The Construction Expansion Keeps On Rolling - Mid-Year Report
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SECTION: Mid-Year Report

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Contact Kim Phelan at (800) 388-0650 ext. 340.

The Construction Expansion Keeps On Rolling

Written By Robert Murray, Vice President and Chief Economist and Jennifer Coskren, Senior Economist McGraw-Hill Construction

Article Date: 08-01-2005
Copyright (C) 2005 Associated Equipment Distributors. All Rights Reserved.

The economy continues to provide support to the market, though risks are on the horizon.

During the spring, the economic mood shifted from anxiety about the economy sliding into another “soft patch” to concerns about rising inflation and labor costs. Through mid-year economic growth continues at a healthy clip, and the fact that the economy could so readily absorb oil prices above $60 per barrel only underscores its strength. Real GDP advanced at a solid 3.6 percent during the first half of 2005, providing a boost to the overall construction market.

The employment recovery has been noteworthy, though the month-to-month job gains are erratic. After hitting 292,000 new jobs in April 2005, job gains decelerated to 104,000 and 142,000 in May and June, respectively. Nonetheless, labor markets are tightening and wages are rising. With this stronger picture, it makes it even more certain that the Fed will continue to tighten monetary policy at its upcoming meetings.

The pickup in the economy and the labor market offered further justification for the Federal Reserve to maintain its regimen of monetary tightening. At its June 29 policy meeting, the Fed lifted the federal funds rate a quarter point to 3.25 percent, the ninth such increase since June 2004 when the federal funds rate stood at 1.0 percent.

In its June statement, the Fed reiterated its intention to move towards a more neutral position at a “pace that is likely to be measured.” The exact point where monetary policy becomes neutral is subject to some debate, but is generally believed to be in the range of 3 percent to 5 percent. Additional rate increases are expected over the course of 2005, bringing the federal funds rate to about 4 percent by year’s end.

All told, the economy continues to provide support to the total construction market, though risks remain on the horizon. Short-term interest rates are moving higher, which will exert some restraint on real estate investment. Adjusting to the higher cost of building materials will also be a limiting factor in the near term.

On the plus side, bank lending standards are easing and real estate continues to be viewed as an attractive investment target.

Commercial Building Weakens
During 2004, the upturn for commercial building became more broad-based. While 2003 saw some growth for stores and hotels, continued weakness by the other structure types meant that the 2003 square footage of new commercial starts was down another 2 percent.

From the peak in 2000 to the trough in 2003, commercial building fell 33 percent. In 2004, each of the commercial structure types showed improvement, lifting the commercial total 7 percent.

The near term is generally positive for commercial building. By June 2005, office employment reached 28.2 million, nearly matching the February 2001 peak of 28.3 million. Market fundamentals such as hotel occupancies and office vacancy rates are improving. As for the cost of financing, even with short-term interest rates edging up, long-term rates have stayed low and bank’s lending standards are easing.

On the negative side, high materials prices and a persistent wariness by U.S. firms will hold back the office, warehouse and manufacturing markets in 2005. In this setting, it’s expected that commercial building will fall by 1 percent in 2005 and grow 4 percent in 2006. Construction activity will then level off, and begin to recede as economic growth settles back.

Store construction in 2004 increased 4 percent following a 10-percent gain in 2003, and brings this structure type close to the record high achieved in 1999.

In recent years, there’s been concern about the nation being “over-stored” and negative news on the retail scene has included store closings by such chains as K-Mart and May Department Stores. The positives, though, have far outweighed the negatives.

Consumer spending remained strong from the 2001 recession year through 2004, and derived demand coming from robust levels of homebuilding has also helped retail construction starts.

The competitive retail landscape has also played a major role in the healthy volume of store construction, as the more successful retail chains have aggressively pursued expansion. Home Depot expects to open approximately 185 new stores in 2005, while its main competitor Lowe’s plans to add 150 stores. Other chains such as Wal-Mart, Target, Kohl’s, Costco, and Walgreen’s continue to add new stores.

