Rock Bottom?

Dec 1, 2008 12:00 PM, By Beck Ireland, Staff Writer

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%).

Fig. 1. 2009 will mark the third consecutive decline in total U.S. construction value, with an estimated falloff of -7%.

“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.

Fig. 2. A severe decline in non-residential spending is expected for 2009.

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.

Fig. 3. Reed Construction Data bucks the trend and predicts a slight increase in spending levels for 2009.

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.”