The decline in new residential construction spending predicted for 2007 is no cause for alarm, say industry economists. Although estimates of a drop in single- and multi-family housing seem unusually high — as much as 8.5% according to the forecast published by Skokie, Ill.-based Portland Cement Association — industry analysis concludes that what may appear to be a severe decrease in spending is actually a return to a better balance among residential and non-residential market sectors.

In the last few years, increased spending in the residential market caused the construction industry to grow faster than the national economy, says Jim Haughey, Ph.D., chief economist for Reed Construction Data, Norcross, Ga., but the end of that era is at hand. “The unusual period of growth for residential construction is not coming back until the next decade,” he says. “The time when margins for everyone in the business has hit their peak is over. However, the decline will stabilize, and non-residential markets will be positive.”

Haughey's firm is predicting a 0.9% increase in residential spending, which includes the remodeling sector, but a 5.9% increase in overall construction spending for 2007 (click here to see Table 1).

“Home prices have outpaced incomes,” says David Wyss, chief economist for Standard & Poor's. “The ratio of home price to income is at a record high, and there were big local bubbles in New York, California, Boston, and Florida. When mortgage rates go up, starts and sales drop.”

Inverse to the downward housing trend, institutional, commercial, manufacturing, and transportation market sectors are set to lead the industry to acceptable margins (Fig. 1). Helping boost non-residential numbers are government legislation, an easing of lending standards for commercial and industrial enterprises, changes in the manufacturing supply chain motivated by increased globalization, and some relief from the inflation raising the cost of materials and oil. Government spending, through the transportation and environmental protection bills and work starts on formerly delayed projects, will act as a catalyst to overall construction put-in-place in the next few years.

“It is a more stable picture,” says Robert Murray, vice president, Economic Affairs, McGraw-Hill Construction, New York, which estimates a 5.1% drop in residential project starts contract value and a 0.6% decline in the contract value of overall construction project starts (click here to see Table 2). “The [construction] economy is moving toward a soft-landing scenario. Once you get above a 5% level [in government spending], there is going to be an increase in projects,” Murray says. “There is continued support for public works, especially in transportation and transit markets. We've been seeing this pattern by sector. If public works goes down, that might be the time for housing to rise again.”

Consumer confidence, spurred by lower interest rates and tax cuts helped keep the economy healthy, says Wyss. “The tax cuts provided extra income, and lower mortgage rates freed up funds, but the saving rate was negative. Now, the tax cuts are over, interest rates are up, home prices are dropping, and the savings rate will remain low.” But Wyss assures the industry that this is a slowdown, not a retreat. “This will be helped by lower energy prices,” he says.

Fortunately, the housing market's decline won't carry a negative impact to the nation's overall economy either. “In order for there to be a broad-based decline in home prices, there has to be contagion from the financial community,” says Martin Regalia, Ph.D., vice president and chief economist for the U.S. Chamber of Commerce. “There isn't a credit crunch. Interest rates are up, but they're not up precipitously. Housing is drifting sideways to down in the next couple of quarters, but there's no erosion. The decline in housing isn't broadening to an overall economic recession.”

The U.S. Dept. of Commerce predicts a 7.2% decrease in residential spending, bringing the increase for overall construction down to 0.3% (Table 3 on page 31).

Balancing act. “Anyone involved in the home-building sector has been concerned about what's been going on the last year or two,” Murray says. According to McGraw-Hill Construction, from 2005 to 2006 single-family housing starts dropped by 15%. The National Association of Home Builders, Washington, D.C., predicts a decline of more than 12% for both this year and next, expecting only a 6% increase in 2008 (Fig. 2) — when the key driver for the housing market will be the growing number of new households formed.

“We expect two million more households to be formed this decade,” says Kermit Baker, chief economist for the American Institute of Architects (AIA), Washington, D.C. “Immigration accounts for most of these new households. More than 10% of our population is foreign-born. The industry should study this population to see what the demand in the future will be.”

The current decline in residential spending has been attributed to diminished affordability for first-time homebuyers and a pullback in investor and second-home demand. Murray cites guidelines from bank regulators discouraging unconventional mortgages. Other industry experts blame rising interest rates (Fig. 3) for the decline. Others disagree. “Even though interest rates have gone up, they are still below 1990s rates,” says Narimann Behravesh, executive vice president and chief economist for economic and financial analyst Global Insight, Waltham, Mass.