As regional malls have lost favor with consumers, open-air “lifestyle” centers have become increasingly popular. These are about one-third the size of an enclosed mall, and offer shoppers an upscale ambience and convenience, such as the ability to park near a store entrance.

The investment community continues to regard retail real estate favorably, with most expecting retail rents to be stable or increase in the coming year. This will contribute to an increase for store construction in 2005 of 1 percent.

In 2004, warehouse construction improved 7 percent. This follows a three-year decline that saw contracting slide 38 percent. With the more sustained strength shown by the economy over the past year, the demand for warehouse space has picked up and vacancy rates have begun to recede.

According to CB Richard Ellis, warehouse vacancies peaked at 11.7 percent in the third quarter of 2003, and by the second quarter of 2005 had slipped to 10.2 percent.

Unfortunately, the turnaround in construction paused in early 2005. The size and scope of projects that have begun so far this year have been on a much smaller scale compared to year-ago levels. However, the latter half of 2005 will gather momentum. The more successful retail chains, such as Wal-Mart, are moving ahead with expansion plans that require more distribution centers.

Since the support provided by the expansion of retailer warehouses will not be strong enough to preserve a positive year, warehouse construction will fall by 3 percent in 2005.

Ending a steep decline, office construction in 2004 advanced 12 percent. After reaching a peak in 2000, contracting over the next three years plunged 52 percent.

With the stronger economy leading to growth for office employment, vacancy rates are now receding.

According to CB Richard Ellis, the suburban office vacancy rate settled back to 15.7 percent in the second quarter of 2005, compared to the most recent peak of 18.2 percent in the third quarter of 2003.

Downtown vacancy rates retreated to 13.4 percent in 2005’s second quarter, compared to a peak of 14.7 percent in the first quarter of 2004. Further reductions in vacancy rates are expected to take place during 2005 and 2006.

The improvement in office employment, combined with the declining trend in office vacancies, has created a more favorable environment for office development. Despite all signs of healthy demand fundamentals, however, the office construction market will fail to recapture the growth of 2004. Construction starts will fall by 5 percent in 2005.

The decline in starts is surprising, given that firms continue to hire at a solid pace and most corporations remain flush with cash. On the positive side, the lull is expected to be short-lived, with renewed growth expected in 2006.

Against the backdrop of a healthier economy and improved demand for travel, 2004 turned out to be a strong year for the lodging sector. According to Smith Travel Research, hotel occupancies in 2004 averaged 61.3 percent versus year-ago levels of 59.1 percent, while revenue per available room increased 7.8 percent.

Occupancy rates and profits continue to improve at a dramatic pace in 2005. In the first half of the year, occupancy rates improved to 62.2 percent, an impressive 2.8 percent point climb from the same period a year ago.

With strengthening financials for the lodging sector, the stage has been set for more construction gains this year. In 2005, contracting for hotels is expected to climb 7 percent. In an interesting development, several lodging companies are planning new chains that will take their styling and amenity cues from boutique hotels, as a way of differentiating themselves from the more typical lodging product.

Manufacturing Retreats
Construction of manufacturing plants in 2004 climbed 13 percent, following the 7 percent rise in 2003, which brought the extended decline over the previous five years to an end.

With the healthier pace of economic growth during the latter half of 2003 and through 2004, businesses have increased their level of investment. This was initially directed at equipment and software purchases, but attention has more recently been turned towards adding productive capacity. Large projects reaching the groundbreaking stage in 2004 included a $363 million refinery in Minnesota, a $300 million biotech facility in California, and a $200 million truck manufacturing plant (Toyota) in Texas.

Over the past two years, a number of economic indicators have become more positive for the manufacturing sector. The value of the U.S. dollar relative to the currencies of major trading partners fell 12 percent in 2003, another 8 percent in 2004, and the current year is expected to see further erosion in the 5 percent to 10 percent range.

The average capacity utilization rate for the first five months of 2005 was 78.1 percent. This is up from an average of 76.0 percent for the first five months of 2004 and an average of 76.7 percent for 2004 as a whole. Overall the manufacturing sector appears to be gradually picking up strength.

