Construction Finds Solid Footing - Mid-Year Report
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SECTION: Mid-Year Report

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Construction Finds Solid Footing

Written By Robert Murray, Vice President and Chief Economist and Kim Kennedy, Manager of Forecasting McGraw-Hill Construction

Article Date: 08-01-2004
Copyright (C) 2004 Associated Equipment Distributors. All Rights Reserved.

GDP is growing, the job market is improving and interest rates are low.

In some ways, the 2004 economy has been more reminiscent of the late 1990s than the new millennium. Real GDP is once again growing at a healthy clip, the job market is improving, and interest rates are remaining historically low (even if some upward movement has been occurring). These conditions are having a positive impact on both the business and consumer sectors, which in turn are providing a modest boost to construction activity. The first-quarter 2004 GDP report showed the economy grew at a 3.9 percent pace after adjusting for inflation – comfortably above the long-term potential (or equilibrium) growth rate for the economy. And healthy gains should continue through the year, with real GDP expected to increase 4.7 percent for the year as a whole. While the economy has been growing at a solid pace for three consecutive quarters, the job market has only recently begun to show signs of life. In March 2004, employment grew strongly for the first time since the recession took hold in early 2001. Moreover, job gains in both April and May remained robust. In June, employment growth slowed again to the slowest pace since February with only 112,000 jobs added, but that slowdown is being viewed as a temporary setback. Since the August 2003 trough, 1.5 million jobs have been added to the economy, bringing total non-agricultural employment to 131.3 million in June. Stronger job growth has dramatically improved confidence that the economy will meet expectations in 2004. Of course, this improved outlook has had ramifications on interest rates. The timing of the initial hike in the federal funds rate, for example, was moved up. Prior to the March employment report, the Fed was not expected to raise interest rates until after the November 2004 elections. But following the turnaround in employment, the Fed chose to push rates higher at mid-year. At their June 30 meeting, the Fed raised the federal funds rate by a quarter percentage point and suggested this measured increase in rates will continue. After all, a federal funds rate of 1 percent (where it had been since June 2003) was highly stimulative and would have led to higher inflation if left unchecked while the economy expanded. Over the next year or so, the Fed is expected to bring the federal funds rate back to a more neutral level of 3 percent to 3.5 percent. With this higher federal funds rate will come generally higher long-term interest rates. But in historical perspective, interest rates will remain low over the next few years, and will not have a dramatic dampening effect on the economy or construction. Nor will inflation have a long-term impact on construction – despite the recent torrent of discussion about higher steel, cement, lumber, and other construction material prices. First, steel prices appear to be stabilizing after the sharp run up earlier in the year. Second, as interest rates move up later this year, the value of the dollar should revive, helping steel and other price issues as well. And third, the strength of the U.S. economy this year will encourage most activity to go forward despite higher prices. Although the impact varies by structure type, these construction materials do not account for a huge share of total construction costs. Labor is the largest single piece, and labor costs remain generally under control. Commercial Construction Up In 2003, commercial construction was a mixed bag of opportunity. Offices and warehouses continued to weaken, but stores and hotels were able to make healthy gains. Total square footage for commercial building slipped 3 percent in 2003 to 788 million square feet, a much smaller decline than during the previous two years when construction declined 16 percent in 2001 and 18 percent in 2002. The strengthening economy in 2004 will help this market “turn the corner” and all commercial structure types should see at least modest growth this year. Commercial square footage is expected to reach 833 million square feet in 2004, an increase of 6 percent from 2003. Limiting the increase in 2004 will be continued caution by real estate lenders and developers, as they wait to see if the pickup in employment can be sustained. In addition, the hike in steel, concrete, and other prices during the first half of 2004, which has created uncertainty in estimating the costs of projects, has exerted some dampening effect thus far in 2004. Store construction in 2003 increased 10 percent to 283 million square feet. Support came from the strong level of homebuilding, combined with continued strength in consumer spending. A major push for store construction comes from the dynamics of the retail market itself. Competition among the major retail chains, along with demand for greater efficiency in store formats, encourages new construction even when sales conditions are less than