Other detractors from the housing market are the rising cost of land, land-use restrictions, such as when local jurisdictions limit the number of new homes, and high energy costs. In some markets, an oversupply of homes is blamed for the decline in the housing market. “There were well over 1.8 million new homes started this year,” Baker says. “The market weakens as inventory begins to build, and homes have been much larger and more expensive. Rising insurance rates, construction amelioration, and hurricane-resistant design will raise costs.”

In order to match housing supply with demand, certain conditions must be met, says Angelo Mozilo, chairman and CEO for Countrywide Financial Corp., Calabasas, Calif. Land-use restrictions must be lessened. building codes must be updated, and permitting and inspection processes must be streamlined and sped up.

According to Haughey, it will be three to four years before housing production is back to where it was at beginning of 2006. “The new residential market is in month nine of a 15- to 20-month inventory correction,” he says. “At the current monthly sales rate, the surplus is about a seven- to eight-month supply of new homes, and more already-sold homes — empty or unaffordable — may soon come on the market.”

Whatever the reason for the decline in new residential construction, the drop will have a major impact on the pattern of total construction in 2007 but won't cause any major fallout for spending in the industry in general, which is buoyed by the health of the national economy. According to Reed Construction Data, the retail vacancy rate, at 9.9%, is at a four-decade low with rents rising 3.5% per year, the office vacancy rate, at 16.1%, continues to fall, and rents are rising 3.1% per year. K-12 enrollment growth, at 0.6%, is also outpacing new classroom supply. Funding for these projects comes from a surge in health care insurance premiums and public medical programs and rising state and local tax receipts. (Fig. 4).

Construction incentives. On Sept. 1, the Bureau of Labor Statistics (BLS) reported that seasonally adjusted construction employment in August totaled a record 7,521,000, up nearly 3% from August 2005. “That was slower growth than had been logged earlier in the year but was still more than double the rate of growth for total non-farm payroll employment,” says Ken Simonson, chief economist, The Associated General Contractors of America (AGC), Arlington, Va. “The growth was concentrated in nonresidential building and specialty trades, although BLS' other three construction categories, residential building and specialty trades, and heavy and civil engineering, also increased.”

As far as heavy engineering, the power market sector is experiencing major growth. “High energy prices and new Clean Air Act standards are driving huge investments in both traditional oil, gas, and coal projects and in a variety of alternatives, notably ethanol and biodiesel plant construction,” Simonson says.

Post-hurricane rebuilding in the Gulf region has so far been primarily focused on infrastructure work. According to Murray, $10 billion of the more than $100 billion in aid from the federal government has been reserved for power construction. The Department of Transportation estimates that $2.5 billion will be needed to rebuild roads and bridges. In addition, the Corps of Engineers will also receive funding to replace or repair structures under its jurisdiction.

The Environmental Protection Act of 2005 still provides tax incentives for oil and gas production, electric utilities, and transmission lines, which are a federal priority, particularly in the Northeast where reliability and capacity improvements are needed. Overall, capacity additions needed throughout the United States have experienced a 5.6% cumulative increase in power generation in 2005 to 2006 versus 4.0% from 2001 to 2004.

The manufacturing market also has money to spend on new non-residential projects. Manufacturing capacity utilization is near 82% — above the usual threshold for a surge in capacity investment. The industry has experienced a 12% increase in demand for U.S. goods exports in the last 12 months. “High corporate profit rates mean that companies don't have to borrow money to pay for expansions,” Haughey says. “This has made money available for commercial loans.”

According to data from McGraw-Hill Construction, construction spending in the retail market tends to follow the trend of residential spending. “What happens to housing happens to retail construction,” Murray says. “Stores and shopping centers derived demand from the housing market, both up and down. Open-air shopping centers will help growth, as will a move to smaller ‘lifestyle center' venues, but it's guaranteed that retail will have a decline. It's part of the change in how Wall Street views big-box stores. They're still growing but not at the same pace as when they were cannibalizing themselves.”

Somewhat dependent upon retail, the warehouse market sector will experience a slowdown in growth for 2007. However, greater demand from increased global trade and a need for larger and more updated facilities will give warehouse spending some upward movement (Fig. 5).

