Mix of Construction Activity Regroups in 2006 - Mid-Year Report
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SECTION: Mid-Year Report

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Mix of Construction Activity Regroups in 2006

Written by Robert Murray, vice president of economic affairs, McGraw Hill Construction

Article Date: 08-01-2006
Copyright (C) 2006 Associated Equipment Distributors. All Rights Reserved.


Slowing single family housing construction will be offset by the upward trend in commercial building.

Overall, 2005 was a year of substantial growth for the construction industry. The value of new construction starts rose 11 percent to $657.4 billion, repeating 2004’s 11 percent increase and substantially above the 2 percent to 6 percent growth in 2001-2003. In 2006, total construction is expected to climb by a more modest 3 percent to $678.8 billion, which on a constant dollar basis translates into a 1 percent decline.

The pattern for total construction will be largely shaped by the slowdown in single family housing construction. At the same time, healthier market fundamentals should solidify the upward trend for commercial building and both institutional building and public works will continue to grow.

Commercial Building Starts

During the first quarter of 2006, job growth has been healthy, advancing at the solid pace of 197,000 jobs per month. Market fundamentals also continue to improve during 2006, including such measures as hotel occupancies and office vacancy rates. Bank lending standards are easing, although long-term rates are beginning to take on a more pronounced upward movement.

The one important negative has been the rise in building materials prices. These increases have created uncertainty in the project financing picture, causing owners and developers to remain cautious about undertaking new construction.

Higher materials costs will continue to be a factor in 2006, but improving fundamentals will enable commercial starts to register further growth. The mix will shift, however, with stores adding a small drag to construction activity, while hotels, offices, and warehouses head upward. The result will be a 6 percent increase.

The competitive retail landscape has played a major role in the healthy volume of store construction, as the more successful retail chains have aggressively pursued expansion. Wal-Mart has announced that it intends to expand its square footage globally another 8 percent in 2006, which for the U.S. market translates into 270 to 280 supercenters. According to one account, Wal-Mart has more than 1,500 potential store sites in the U.S. in various phases of review for construction. Kohl’s plans to add 500 new stores over the next five years, while Target also continues to expand at a healthy pace. J.C. Penney has announced that it’s launching a major store upgrade program, which will involve renovating 250 existing stores and constructing more than 170 new ones by 2009. About 90 percent of the new J.C. Penney stores will be off-mall.

The expected slowdown in housing starts could have an impact on expansion plans for Home Depot and Lowe’s. Over the next five years, Home Depot plans to open 400-500 new retail stores. While this still represents considerable growth, the projected pace is about half the number of units added over the past five years.

Office construction advanced 14 percent in 2004 and despite concerns over higher materials costs, the large-scale projects that shaped 2004 reemerged in 2006. Two of the highest-profile projects are located in New York City. Goldman Sachs, after months of negotiations with city and state officials, agreed to build its massive new headquarters in lower Manhattan. And following design changes to answer security concerns, the Freedom Tower is expected to break ground before the end of 2006. For 2006, office construction starts will rise 11 percent. While additional growth for offices is anticipated for 2007 and 2008, the recovery will be more modest than in prior years, and office construction starts will not approach the last peak set in 2000.

The turnaround in the business sector’s bottom line and the return of the corporate traveler proved to be a very positive signal for the hotel sector in 2005. Occupancy rates and profits improved at a dramatic pace over the past year. An even more positive indicator was found in the revenue per available room (revpar) statistics. Smith Travel estimates revpar advanced 8.4 percent in 2005, the fastest rate of change since STR began tracking revpar back in 1987. In the first quarter of 2006, occupancies continued to show growth relative to the prior year, while revenue per available room jumped an impressive 9.7 percent.

Despite these solid industry fundamentals, U.S. hotel construction starts rose just 3 percent in 2005. However, those projects that were delayed and helped contribute to the weaker 2005 will contribute to substantial construction growth in 2006. In Las Vegas, construction on the 3,000 room Palazzo hotel tower began in March, and groundbreaking for the 2,000 room Wynn Encore is expected later this year. The strengthening convention business will be supported in 2006 by the start of additional convention center hotels, located in such cities as Baltimore, Phoenix, and San Diego. With both mega-projects and a more broad-based expansion taking place in 2006, hotel construction is forecast to jump 25 percent.

Manufacturing Starts

Construction of manufacturing buildings in 2005 dropped 14 percent, surprising since a number of economic indicators showed a U.S. manufacturing sector that was improving. In this light, it’s believed that 2005 represented a brief departure in what will still be a broad upward trend for this structure type that will continue into 2007 and 2008. It’s also worth noting that while the square footage of new manufacturing starts slipped in 2005, the dollar amount for this structure type increased 7 percent.

