Record-breaking residential market tapers off and non-residential sector rebounds, leading to another flat year for construction

Electrical contracting and engineering firms closed their eyes, fastened their seat belts, and embarked on a tumultuous journey over the last few years. During the dot-com boom, many companies' sales soared up to new heights, but then plummeted when the economy took a downturn. To keep from sliding off a slippery road, many firms slashed budgets or took jobs at or below cost to compete in an intense buyer's market. Economists forecast that the worst may now be over for the construction industry, but the recovery won't happen overnight.

“Construction moves at a different pace, and that was a good thing in 2001 and 2002,” says Ken Simonson, chief economist for the Associated General Contractors of America. “When the rest of the economy slowed down, construction still had quite a bit of momentum from the boom days of 1999 and 2000.”

While construction activity is slow to drop off, it also takes more time to fully recover than the general economy. David Wyss, chief economist for Standard and Poors, says the recession hit the United States in three different layers.

“The first to go under were the dot-com and high-tech companies,” Wyss says. “The second wave were manufacturing and capital goods, and then after Sept. 11, tourism got hit. They are now coming out in reverse order.”

The earliest recoveries are being seen in tourist-related states like Florida, Nevada, and Arizona. The areas with a high manufacturing base, such as the Midwest, and technology hot spots like Texas, Silicon Valley, and Denver, were the hardest hit and could be the last to recover.

Regional differences, however, aren't as prominent as they were five or 10 years ago. Cars are no longer exclusively manufactured in Detroit, not all financial centers are headquartered in New York City, and factories are spread across the country.

Today many regions specialize in diverse industries so if one market declines, another will help sustain the local economy. For that reason, the decline of manufacturing and commercial construction was often offset by the strength of housing, health-care, and educational work in 2003.

McGraw-Hill Construction Dodge forecasts total construction starts will edge up 1% to $508.9 billion next year. Certain pockets of opportunity will exist for engineering firms and electrical contractors in 2004, but the level of construction activity may not start to pick up until late in the year. Increased levels of employment, a rise in incomes, and higher state taxes could eventually lead to higher capital expenditure levels at the state level. As the economy gains momentum, retail construction activity will be one of the first markets to bounce back. Other non-residential markets like commercial, office, and industrial, however, could take a longer period of time to recover. Weak economic conditions over the past few years led to mass layoffs, which caused office vacancy rates to skyrocket. Tepid manufacturing conditions also hurt the industrial sector. Finally, the uncertainty surrounding 9/11 and the Iraq war affected commercial and retail investments. Each of these conditions is finally starting to turn around as the economy begins to recover. Edward Sullivan, chief economist for the Portland Cement Association, says a convergence of these factors indicate next year will be the turning point for construction and 2005 will be a very strong year.

“Construction put in place has declined each of the last three years, and 2004 is the end of the decline,” Sullivan says. “After it flattens, it will take off in 2005 and beyond. At this time next year, you'll start to see it pick up.”

To help your company get on the road to recovery, this article presents the economic forecasts for the five different regions as well as the markets to watch for 2004.

REGIONAL OUTLOOK

(For a region-by-region look at construction statistics, click here).

Northeast.Firms in the Northeast generally expect flat sales due to the region's high commercial office vacancy rate. An overbuilding of commercial office buildings in New York City, New Jersey, and Connecticut in the late '90s has dampened the demand for new office space. Until the economy starts to recover, the Northeast could experience a fairly stagnant office construction and renovation market over the next year.

The Northeast, particularly New York and Boston, also has a high concentration of business services, health-care, consulting, software, and finance industries that weakened very late during the recession. Compounding the problem, the region is also facing tighter state government budgets and a slowdown in public work.

“The Northeast has been down, but not horrendously,” Wyss says. “The financial services [sector] took a big hit because of the stock market decline. It will also take awhile for the high-tech [sector] in New England to really come back.”