On the move. In 2005, the construction industry experienced a pause in which many office projects were reassessed and then deferred due to higher materials costs and rising vacancy rates. These projects are now being redesigned and reassessed to proceed after the lag. “Market fundamentals are strong and conducive to more projects taking place,” Murray says.

According to McGraw-Hill Construction's forecast, project starts have increased progressively since last spring. From January to August 2006 non-residential construction starts increased 9.5%, compared to that time period in 2005. In July, spending on non-residential construction experienced 15.8% growth, compared to July 2005. “Construction starts over the next few months will do better than construction spending,” Haughey says. “And then that will reverse.”

The biggest examples of delayed projects now back on track to start have been spurred on by the federal highway bill, Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users (SAFETEA-LU). The bill authorizes the federal surface transportation programs for highways, highway safety, and transit for the five-year period from 2005 to 2009. “Highways and bridges are one of the safer investments to bank on, so to speak,” Murray says.

SAFETEA-LU, enacted in August 2005, replaces TEA-21, which expired on Sept. 30, 2003, and is funded at $286.5 billion, up 38% compared to TEA-21. With the passage of the bill, many states are going ahead with previously delayed projects.

“The greatest challenge we faced in 2005 was the delay in most new transit projects that was a consequence of delayed passage of the Federal Transportation Bill,” says Jeffrey M. Levy, president and CEO of RailWorks Corp., New York. “Many new starts and expansions of new and legacy systems that had been planned for many years could not proceed to construction. Most of these projects are now proceeding through the bid and award phase with work beginning in late 2006 into early 2007.”

A price above oil. Even with funding from SAFETEA-LU, transportation and transit projects were hit hard by the rising cost of materials. BLS reported on Sept. 19 that the producer price index (PPI) for materials and components for construction rose 8.8% from August 2005 to August 2006, compared to a 3.7% increase in the PPI for finished goods and 3.8% growth in the consumer price index (CPI) for all urban consumers. “Two construction segments were hit even harder: 10.3% for ‘other heavy construction' and 13.8% for highways and streets,” says AGC's Simonson. “A wide variety of materials contributed to the total: The 12-month increase in the PPI for copper and brass mill shapes was 81%; diesel fuel, 27%; plastic construction products, 20%; and concrete products, 10%.”

However, there is some relief in sight for the near future into 2007. As residential demand for materials decreases and the 12-month comparison shifts to months most affected by Hurricanes Katrina and Rita, the upward pressure will be less. “For the next few months, materials cost increases will not be as severe,” Simonson says. “But contractors will be constrained to use generally fixed quantities of materials for which there is worldwide or economy-wide demand and often slow-growing supply. They must pay to have the materials physically delivered, using congested transport modes. These facts make it likely that material cost increases will usually outpace the 3% to 4% annual rate of increase in the CPI or overall PPI.”

Economists expect the price of copper to decline as supplies hit inventory build. However, a major slowdown may not occur until demand decreases after the construction is completed for the 2008 Olympics in Beijing. “Recent oil prices, in the $55- to $60-per-barrel range, have offered near-term relief,” Regalia says “But the true spike has been in the industrial metals category. Everyone looks at fuel, but the pricing has been in the metals commodities.”

The highest price paid for copper was $3,550 per metric ton until in may when it hit its peak at $8,700 per metric ton. The recent mining strike in Escondida, Chile — strikes are usually a transitory event but not this time — caused 50,000 tons of loss in production, so supply fell below three weeks of inventory for consumption. “Copper is only now hitting inventory,” says John Mothersole, principal, Industry Practice, Global Insight. “It's not until you hit inventory build that you see price decline.”

Mothersole predicts that prices will go down but that they will remain at a relatively high level, compared to historical pricing.

The reason for the sustained high levels is increased global demand as well as speculation. “No one should forget that what people in the construction industry think of as materials people on Wall Street think of as financials,” says Haughey. “There has been a healthy element of speculation.”

Speculation may also have been behind the hikes in oil prices. “There hasn't been a supply disruption,” says Global Insight's Behravesh. “We will never run out of oil.” However, the decline in diesel prices lags behind gasoline. “If the weather is warm this winter, diesel has 15 to 20 cents a gallon to give up,” Haughey says. “If it's cold, it'll stay the same.” However, plastics have responded to the drop in oil prices.