favorable. One of the more noticeable trends in recent years has been the continued shift away from mega-mall projects and towards smaller-scale retail venues. As traditional enclosed malls decline in popularity, they are frequently converted to an outdoor mall format. Finally, given the continued strength of consumer spending, stores are increasingly being viewed as a favorable target by the real estate investment community. In 2004, these supportive trends will lead to another gain for stores and shopping centers, as construction rises 2 percent to 288 million square feet. Office construction, which peaked at 298 million square feet in 2000, fell sharply over the next three years, dropping to 143 million square feet in 2003. Even though contracting continued to weaken in 2003, the rate of decline eased considerably (with a decline of 9 percent in 2003, compared to 24 percent in 2001 and 30 percent in 2002). At the end of the 1990s, the demand for office space was buoyed by the lengthy economic expansion, in combination with the surging tech sector. Office employment grew at a pace of 1 million workers per year from 1997 through 2000, which helped to absorb new office space coming onto the market. However, the tech bust of 2000 and the 2001 recession sent the office market into a tailspin. With the labor market finally stabilizing, vacancy rates have begun to see very modest improvement. According to CB Richard Ellis, the suburban office vacancy rate fell to 17.9 percent in the first quarter of 2004, down from a peak of 18.2 percent in the third quarter of 2003. Downtown vacancy rates inched up to 14.7 percent in the first quarter of 2004, but have changed very little over the past four quarters. Renewed growth in office employment will be a slow process. With vacancies still high and rents flat, there will be no broad push in 2004 to spur more construction. Construction is not expected to rebound in large markets with high vacancies, but growth could occur in secondary markets that did not take part in the late 1990s boom. Overall, the pluses will begin to outweigh the negatives during 2004, which will lead to a 7 percent gain in construction to 153 million square feet. Hotel construction declined 25 percent in 2001 and 24 percent in 2002, bringing contracting down to 40 million square feet – well below the 1998 peak of 93 million square feet. During 2003, hotel construction starts took a surprisingly positive turn and strengthened by 13 percent to 45 million square feet. Against the backdrop of a healthier economy and improved demand for travel, 2004 is shaping up to be a solid year for the lodging industry. According to Smith Travel Research, room demand should rise 4 percent in 2004 and revenue per available room should see an upswing of 6 percent. Occupancies will reach 60.8 percent – well below 2000’s peak of 63.7 percent but a significant improvement over 2002’s trough of 59.1 percent. Manufacturing Recovers The long decline for manufacturing plant construction has run its course. After five long years of painful decline, contracting finally grew a modest 3 percent in 2003 to reach 69 million square feet. As in recent years, automotive plant construction was one of this category’s more active segments in 2003, and included the start of projects such as the $99 million General Motors plant in Oklahoma, the $80 million Nissan plant expansion in Mississippi, and the $60 million Daimler Chrysler plant in Michigan. Gains were also evident in a few other segments, such as lumber/wood products and paper products, compared to very low 2002 levels. One notable project, a $600 million conversion of an Intel semiconductor plant in Arizona, helped the dollar volume for manufacturing construction jump 17 percent in 2003, the first increase in six years. Economic indicators for the manufacturing sector showed some pluses in 2003, compared to the generally negative reports during 2002. Industrial production picked up over the summer, helped in particular by gains for high-tech goods. Factory orders have strengthened, and the ISM purchasing managers’ index indicates that the manufacturing sector expanded during the second half of last year and into the first half of 2004. The U.S. dollar has also declined relative to the euro and the yen, helping the position of U.S. goods abroad. And, after a lengthy stay at 73 percent, capacity utilization for manufacturing began to edge up at the end of 2003, climbing above 75 percent by mid-2004. The increasing volume of positive news indicates the manufacturing sector has turned the corner. Economic growth averaged 6 percent during the second half of 2003 and nearly 4 percent in the first quarter of 2004, which will help lift demand for goods. And, since new construction has been limited in recent years, aging plants will give rise to the mounting need for more efficient facilities to stay competitive. For 2004, manufacturing construction starts will inch ahead 1 percent to 70 million square feet. Institutional Building Settles Back The drivers for institutional building have become more mixed over the past few years. On the positive side, demographic pressures continue to support construction, due to rising student enrollments and the ongoing population shift to the South and West. Several types of institutional building are tied to