would take a decade to come back,” he says. Yet, he's unable to make predictions beyond it being soft for several years. “My best guess is we're in for some very difficult times in this industry in the next couple of years. It may be soft for as many as three or four, but again the cycles come and go.”
Instead, FMI examines the impetus behind construction spending. “Consumer demand and demographics are ultimately what drives construction activity, especially in a vertical market,” Harris says. “Most of us tend to think that our projects are somewhat derived from the developers or private spending or public budgets, or whatever the immediate issue might be, but it's always good to peel the onion and look at what's behind that money.”
Sidebar: Strategies for Hard Times
Under any economic condition, you want to position your firm for success. However, in a weakened economy, revitalizing your strategies for success may mean the difference between keeping your doors open or shutting them for good. “You always want to get your business ahead of the money,” says Hank M. Harris, president and managing director, FMI Corp., Raleigh, N.C. “You always want to try to get your business to where the demand is.”
Therefore, in order to position yourself for success, you should have a contingency plan. The following are suggestions for formulating your own:
• Check for warning signs. A key indicator that your region is headed for tough times is an increased number of project delays and cancellations in your area.
• Look outside your own sphere of influence. Gather and read as much economic and market data as you can from the outside. The AIA Billings Index is a reliable indicator. “Beginning in January 2008, the Billings Index gave us an indication that there was less work on the boards,” says Lee Smither, managing director of the management consulting group for FMI Corp. “It was certainly a shot over the bow, if you will, back in January.”
• Challenge your old way of conducting business. The strategies you use during good financial times might not work under a weakened economy with increased competition. “The things you believed were true before may not be true now in your marketplace and for your future,” Smither says.
• Examine the incremental economics of your business. Track your metrics, such as the number of new contracts versus the previous year, gross profits, overhead, cash flow, labor productivity, liquidity ratio, rate of backlog fill, amount of work on the boards, and age of collections. “What are some of those incremental economics that are business-specific?” Smither asks. “Get back to the balance sheet, and look at how strong you are.”
• Contingency planning for the next six to 12 months. Using your metrics, put a plan in place for at least a 10% shortfall in revenue or work. If the recession lasts longer, from nine to 12 months, or spans more than a year, begin to develop a long-range plan with critical actions you can take that will ensure your survival and establish a mechanism for cost-cutting in your business based upon sound financial analysis and advice.
• Look at your organizational structure. Get back to basics. Implement best practices project management to reinvigorate productivity. Look at your general conditions. Reward employees who are margin aggressive. Fix or eliminate any marginal locations. Ask yourself if your structure works based upon what you think is coming in the future. “Will there be too much redundancy in places where one time it was good because you were so busy you couldn’t see straight, but now becomes burdensome?” asks Smither. “We have a lot of clients that have admitted that over the last five to seven years, they’ve gotten sort of lazy with regard to their project management practices; they were just trying to get work done.”
• Undertake scenario-based business planning. Perform exercises for changing economic environments. Hold a planning session to discuss the best-case/worst-case/expected-case scenarios. “If you’re a multi-divisional company that has vertical markets, you go through all the different scenarios for each division,” Smither says. “Each major department does it, too. This whole process takes about a month or two to go through, but it’s well worth it.”
• Keep score. Track risk management: Check over subcontracts before they’re signed, keep insurance certificates up-to-date, implement or refresh safety programs, and verify and perform due diligence on the project funding before breaking ground.
• Establish cost-cutting hierarchy. Non-people-related cuts come first, followed by office staff, and then professionals in the field. Examine your different locations and profit centers. Delay capital expenditures. Look at hiring.
Source: FMI Corp.