Despite favorable conditions, manufacturing construction will take a breather in 2005, declining 9 percent. Reasons contributing to the retreat are numerous, including a shift towards leaner manufacturing and outsourcing; technical innovations, and the persistent wariness by firms towards adding new capacity.

Institutional Building Steady
Institutional building continued to slide in 2004, dropping 8 percent. In the long-term this sector responds to demographic forces such as rising student enrollments and the growth of the elderly population. In the short-term, the fiscal health of states and localities shapes the pattern of construction activity, with a lag.

Deterioration of state and local finances from 2001 through 2003 had a dampening impact on construction activity that carried through 2004. The initial signs of improved fiscal health last year will begin to have some benefit for the institutional structure types in 2005, as the total square footage for this category rises 1 percent.

Improving conditions at the state and local level will be particularly beneficial to education and dormitory construction, which will buttress institutional construction in 2005. Healthcare will also remain a bright spot.

The educational building category continued to weaken in 2004, as contracting fell 14 percent. The loss of momentum was widespread: primary schools were down 11 percent; junior highs were down 9 percent; high schools were down 15 percent; colleges and universities were down 14 percent; libraries were down 30 percent; and educational laboratories were down 33 percent.

Showing stronger activity in 2004 were museums, up 14 percent, and vocational schools, up 40 percent.

Regionally, the South Atlantic was down 9 percent, the Midwest was down 10 percent, the South Central was down 11, the West was down 19 percent, and the Northeast was down 21 percent.

The need for school construction remains strong and funding has been made available through numerous bond measures passed across the nation. The November 2004 elections included major bond measures being passed in California, Arizona, and Texas, and each state is expected to see healthy enrollment growth over the next 10 years.

In addition, the improving stock market has helped college endowments to strengthen again, and the educational building category is expected to rise 5 percent in 2005.

In 2004, healthcare facilities edged up 1 percent. Hospital construction grew 4 percent, while clinics and nursing homes edged up 1 percent. In recent years, several of the large hospital chains have engaged in major capital expansion programs, keeping hospital construction strong.

Contracting eased back slightly in 2003, but overall, hospital construction over the past four years has been at a high level by historical standards.

The need for hospitals to stay competitive by investing in new technology and replacing aging facilities will remain strong. Moreover, growing healthcare expenditures will further boost the need for new hospitals. According to the Centers for Medicare and Medicaid Services, national healthcare expenditures will increase 7 percent in 2005 to $1.9 trillion.

As a percentage of GDP, healthcare expenditures in 2004 were 15.7 percent, up slightly from 2003. This share will grow slowly until late in the decade when baby boomers are set to retire. Once baby boomers begin to retire, healthcare expenditures as a percent of GDP could grow much more quickly.

The clinic segment over the past decade has been boosted by the trend towards specialty outpatient care clinics, also known as “boutique hospitals,” that were generally directed at a niche such as cardiovascular services or orthopedics. According to the Lewin Group’s analysis of MedPAC and AHA data, limited-service hospitals grew 52 percent from 2,462 in 1997 to 3,735 in 2003, and ambulatory surgical centers rose 265 percent over this same period from 31 to 113.

In this current environment, heathcare facilities construction will increase 4 percent in 2005.

Public building slipped 3 percent in 2004, dropping 24 percent below the average for the second half of the 1990s. By segment: police/fire stations were down 11 percent; courthouses were down 5 percent; detention facilities were unchanged; post offices were up 1 percent; and armories/military buildings were up 10 percent.

For 2005, restrained funding at both the federal and state levels of government will produce a 1 percent drop.

In 2004, religious buildings fell 6 percent. Another 13 percent drop is forecast for 2005. While charitable giving has improved with the healthier economy, it will be at least another year before it has a positive benefit on construction starts.

The transportation buildings category increased 3 percent in 2004. While airline terminal work continued to weaken, dropping 24 percent, other segments showed improvement, such as bus and rail terminals, up 2 percent; aircraft service facilities, up 10 percent; bus and truck service facilities, up 25 percent; and rail service facilities, up 62 percent.

During 2005, the overall miscellaneous non-residential category will remain flat even with airline terminals adding a strong element of support to the category this year. At the top of this list has to be the JetBlue terminal at JFK airport in New York.