single-family housing (with a lag), so the recent (2001-2004) strength in single-family housing will help cushion other factors that may weaken institutional structures in 2004. The large volume of bond measures passed in recent years is also a plus. On the down side, however, the fiscal position of state governments has deteriorated substantially. States have trimmed spending in order to get budgets into better balance, and, as noted in the Fiscal Survey of the States, “even politically sensitive programs such as Medicaid and K-12 education have not been immune from budget cuts.” After sliding 5 percent in 2003 to 531 million square feet, institutional building is expected to drop another 5 percent in 2004 to 507 million square feet. School construction is expected to decline for the third straight year, following its record high in 2001. Hospitals and clinics will retreat for the second straight year, as they deal with lower Medicare reimbursements and market uncertainty. Two categories that would appear to have some chance of improvement are transportation/freight terminals and amusement-related projects, which should see some upward movement as the result of strengthening economic conditions. In the November 2003 elections, large school construction measures were approved in San Antonio ($449 million), Denver ($311 million), Guilford County, N.C ($300 million), San Francisco ($295 million), and Fairfax County, Va. ($291 million). California voters approved Proposition 55 in March 2004, providing for the issuance of $12.3 billion in bonds for school construction and improvement. At the same time, state and local fiscal problems resulting from the weak economy. during 2001 and 2002 have altered the funding situation. To close budget gaps, spending cuts are being made, and states are searching for additional sources of revenue. This has clearly had a negative impact on public schools and colleges. With this greater fiscal stress, total educational building will continue to slide, with 2004 construction dropping to 223 million square feet, another 7 percent decline. Housing to Continue Up in 2004 Once considered to be one of the more cyclically sensitive parts of the construction industry, single-family housing ran counter to the weakness in the 2001 economy, posting a 3 percent gain in dwelling units. The unsteady expansion during 2002 and the early months of 2003 had little negative impact as well. Single-family housing has maintained an upward trend over the past three years, bringing construction to 1.417 million units in 2003 – a 9 percent gain over 2002 and 20 percent higher than the 1.184 million units in 2000, just prior to the start of recession. The number of single-family starts in 2003 was also the highest since 1978, topping any of the peak years during the 1980s or 1990s. In the near term, the level of single-family housing is determined by a variety of economic factors. Over the past three years, the most significant factor has been low mortgage rates. After averaging 8.1 percent in 2000, the 30-year fixed mortgage rate moved steadily downward: to 7.0 percent in 2001, 6.5 percent in 2002, and 5.8 percent in 2003. By March 2004, this rate had fallen to an even lower 5.4 percent. But in April 2004, the March reports on employment and consumer prices contributed to a jump, bringing the mortgage rate back up to 6.3 percent in May and June. In early July, despite higher short-term interest rates, mortgage rates settled back to 6.0 percent. Despite the moderate pickup in mortgage rates, homebuyer demand has remained robust. In 2003, new homes sales advanced 12 percent to an all-time high of 1.085 million units. Existing homes sales also established a new record in 2003, rising 10 percent to 6.1 million units. But this year, home sales have even surpassed these records. In May 2004, both new and existing single-family home sales reached new all-time peaks – 1.369 million units for new home sales and 6.80 million units for existing home sales (both at seasonally adjusted annual rates). The current supply situation for new homes suggests that the housing market is in reasonable balance and won’t be vulnerable to a sharp correction. The number of months of supply of new homes, which is derived by dividing the sales inventory by the pace of new home sales, has been fairly steady at about four months since 1998. The inventory of homes for sale has risen, but the brisk pace of new home sales has offset that climb. In May 2004, the number of months of supply was at 3.3 months, after reaching 3.9 months in April. A supply of less than four months represents a very manageable inventory position for housing developers and is consistent with the sense that any emerging slowdown for construction will be mild. Single-family housing should remain healthy in 2004, but several factors suggest the second half of the year will hold a mildly slower pace for construction. Most important will be the pattern for mortgage rates. The 30-year fixed rate is expected to continue to move upward, rising to 6.5 percent by the close of 2004. There is little doubt the economy is strengthening, given the robust performance since the latter half of 2003 and the improving employment picture. Financial markets will respond to this sustained strength for the economy with mildly higher long-term interest