The first quarter of 2006 saw the start of two large ethanol plants. The call by the Bush Administration for the greater use of ethanol to power cars, plus the request that more refinery capacity be built, could potentially lead to enhanced construction activity related to these manufacturing segments.

The manufacturing index issued by the Institute for Supply Management stayed above the 50 mark throughout 2005 and during the early months of 2006, depicting an expanding manufacturing sector.

This sector should see renewed expansion in 2006, and construction is expected to rise 12 percent. The more active segments will include pharmaceutical and biotech projects, and ethanol plants are expected to stay at the elevated pace recorded over the past year. The need to replace aging plants with more efficient facilities should contribute to growth in 2006 and then over the next two years.

Institutional Building

Institutional building grew 4 percent in 2005, ending a three-year decline. Fiscal conditions for state and local governments have shown discernible if hesitant improvement and broader demographic factors, such as rising student enrollments remain positive. In 2006, institutional building is forecast to rise 3 percent.

The educational building category in 2005 advanced 5 percent, ending the downward trend. The category showed growth for laboratories (up 18 percent), primary schools and junior highs (up 13 percent), colleges (up 4 percent), although high schools were down 4 percent, libraries fell 7 percent, and vocational schools slipped 8 percent.

Based on projected enrollments, the need for school construction remains strong, and the passage of major bond measures has made funding available. With improving fiscal state conditions, it’s expected that more of this money will lead to construction starts, elevating the level of contracting over the next two years.

In 2006, contracting for the educational building category is forecast to rise 5 percent to although the rising cost of building materials will be a problem. The increased cost for projects has caused at least a few school districts to adjust construction plans.

The healthcare facilities category jumped 13 percent in 2005. Hospitals soared 18 percent, while clinics and nursing homes grew 9 percent. In recent years, several of the large hospital chains have engaged in major capital expansion programs, keeping the hospital segment strong. Of note, 42 projects valued at $75 million or more reached groundbreaking. During the first three months of 2006, four such projects reached groundbreaking, a more subdued pace.

The clinic segment over the past decade was boosted by the trend towards specialty outpatient care clinics ("boutique hospitals"). A near-term constraint was a provision included in the Medicare reform bill that imposed a moratorium from December 2003 through June 2005, prohibiting physicians from referring patients to specialty hospitals in which they hold a financial interest. The end of this moratorium on June 8 had the potential to lift clinic construction, and the clinic segment did register 9 percent growth in 2005.

Another positive that helped 2005 construction was the ever-present need for hospitals to stay competitive by investing in new technologies and replacing aging facilities. Finally, always in the background is the growing demand for healthcare services, which are expected to rise significantly as the baby boom generation moves toward retirement age. For 2006, construction of healthcare facilities will advance an additional 1 percent.

The public building category in 2005 slipped an additional 2 percent, following a five-year retrenchment that saw contracting slide 32 percent from its peak in 1999. By major segment, declines were reported for courthouses (down 17 percent) and detention facilities (down 13 percent), while growth was reported for armories/military buildings (up 4 percent), police/fire stations (up 17 percent), and post offices (up 96 percent from a negligible 2004).

In 2006, public building construction is expected to retreat another 3 percent, due partly to the reduced federal support for courthouse projects that were present in fiscal 2005 appropriations. Although fiscal 2006 appropriations included moderate increases in funding in courthouse projects, the impact at the construction site is not expected to take place until next year.

The transportation buildings category (miscellaneous non-residential) grew 6 percent in 2005. A sharp increase in airline terminal construction, which rose 79 percent from a very weak 2004, helped boost this category. Construction of freight terminals also increased in 2005. With sustained growth for the economy of at least 3.5 percent expected over the next year, the need for terminal work will continue to rise and construction starts in 2006 will grow 6 percent.

Housing Starts

The performance of single family housing during the first half of this decade was truly extraordinary. Once considered to be one of the more cyclically sensitive parts of the construction industry, single family housing ran counter to the weakness for the general economy during 2001 and has since risen steadily.

In 2005, single family housing advanced 5 percent to 1.627 million units. This marks yet another new, all-time high, topping the prior record of 1.552 million units set in 2004. During the 2001-2005 period, the average number of new single family units constructed per year was 34 percent above the average for the 1990s and 55 percent above the average for the 1980s.

In the near term, single family housing construction is determined by economic factors, the most prominent being mortgage rates, which for some time held at historically low levels. The low-rate environment continued through much of 2005, with the 30-year fixed rate averaging an unexpectedly low 5.87 percent over the year (barely changed from the 5.83 percent in 2003 or the 5.84 percent in 2004).