Another factor that will affect the Northeast region in 2004 is the recent blackout, which left 50 million people without power in the Northeast and Canada. This event brought the issue of the nation's aging transmission network to the forefront of many discussions. Deregulation may have created the need for new power plants, but utilities delayed plans to upgrade their transmission lines. Congress is now considering an energy bill that would slow the Federal Energy Regulatory Commission's drive to set nationwide transmission grid rules. The passage of this Bill could result in further delays in investment of new lines.

West. Like the Northeast, the West also has a significant number of high-tech, microchip, and software companies located in the area. Silicon Valley, which thrived during the dot-com boom, crashed during the recession. Cupertino Electric, an electrical contracting firm based in San Jose, Calif., saw its 2002 sales plummet 47% from 2001 levels due to the poor market conditions, particularly in the San Francisco Bay Area. Last year's sales for Rosendin Electric, another contractor headquartered in the Silicon Valley, dropped 36% from 2001.

Sullivan says the state of California is like a tale of two cities. The northern part of the Golden State is more high-tech and has performed poorly, while the southern part should remain strong throughout 2004. Oregon, another state that specializes in the high-tech and microprocessor industries, was also hit hard by the faltering economy and the drop in computer spending. As the economy improves, however, the United States could see a pent-up demand for high-tech goods, says Sullivan. Corporations typically invest in computer upgrades every three years, but due to the faltering economy, some companies have put a hold on capital expenditures.

“The last few years, computer spending has been down even though the demand has been there,” Sullivan says. “I think as you get a stronger business environment that demand is going to be released, and that's going to push a lot of strength in computer spending and high-tech in general.”

As engineering and construction firms wait for a recovery in California, the state is wrestling with its $38 billion state deficit. During the robust economy, the state added 55,000 state workers. When the stock market collapsed, California saw a decline in the source of revenues, and the budgets nearly disappeared overnight. California is now one of 45 states facing budget deficits next year.

South Atlantic. A population influx in this region has created the need for infrastructure, services, buildings, and retail. The tourism industry, which has been significantly down in the past two years, is recovering. Hotels, timeshares, retirement communities, and entertainment complexes are now under construction in Florida and other states in the region.

The South is also home to many food, clothing, and furniture manufacturing plants. Because consumers continually purchase these goods, the factories were sheltered from the dramatic swings experienced by the manufacturers of cars and computers. While some of the plants may have felt a temporary slowdown, they didn't endure the cyclical conditions common in other industries. McGraw-Hill expects construction starts for commercial and manufacturing in this region to increase 11% in 2004.

North Central. This region is home to many of the nation's manufacturing plants, which were hit hard early during the recession. While these factories may not enjoy an immediate recovery, conditions have stopped getting worse. Contracting for manufacturing plant construction peaked at 191 million sq ft in 1997. By 2002, contracting plunged 65% to 66 million sq ft, and capacity utilization fell from a typical range of 80% to 85% down to 73%. This translated into the layoff of 2 million workers at American manufacturing plants since fall 2000. Many of these lost jobs were in industrial swing states like Pennsylvania, Ohio, and Missouri.

After experiencing a slide in manufacturing employment and a dip in capacity utilization, the nation may soon see an end to the freefall in manufacturing plant construction. This market could flatten out in 2003 at 65 million sq ft and climb 8% in 2004 to 70 million sq ft, which is still 60% below the 1997 peak, according to McGraw-Hill. Automobile plant construction will show the most activity with the start of major construction projects, including a $60 million Daimler Chrysler plant in Michigan.

The Institute for Supply Management also recently reported some good news for the manufacturing sector. According to its survey of purchasing managers, American manufacturing activity rose to its highest level in two decades in November. The survey indicated the three-year slump in manufacturing may be coming to a close, and manufacturers may begin expanding their work force to keep up with the increased demand.

The slowdown in the manufacturing sector can be directly linked to the lessened demand for U.S. goods and the subsequent offshoring of production. According to Electrical Wholesaling's annual Market Planning Guide, the industrial market accounted for 45.8% of electrical wholesalers' annual revenues in 1992. A little more than a decade later, it dropped to 30.5%. Jerry Jasinowski, president of the National Association of Manufacturers, attributed the 33% decline to rapidly rising business costs due to the burden of government rules and requirements. Companies often had to choose between laying off their workers and outsourcing production to foreign countries.