Housing Slowdown Coming
In 2004, single family housing continued its extraordinary performance of the current decade. Construction rose an additional 10 percent, climbing to 1.552 million units, a record amount. All-time highs in 2004 were also set for new home sales, up 11 percent to 1.203 million units and existing home sales, up 10 percent to 6.784 million units.

Not surprisingly, a new record was also set for renovation work, with the Commerce Department reporting that improvements and repairs for owner-occupied one-unit properties were up 17 percent to $136.1 billion. The total amount of residential improvements and repairs, including rental and multi-unit properties, was estimated to be up 12 percent to $198.6 billion.

In the near term, the level of single-family housing is determined by a variety of economic factors. Since 2001, 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.

Rates bottomed out in March 2004 at 5.4 percent, although levels did quickly rise above 6 percent by May. However, by year-end, mortgage rates at once again dipped below 6 percent, further fueling the insatiable appetite for residential real estate.

The year 2005 has seen a continuation of the low rate environment, as mortgage rates fell to 5.6 percent in June.

In addition to the low cost of financing, demand has been boosted by the attractiveness of housing as an investment, especially when compared to the lackluster performance of the stock market at the start of the decade. During 2004, the average price of a new home jumped 11.4 percent to $274,500. (The median price of a new home in 2004 increased 13.3 percent to $221,000.)

Home price appreciation has been even more pronounced in 2005 – in June, the median price of an existing home rose 14.7 percent, just shy of the extraordinary 15.1 percent annualized pace set in April.

As home prices skyrocket, lenders have become increasingly creative when it comes to ensuring homeowners can afford the houses of their dreams. Interest-only mortgages, which can shave as much as 20 percent to 30 percent off the standard fixed-rate payment, have become extremely popular; California markets, in particular, are a hotspot for interest rate only mortgages.

According to Loan-Performance, 47.6 percent of all mortgages issued in San Diego in 2004 were interest-only. The other top markets for these mortgages were Atlanta, 45.5 percent, San Francisco 45.3 percent, Denver 43.4 percent, Oakland 43.1 percent and San Jose 41.1 percent.

The combination of robust home price appreciation, low mortgage rates and a healthy US economy will engender another rise in single family home construction for 2005. For the nation as a whole, construction of single family housing is estimated at 1.575 million units, up 2 percent from 2004’s record volume.

However, beginning next year, the outlook for the housing market becomes less upbeat.

Despite remaining close to or below 6.0 percent during the first four months of 2005, the 30-year fixed mortgage rate is expected to edge upward during the latter half of the year, climbing above 6.5 percent.

Multi-family housing in 2004 increased 4 percent to 461,000 units. In both 2003 and 2004, multi-family housing topped its peak of 442,000 units in 1999, although it was still well below the peak amounts reached in the 1980s and 1970s.

In 2004, the leading metropolitan markets for multi-family construction were: New York, up 30 percent; Miami, up 16 percent; Atlanta, up 65 percent; Los Angeles, up 40 percent; Chicago, up 13 percent; and Washington DC, up 9 percent.

One of the biggest drivers of multi-family construction in recent years has been the booming condominium market. Multi-family housing is shaped by both the for-sale and for-rent sides of the housing market, so that gains in the for-sale (townhouse/condominium) market over the past few years were able to offset some of the downturn in the income-producing side of the market (rental apartments). With single family home prices slowly slipping away from many first time homebuyers’ grasp, the demand for less expensive condos and townhomes has been insatiable.

Over the past year, there’s been concern about the rental portion of the multi-family market. Yet, with the improving employment picture during 2004, vacancy rates have begun to recede and the rental market has seen improvement.

According to Reis, by the first quarter of 2005, apartment vacancies settled back to 6.6 percent, a substantial recovery from the 7.1 percent of a year earlier. Effective rents are also rising, though at a rather tempered pace. Reis says rents rose 0.6 percent in the first quarter.

The longer-term factors for multi-family housing continue to be positive. The real estate finance community favorably views this property type, 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.