But mortgage rates are headed upward in 2006. The 30-year fixed rate averaged 6.2 percent in January and February, followed by 6.3 percent in March and 6.5 percent in April. In the last week of April, the 30-year fixed rate climbed to 6.6 percent, the highest level in almost four years.

The National Association of Realtors (NAR) reported 7.075 million existing homes were sold in 2005, up 4 percent from 2004’s record number. The U.S. Commerce Department, which tracks this data, reports sales of new homes in 2005 climbed 7 percent to 1.283 million – also a new record high. In the first quarter of 2006, existing home sales averaged 6.797 million and new home sales were 1.159 million, still healthy levels. At the same time, the March reports for both showed supply had climbed to 5.5 months, higher than the 4 months level present since the late 1990s. As the inventory of unsold homes rises, builders will pull back on the volume of construction.

Single family housing starts will retreat modestly in 2006, as activity slides 5 percent to 1.545 million units. Contributing to this decline, of course, will be higher mortgage rates, with the 30-year fixed rate expected to be at about 7 percent by year-end.

The Federal Reserve will continue to tighten monetary policy, with the federal funds rate moving up to at least 5.25 percent. The increase in the federal funds rate will be paralleled by the prime rate, which means the monthly payments for adjustable rate mortgages will continue to rise. The result will be mild dampening of homebuyer demand, especially in the overpriced markets in California and the Northeast. Home prices in these areas will decelerate, meaning in most cases a slower rate of growth.

In 2005, multi-family housing had a great run, with the full year climbing 8 percent to 504,000 units – the highest volume since 1987. The top five metropolitan markets in 2005 for multi-family housing, ranked by the numbers of multi-family starts, were New York, Miami, Chicago, Washington DC, and Los Angeles.

One of the major reasons for the recent strength in multi-family housing was the renewed popularity of condominiums and townhouses. Development of new condos and the conversion of apartment buildings into condos have risen in virtually every metropolitan area. But apartments are making a comeback.

The first quarter of 2006 included the start of these large condominium projects – the $330 million Palms Plaza condominium in Las Vegas, the $221 million One Rincon condo in San Francisco, the $197 million Trump Towers condo in Sunny Isles Beach, Fla., and the $165 million Trump Plaza luxury residential tower in Jersey City, N.J.

Public Works/Electric Utilities

Public works and electric utility construction in 2005 increased 7 percent to $101.8 billion. Construction benefited from environmental mandates, hurricane-disaster relief, and the welcome passage of the new federal-aid highway bill (SAFETEA-LU). Highways and bridges showed moderate growth of 7 percent, but gains in awards for water projects increased 16 percent. While SAFETEA-LU turned out to be less generous than most state departments of transportation had initially hoped, its passage did eliminate the uncertainty that made the states hesitant to move forward with new projects.

SAFETEA-LU will keep highway and bridge construction on an upward path. For fiscal 2006, the obligation limitation for highway spending was set at $36 billion, up 5 percent. State spending on transportation infrastructure will rise as well. In the end, contracting for highways and bridges will rise 11 percent in 2006 to $49.1 billion.

Environmental public works in 2005 surged 16 percent, among the largest gains on record for the combined categories of wastewater, drinking water, and river and harbor development. Projects ranged from desalinization plants in California, to a substantial water tunnel project in New York, to aqueducts and reservoirs in Colorado, to levee repair and reconstruction in Louisiana, to combined sewer overflow projects throughout the nation. The large increase suggests most types of activity will subside toward their trend rates of growth in 2006. The exception, of course, will be reservoirs, levees, rivers and shoreline projects.

Electric utility construction starts continued to slip in 2005, but recent evidence suggests the extended retreat is ending. In 2005, starts declined 2 percent to $7.1 billion. In 2006, contracting will begin to edge upward, supported by rising demand for electricity, incentives for wind power and clean coal, and easier permitting for natural gas projects.

Aside from power plants, the need for more transmission line work will also stay strong – new construction starts for power lines surged 243 percent from 2002 through 2004. While 2005 saw a 28 percent decline, the dollar amount of transmission line work was still considerably above what had been reported a few years ago.

In addition, the construction of new gas plants and pipelines is now poised for growth. Contracting was up sharply in 2005 as energy companies expanded their storage facilities and increased their import capacity. Sharply higher prices for natural gas have led many of these companies to request permits for new facilities, but this effort was largely an uphill battle until the recent passage of the omnibus energy bill. This legislation placed decision-making responsibilities solely in the hands of the Federal Energy Regulatory Commission (FERC). Because re-gasification plants are very expensive to build, an increase in the construction of these facilities will certainly lift contracting for the overall utility category in future years.


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