While the overall manufacturing sector could soon turn around, McGraw-Hill forecasts a bleak outlook for the North Central region next year. This region could realize the largest year-to-date decline in construction starts out of the five regions in 2004 due to a predicted 4% drop in residential and a 9% decrease in non-building construction, which includes highways, bridges, public works, and electric utilities. When looking at the national picture for non-building construction, McGraw-Hill expects a drop in nearly all three of the major segments — transportation, electric utilities, and water supply construction. Electric utility construction reached an all-time high in 2001 at $23.7 billion, but it plunged 49% in 2002 and should fall another 23% in 2003. Another historically strong market, water supply construction, could also fall 17% due to a cut in federal spending. According to McGraw-Hill, the Bush administration may cut Environmental Protection Agency water infrastructure grants by at least 15% in 2004.

South Central. Construction starts are forecasted to be flat for the South Central region next year. High office vacancy rates, a drop-off in power plant construction, and a 10% decline in multi-family housing starts are three of the major factors contributing to the region's weak outlook. Austin, Texas, which served as one of the tech hot spots during the dot-com boom, posted a 53% drop in office construction in 2002 and a 17% decline during the first nine months of 2003. Two of the top 10 markets for office construction, Dallas and Houston, dropped by 51% and 35%, respectively, in 2002.

The downturn in the office construction market led to surging office vacancy rates. U.S. companies hired 1 million new workers from 1997 to 2000 and leased offices in anticipation of continued growth. When the economy crumbled, the suburban office vacancy rate increased to 17.9% in the second quarter of 2003, compared to 8.6% in 2000. According to the Federal Reserve Bank, Dallas has the nation's third highest vacancy rate of more than 25% in its central business district (Table above).

Along with the office construction market, this region is also dealing with the slowdown in power plant construction. As one of the 24 states that implemented a deregulation program, Texas' pace of new utility construction increased six-fold in 1999. From 1999 to 2000, Texas led the nation as the top state for power plant construction. California took over the lead in 2001, which was the turning point for the electric utility market. But the country's concern quickly shifted from capacity shortages to oversupply. Capacity utilization reached a peak of 95% in 2000, but during the first eight months of 2003, it dropped to 88%. McGraw-Hill forecasts the electric utility market will drop 19% next year to $7.5 billion due to the decline in capacity utilization.

The final contributing factor to the South Central's flat forecast is the decline in multi-family housing starts. Unlike three of the other regions, which expect substantial gains in this market segment, the South Central region anticipates a 10% drop.

The South Central region, like the four other geographic regions in the country, will face different highs and lows next year. Some regions will see a rebound in the commercial and manufacturing sectors, while others will experience a decline in in residential construction, which may finally be coming off of its high.

When devising their construction forecasts, economists not only evaluate the different areas of the country, but also the top market segments. The following section outlines their predictions for next year's notable markets.

MARKETS TO WATCH IN 2004

RESIDENTIAL

Single-Family Housing. Single-family home construction, which posted record gains for the past six years, could drop 2% next year to $226 billion. Sullivan of the Portland Cement Association attributes the decline in residential construction to the strengthening of the overall economy and the rise in interest rates. Low mortgage rates will likely continue through the first part of 2004, but as soon as they begin to increase, the residential market will start to fall off.

“It's going to be a cooling rather than a dramatic drop-off,” Sullivan says. “Residential construction activity, while declining, will still be at historically high levels. As the economy strengthens this year and through next year, you're going to see a gradual and sustained strengthening on the non-residential side.”

Construction put-in-place consists of three major segments — residential, public, and non-residential construction. Because single-family housing accounts for three-quarters of the residential construction put-in-place figures, the slight dip in housing starts will be enough to drag down overall construction.