rates. Moreover, the growth in jobs and income will only be enough to modestly outweigh the negative of higher mortgage rates. In the parts of the nation that have experienced substantial home price gains over the past two years, such as the Northeast and California, first-time homebuyers are finding it increasingly difficult to buy a home – a situation that higher mortgage rates won’t help. And, with the stock market now showing an upward trend, combined with a slower pace expected for home price appreciation, the investment component of homebuyer demand will be diminished. As a result, single-family housing in 2004 will climb only 5 percent to 1.495 million units. Multifamily housing bounced back 10 percent in 2003 to 441,000 units. After climbing to 442,000 units back in 1999, multifamily housing had essentially steadied at roughly 400,000 units – failing to show the gains of single-family housing, but avoiding the declines reported by the commercial structures. During 2003, Florida once again reported the highest level of new multifamily housing units, maintaining the brisk pace that had been prevalent since 1999. Rounding out the top five states for new multifamily units in 2003 were California, Texas, New York, and North Carolina. Despite the gains in 2003, the health of the rental market was viewed with greater concern. Rental vacancy rates moved up, reaching 10.2 percent by the fourth quarter of 2003, and vacancy rates in buildings with five or more units were reported at 11.9 percent. Rents were essentially flat on the national level, and fell in some distressed markets with owners offering as much as four months free rent. An important reason behind the market softness has been low mortgage rates, which have provided a strong incentive for renters to join the homeownership ranks. Not surprisingly, condominiums comprise a growing share of multifamily development. At the same time, however, rental properties continue to sell at high prices, despite the erosion in near-term fundamentals. This has kept the construction market for even rental apartments higher than what vacancy rates and rental growth might suggest. Furthermore, the longer-term factors for multifamily housing continue to be positive. This property type is still viewed positively by the real estate finance community, given its relatively stable revenue stream compared to the other commercial sectors. While rents have been flat recently, the sharp rise in housing prices in certain markets provides room for rents to move up. And multifamily housing continues to be supported by the emphasis on downtown redevelopment in a number of cities around the nation. Demographics for multifamily housing are also beginning to turn positive, with the number of 20 to 34 year olds set to rise as the large Echo Boom generation (the children of baby boomers) replaces the smaller Generation X population among this age group. The potential boost coming from “empty-nesters” is also substantial, given the fact that the baby boom generation is moving into their fifties. Still, multifamily starts will slip slightly in 2004 with a 2 percent decline to 430,000 units, as rising mortgage rates and continued rental weakness causes activity to stabilize close to 2003 levels. Public Works Weakens Public works construction in 2002 advanced 5 percent to $87.8 billion, marking the fourth straight year of growth in the 5 percent to 9 percent range. However, the funding backdrop for public works has shifted dramatically. The recession of 2001 led to a sharp decline in tax revenues, and coupled with increases in federal spending, the federal budget moved from a surplus of $127 billion in fiscal 2001 to a deficit of $374 billion in fiscal 2003. State governments, which by law are not permitted to run deficits, have seen their year-end balances slide from 10.4 percent of expenditures in 2000 down to 3.1 percent in 2003. This changed fiscal environment is now dampening public works construction. At the federal level, the near-term impact hasn’t been too severe, given funding levels approved by Congress over the past year. The federal-aid highway program for fiscal 2003 was reduced just 1 percent, and highway funding for fiscal 2004 was increased 4 percent, as part of the Omnibus Spending Bill that Congress passed in January 2004. The impact of reduced state funding has been more discernible, however. Several large transportation bond initiatives were voted down in the November 2002 elections, including the $7.8 billion referendum in Washington State. There’s concern about the ability of states to match federal road dollars, and there’s also the potential that money will be shifted out of state transportation trust funds as states try to bring budgets into better balance. In addition, this year’s higher steel prices are causing some public works projects to be re-evaluated. In this climate, it’s not surprising public works construction has pulled back from the steady growth of 1998-2002. The volume of new construction starts dropped 6 percent in 2003 to $82.6 billion, with declines in four of the six project types (highways, river/harbor development, water supply, and other non-building). In particular, the difficulty in getting state budgets approved and money allocated for specific projects appears to be a major constraint on new