For 2005, multi-family housing is expected to increase another 2 percent to 468,000 units. Financing should be available for viable projects, and first-time homebuyers in the overpriced Northeast and California markets will increasingly turn their focus towards purchasing condominiums.

Public Works on the Rise
Public works construction in 2004 climbed 4 percent, following the 6 percent decline in 2003; the project types most responsible were sewers and water supply systems. Highway construction was essentially flat, and bridge starts retreated.

So far, the impact of tight fiscal conditions at the federal level has essentially restrained the rate of growth for construction activity, as opposed to causing steep declines. At the state level, the tough fiscal environment has proven to have some limiting impact.

In both the November 2002 and November 2003 elections, several large bond initiatives were voted down, including a $7.8 billion transportation referendum in Washington State. There was also concern about the ability of states to match federal road dollars, plus the possibility states would shift money out of transportation trust funds as they worked to bring their budgets into better balance.

On the plus side, the November 2004 elections showed renewed support at the state level for transportation projects. This included such examples as Colorado voters approving a sales tax increase to fund a light rail program for the Denver area, Seattle voters reaffirming approval for that city’s planned monorail, and Virginia voters agreeing to more spending for highway and mass transit upgrades.

In November 2004, Congress approved federal funding levels for fiscal 2005, with support continuing to be directed at transportation public works. Showing gains were the federal aid highway program, up 2 percent; mass transit funding, up 5 percent; and airport improvement grants, up 3 percent.

On the environmental side, the Corps of Engineers construction account was increased 2 percent and the Bureau of Reclamation funding was held steady, but EPA water infrastructure grants were reduced 8 percent (including a 19 percent cut for clean water revolving funds).

The 2006 federal budget proposed by the Bush Administration requests non-security related discretionary spending be reduced about 1 percent. It’s expected the emphasis will still be on funding transportation projects, meaning the environmental programs could take a hit.

In 2005, public works construction will increase 6 percent. In particular, 2005 continues to see strong gains for water supply systems, in part reflecting the need to increase capacity due to this decade’s surge in residential development.

In 2004, highway construction edged up 1 percent to $31.3 billion, while bridge construction dropped 14 percent to $9.7 billion. Congress has continued to approve annual appropriations for highway/bridge construction, but not having a multi-year federal transportation bill in place has been a limiting factor. This is because uncertainty over future funding levels has made it more difficult for state departments of transportation to approve major projects.

Sewer construction in 2004 advanced 7 percent to $11.4 billion, aided by such projects as the start of a $191 million sewer tunnel in Atlanta. That city is in the midst of a $3 billion, 14-year program to improve its waste water system. In 2005, sewer construction will see some negative impact from reduced funding for clean water state revolving funds, yet construction is still expected to grow 9 percent.

In 2004, water supply systems jumped 12 percent to $9.6 billion, bouncing back from a weak 2003. This project type has been boosted by EPA mandates for local water systems to upgrade their infrastructures, as well as broader demand arising from the heightened residential development of recent years.

In 2005, water supply construction is expected to soar an additional 16 percent.

New construction starts for electric utilities continued to retreat in 2004, dropping 21 percent to $7 billion. Since reaching an all-time high in 2001 at $24.1 billion, electric utility contracting has plunged 71 percent.

Overall, the electric utility market still has an oversupply of capacity, and electric utility starts will continue to decline in 2005, slipping 2 percent to $6.9 billion.

Aside from power plants, this category includes transmission lines. While power plant construction is still sliding, transmission line work has picked up substantially.

Contracting in 2003 increased 112 percent, followed by another 57 percent gain in 2004.

The recent pickup in transmission line work represents attempts by utilities and states to close the gap between the greater capacity to produce electricity and the capability to send the electricity where it’s needed.

The Shape Of 2005
The year 2005 will see the value of new construction starts rise 6 percent to $623 billion. Strong first half activity for residential building and public works ensures that both sectors will see decent growth for the year as a whole. Institutional building will also help out, helped specifically by an upturn for school construction after its 2004 decline. The pause experienced by commercial building in 2005 is expected to be a short-lived event, although the weak first quarter means the full year total may not be able to match the 2004 level.

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