Multi-Family Housing. The decline in single-family home construction may be slightly offset by the multi-family housing market, which is predicted to edge up 1%. Multi-family housing, which McGraw-Hill considers an “income property,” is prone to cyclical conditions. First-time homebuyers took advantage of record low mortgage rates by pulling out of the multi-family housing section and moving into the single-family market. Vacancy rates for multi-family homes subsequently rose to a national rate of 9.6%, and rental prices flattened. Sullivan says the multi-family market has some hot spots across the country, but overall, it will remain weak into 2005.

NON-RESIDENTIAL

Retail. A very short lag exists between an improvement in overall economic conditions and a turnaround in retail construction, says Sullivan. Unlike other market segments, retail is scheduled to show further improvement in both 2004 and 2005. McGraw-Hill forecasts a 3% increase in construction starts for stores and shopping centers in 2004.

Wyss of Standard and Poors says the retail market held up better than he expected. Retail tends to lag the housing market, so developers constructed strip malls near new residential developments.

“When you do a housing development, you have to put the grocery store and drug store on the corner,” Wyss says. “Because residential has been so strong, that's led to strength in the small shopping centers. On the other hand, the larger malls will take awhile to come back. I think they'll stay soft for at least another year.”

Hotels. The construction and renovation of hotels has been another unexpected area of strength. Tourism is starting to pick up again in many regions, and hotels are renovating their facilities to meet travelers' needs. Since business was so robust in the late '90s, many hotel chains built new hotels but didn't keep up with renovation. Now that occupancy rates are down, the owners are using this opportunity to update their existing hotels, especially those designed for budget-minded business travelers. Airports. The gradual recovery in the tourism market could also boost the airport construction market, which was down 13% during the first nine months of 2003. ZweigWhite, a Natick, Mass.-based consulting firm, surveyed 75 design firms, and the respondents named aviation as one of the hot markets for 2004 (see Market Watch on page 10). Airport construction could show increased activity in 2004 due to the recent approval of a four-year, $60 billion aviation bill, which includes $14.2 billion for federal airport grants. Educational. Rising student enrollments have fueled growth in the educational building category, but tight state budgets may keep this segment in check. School construction increased 19% in 1999 to 243 million sq ft and then reached an all-time high of 247 million sq ft in 2001. In 2003, McGraw-Hill expects a 5% drop to 240 million sq ft. For the first nine months of this year, junior high schools, libraries, and laboratories have all shown strength, but primary schools, senior highs, museums, and universities have reported declines.

The National Center for Education Statistics found that K-8 enrollment reached its peak in 2002 and will now continue on a gradual decline. The most significant gains in enrollment will be seen in the West and the South, especially Texas and California. One factor hampering school construction is the lack of available funding. Many of the schools have had to deal with a state and local financial crisis.

“State budgets are a total mess,” says Wyss of Standard and Poors. “The combined state budget deficits are going to be a record this year. It's hard to see how they can get much activity done on the education front.”

Although the United States has endured a mild recession, the economic conditions affected tax revenue more than normal due to the dropoff in the stock market. Wyss says the state governments didn't respond quickly enough to the recession, which made it harder for them to bring spending under control, cut expenditures, or raise taxes to manage the budget deficit. The education market is mostly funded by public money, and typically follows a three-year pattern. The first year is marked by a poor economy, the next year, little tax money, and the third year, there's no money for the schools to spend. Once the funding returns, however, many of the projects on the books will get underway.

“I think as the financial picture improves for the state and local governments, spending in those areas is going to improve, because the underlying demographics are there,” Sullivan says.

Simonson also took an optimistic look at the school construction market next year. He says school construction is often insulated from the revenue problems affecting other state and local construction markets because a majority of school districts get their funding from bond issues or directly from property tax revenues. With the hot housing market, residential property tax receipts have been on the rise. Voters also passed a record volume of bond issues in November 2002, and most of that money was earmarked for school construction and reconstruction. Finally, due to the population shift into new homes and subdivisions, more school construction is accompanying the new housing construction.