The prices of most materials will decline, but won't return to pre-2004 costs any time soon. “The weak economic climate of 2000 to 2003 was nirvana for estimators,” says Haughey. “They could give a number that was good a few months later. The demand surge of 2004 was a rude shock. Then the hurricanes caused a supply shortage that passed, but materials still rose at 12%.”

Adequate compensation. Another increased cost for the construction industry will be the price of labor. “There will be a skilled labor shortage, particularly in the hot markets,” Haughey says. “Wage-rate gains have lagged the economy in non-residential and heavy construction markets but will accelerate in 2007. This will spread to non-union shops as well.”

With a labor pool reduced by stronger immigration enforcement and hiring by manufacturers and motor carriers, firms may have to pay a higher price for labor. “The housing sector added the most jobs, but those were the lowest paid,” Simonson says. “Now non-residential is adding jobs that are higher wage, but most non-residential construction people say the labor market is tight. They have a hard time finding qualified workers and subcontractors.”

Fortunately, the non-residential sectors may be able to absorb the workers laid off from the home-building sector. Some skills, such as wiring and heating and ventilation, are transferable from residential to commercial jobs to some degree,” says Simonson. “But not all subcontractors have the size or ‘scale' to work commercial projects when residential contracts dry up.”

Even with offering higher wages, some contractors may have trouble finding enough employees to work on projects. “Contractors may have trouble getting bids from subs, especially in busy markets and areas,” Simonson says. “The subs could be calling the shots.”

Remodeling the industry. The 2007 outlook for the construction industry economy can be seen in the microcosm of the residential sector. While portions of the sector — single-family and some instances of multi-family housing in the more overbuilt regions of the country, such as California, Arizona, Nevada, and Florida — are in serious decline, experiencing a correction in inventory, there are regions and segments that will continue to experience generous growth throughout the next few years. Industry experts point to the residential remodeling market, which has almost doubled in size over the past decade, as a prime example (Fig. 6 on page 38).

“Remodeling is just as strong as last year,” Baker says. “It will soften in the remainder of the year, but not like new home construction.”

Some of the fastest growth in the remodeling market comes from higher-end kitchen and bathroom remodels, as well as additions. According to the AIA “Home Designs Trends Survey,” the panel of residential architects claims that the popularity of telecommuting has continued to keep home offices at the forefront of remodeling. Homeowners offset the cost of the construction by saving on childcare, eldercare, and fuel costs.

Older homes are high on the list for refurbishment, particularly models built prior to World War II. “Not surprisingly, owners of older homes spend more on remodeling than owners of newer homes,” Baker says.

Homeowners want to make their existing residences safer, more convenient, but most of all more energy efficient. Of the categories of automated systems put into existing single-family homes, energy-management systems experienced the greatest increase for home remodeling (Fig. 7).

The baby boomers are also interested in greater energy efficiency. “They have money to invest in changes instead of putting on a sweater and turning down the thermostat,” Baker says. “The strongest incentive is rising home energy costs.”

A recent survey by Washington, D.C.-based AARP, the nonprofit, nonpartisan membership organization for people age 50 and over in the United States, concludes that 90% to 95% of seniors would prefer to age in their current homes. Therefore, in the next few years those homes will have to be modified to accommodate the needs of an aging population with ramps, elevators, security and alarm systems, and “easy-to-use” features, such as added handles.

“There's a lot of evidence that aging baby boomers have acquired wealth through equity in their homes,” Baker says. “They can afford the changes to their homes so they can stay there. Meeting the needs of the senior population will be a driving force in the next decade.”

Construction traditionally follows a boom and bust cycle, dependent on the nation's economic health. Facing a relatively healthy nation, the industry has provoked rather optimistic forecasts, despite a sharp decline in the residential housing market. According to those economists, the decline is currently at its worst. They expect the market to correct itself and return to its regular steady growth rate once we reach 2008 and beyond. In the meantime, non-residential segments (commercial, institutional, and power) will buoy the industry as a whole, absorbing some of the workers laid off from residential, while others may find jobs working on remodeling projects — all part of the rugged balance of construction.