construction starts. Tight budgets have continued in 2004, and public works are expected to see a further 2 percent decline to $81.3 billion. Highway and bridge construction edged up 1 percent in 2002 to $43.5 billion, a slower pace of growth after a 14 percent gain in 2000 and 5 percent gain in 2001. This pattern of decelerating growth was anticipated as the six-year interval (1998-2003) covered by the Transportation Equity Act for the 21st Century, or TEA-21, approached its end. Bridge construction in particular was boosted in 2002 by the start of several major projects, including the more than $1 billion replacement of the San Francisco Bay Bridge. In 2003, there were also several large bridge projects reaching the construction start stage. This contributed to a 4 percent increase for bridge construction, but at the same time, highway construction retreated 4 percent, leading to a 2 percent decline for the 2003 highway/bridge total to $42.5 billion. TEA-21 provided $220 billion for transportation work, a 40 percent increase compared to the previous six years. With the expiration of TEA-21 on September 30, 2003, considerable discussion transpired about the shape of the replacement bill, but no final agreement was reached. The subsequent passage of the continuing resolution kept spending at its fiscal 2003 pace. In January, when the fiscal 2004 spending legislation was finally enacted, the federal-aid highway program received a 4 percent increase and mass transit a 1 percent gain. On the down side, Congress has still not been able to finalize the successor to TEA-21, necessitating another extension through the end of July. The uncertainty over future funding levels has made it more difficult for state departments of transportation to approve major projects. Given the 2004 uncertainties over funding and costs, highway and bridge construction is expected to drop another 7 percent this year to $39.5 billion. Sewer construction in 2003 increased 1 percent. This was due largely to several substantial projects reaching the start stage, such as a $181 million wastewater treatment facility in the Bronx, NY. However, given continued tight fiscal conditions and greater difficulty in raising funds for major projects, sewer construction will decline 3 percent in 2004. The downward trend for electric utility construction continued in 2003. Construction contracts dropped 26 percent to $8.9 billion last year – well below 2001’s all-time high of $24.3 billion. This category includes both power plants and transmission lines, and while power plant construction has fallen sharply, transmission line work is beginning to pick up. While comprising just 8 percent of the electric utility starts in 2003, power line work more than doubled last year. The Northeast blackout in August 2003 raised concern about the condition of the transmission line network. While deregulation spurred construction of new plants, investment in transmission lines receded. As older utilities recognized they might have to divest some assets, upgrades to transmission lines were delayed. In addition, regions facing power shortfalls turned their attention to finding the least expensive source of power, rather than the closest, thereby straining the transmission network. Several pieces of legislation being considered by Congress would require utilities to join regional transmission groups – although federal energy legislation is not expected to pass during 2004. Law-makers in the Northeast and Midwest generally favor this type of legislation, while those in the South and West oppose it. As more plants from the 1999-2001 construction boom become operational, capacity utilization continues to decline creating little incentive to start new power plants. As a result, electric utility construction in 2004 is expected to drop 15 percent to $7.5 billion, with further declines to come in 2005. The transmission line component, however, should either stabilize or see another increase. In one case, a Wisconsin utility has proposed building over the next 10 years more than $2 billion of high voltage power lines to upgrade Wisconsin’s power grid. In another case, a New York-based developer has proposed constructing a 130-mile underground transmission line between upstate New York and New York City. The Shape of 2004 The underlying dynamic of the construction market will slowly shift during 2004. Single-family housing will continue to outpace other types of construction to reach an unprecedented level of activity this year. But the housing expansion will begin to show its age as the year concludes. As mortgage rates move higher, the strong upward push to total construction activity will shift away from the housing sector, but will be picked up by a recovering commercial building sector. Commercial and industrial construction will continue – and expand – the turnaround that was beginning to take shape in 2003. Institutional building and public works, by contrast, will be restrained in 2004 by the difficult fiscal climate facing the federal and state governments. All told, total construction will increase 6 percent in 2004 to $562 billion. Excerpted from August 2004 Construction Equipment Distribution. For the complete article, email jbrockmann@aednet.or g or to subscribe, CLICK HERE.
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