The school construction market will also be driven by the need to renovate and expand the nation's educational facilities. For example, construction firms in New Jersey will soon see an influx of new projects due to an $8.6 billion construction and renovation program. The Educational Facilities Construction and Financing Act of New Jersey, the largest state-funded school program in the state's history, will invest $12 billion in public school construction and renovation over the next decade. The project will involve thousands of schools in more than 500 school districts and create job opportunities for electrical construction firms.

Health-Care. Many hospital chains were undergoing major capital expansion programs through 2002, but the level of activity is beginning to slow down. Health-care construction, which increased 6% to 97 million sq ft in 2002, could drop 9% to 88 million sq ft in 2003, and fall an additional 6% to 83 million sq ft in 2004, according to McGraw-Hill. Hospital construction, which was up 11% in 2002, slipped 5% during the first nine months of 2003. Clinics will follow the downward trend by falling 14% in 2003 after posting a 4% gain in 2002 due to the increased construction of specialized outpatient clinics.

The drop in health-care construction can be attributed to a cut in financial support. Doctors' fees for treating Medicare patients were cut 5%, and future program cuts are anticipated. One major health-care firm, Tenet Healthcare, reported a quarterly loss of $55 million and has announced it will close down 14 of its 114 hospitals, according to McGraw-Hill. While the health-care market will be down in 2004, Simonson expects the segment to remain steady.

“Employer expenditures for health-care are going to be rising by 12% to 15% again in 2004,” Simonson says. “Government expenditures are also going to be going up, so a piece of that definitely spills over into hospitals, doctors' offices, stand-alone clinics and other types of health-related construction.”

Another factor that could boost the health-care market is legislation passed by California to make most of their hospitals unqualified due to seismic conditions. In many cases, it's less expensive to build a new facility than to make an existing hospital seismically compliant. By building a new hospital, developers can take advantage of new technology, more efficient planning, and new equipment. For example, the University of Southern California is rebuilding, rather than renovating, its medical center to replace a facility that was badly damaged in the 1994 Northridge Earthquake.

Military construction. The level of activity for military construction could slow down in 2004. The House recently approved a 13% cut of the Department of Defense's fiscal 2004 construction budget. The measure includes more than $1 billion for the construction and rehabilitation of military family housing, which is down 20% from the 2003 level. Other military construction, such as barracks, airfield work, and health-care facilities, is also down 9% from 2003. LOOKING AHEAD

Without a crystal ball or a time machine, the construction economists will not be able to pinpoint the exact increase or decrease in the level of construction for 2004.

“You can predict that the stock market will turn around, but it's another story to say exactly when it will happen,” Sullivan says. “This isn't a typical forecast because 2004 will be a turning point for the construction industry.”

Sullivan says the majority of his construction forecast, which he presented at Reed Construction Data's North American Forecast meeting, is based on the assumption that the labor markets will turn around. Sullivan estimates about 1.7 million new jobs will be created next year, compared to an average of 2.5 million jobs between 1996 and 2000.

“If the labor markets don't turn soon, eventually consumer spending is going to weaken and you're going to get much slower growth in 2004,” Sullivan says. “You'll start to see some kind of job creation at the end of this year and carry through 2004. If that doesn't happen, then a more pessimistic view is going to creep into the whole consensus among the economists. Right now we are on pretty firm ground that the labor market has already turned.”

Throughout fall 2003, many of the nation's construction economists presented their forecasts at national meetings. While each has a slightly different outlook for the construction industry next year, the majority agreed the worst is over for the construction industry. Electrical engineering and contracting firms, however, won't see an immediate recovery. It could take another year until the industry fully rebuilds its strength. Until that time, firms are focusing on training their teams, cutting back operating costs, and branching out into new markets. The construction industry, like a long and winding road, has its ups, downs, twists, and turns, and in order to survive, a firm must prepare for what lies ahead.

Editor's note: For more information on the 2004 forecast for the construction industry, please visit EC&M's Web site at www.ecmweb.com. The exclusive Web feature, “How to Prepare For the Upturn in Construction,” (online Dec. 15) will offer strategies for growing your business in down times. You can also read Electrical Wholesaling's Market Planning Guide at www.ewweb.com to learn more about the outlook for your region.