Business Outlook 2007 - Midyear Update - Midyear Report
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SECTION: Midyear Report

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Business Outlook 2007 - Midyear Update

Written By Robert Murray, McGraw Hill

Article Date: 08-01-2007
Copyright (C) 2007 Associated Equipment Distributors. All Rights Reserved.


Brawny hotel, school and healthcare construction won't have quite enough muscle to pull totals out of housing's soppy cellar.

The value of new construction starts in 2006 increased a slight 2 percent to $678.9 billion, marking a change from the double-digit growth of 2004 and 2005. The overall pattern in 2006 was shaped by the steep decline for single-family housing, which pulled residential building down 11 percent. In contrast, nonresidential building jumped 18 percent, its largest gain so far this decade.

Boosting the nonresidential total was a surge of hotel projects, along with expansion for offices, schools, and healthcare facilities. Nonbuilding construction also contributed, rising 20 percent with heightened contracting for both public works and electric utilities. 

In 2007, total construction is forecast to drop 5 percent to $641.7 billion, which would be the first current dollar decline since 1991. Single-family housing will continue to exert a downward pull on residential building, bringing this sector down another 16 percent. The dollar volume gain for nonresidential building, at 7 percent, will be smaller than last year. Nonbuilding construction is expected to see more modest 3 percent growth, as greater public works activity is offset by a slightly slower pace for electric utilities following last year’s surge.

Economic Environment

The deceleration for the U.S. economy was pronounced in early 2007. Real GDP growth for first quarter 2007 came in at just 0.7 percent, down from 2.5 percent at the end of 2006. The weak first quarter raised concerns about recession, although these concerns were alleviated to some extent by the fact that job growth continued to move at a moderate clip.

During the first half of 2007, an average of 145,000 jobs were created each month, not as rapid as the 2006 pace of 189,000 jobs per month, but still showing forward momentum for the economy. With economic growth for the second quarter pegged at 2.0 percent to 2.5 percent, followed by somewhat stronger gains to come, it’s estimated that the U.S. economy for full-year 2007 will expand 2.2 percent. Compared to the 3.3 percent gain in 2006, this would constitute the widely anticipated “soft landing.”

The reduced pace of job growth means some dampening effect on commercial building, such as slower absorption of office space than what occurred during 2006. In addition, evidence is emerging that lending standards on commercial real estate loans are becoming more restrictive. In its April 2007 survey of bank lending officers, the Federal Reserve reported that 30 percent of the respondents had tightened standards on commercial real estate loans, compared to the previous quarter. 

The residential market has also seen more stringent standards, as the April survey showed 15 percent of the respondents reporting tighter standards on prime residential mortgages, while a much larger percentage reported tightening for nontraditional mortgages (45 percent) and subprime mortgages (56 percent). 

To help contain the turmoil arising from the subprime mortgage market, federal bank regulators issued guidelines at the end of June aimed at curbing lax underwriting standards. And, long-term interest rates in late spring began to edge upward, after holding at very low levels for more than a year. 

On the plus side, the 2007 construction market continues to be supported by several factors. For this year at least, state and local finances remain relatively healthy, providing support to such publicly financed project types as schools. And, federal funding will continue to benefit transportation public works, while environmental mandates and state financing are helping to lift environmental public works projects.

Commercial Buildings

The commercial building sector in 2006 reported its third straight year of expansion, as square footage of new construction starts grew 7 percent, while the dollar volume soared 26 percent. The square footage/value differential reflected the start of several massive hotel and office projects, as well as the impact of higher materials costs. In 2007, the commercial building sector will in effect be rounding a peak, with square footage settling back 1 percent, although the dollar volume of new commercial projects will still increase 5 percent.

Store construction in 2006 retreated 2 percent to 303 million square feet – still a very robust level of activity by historical standards. 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.  

Given its lagged relationship to single-family housing, store construction is expected to weaken further in 2007, although the early results this year show contracting remaining at a high level. During the first half of 2007, groundbreaking for new store projects was particularly brisk in such markets as Chicago, Phoenix, Atlanta, Dallas and Houston.  

The construction of “lifestyle centers”, open-air shopping centers with an upscale ambience, continues to help the overall amount of store construction stay at a healthy volume for the present. 

Still, it’s expected that store construction will begin to slow more discernibly. At the start of 2006, Home Depot announced that it planned to open 400 to 500 new retail stores over the next five years, about half the number that were added over the previous five years. In May, Wal-Mart announced that it will open 190 to 200 supercenters this year, down from the prior year’s plan of 270 supercenters. 

With more subdued expansion expected from the major retail chains in 2007, combined with the downward pull from housing, store construction in 2007 is forecast to decline 3 percent to 295 million square feet, with a steeper drop expected in 2008. 

Warehouse construction stalled in 2006, slipping 7 percent to 205 million square feet. Market fundamentals have been generally positive, with vacancy rates, as reported by CB Richard Ellis, retreating from 11.7 percent in third quarter 2003 to 9.5 percent by third quarter 2006, and holding at that level through the end of last year.  

However, the vacancy rate has most recently seen slight upward movement, edging up to 9.7 percent in first quarter 2007. In addition, it’s possible that investor interest in speculative warehouse construction has waned compared to 2005, given the slower growth now evident in the economy. Warehouse construction in 2007 is expected to grow 3 percent to 212 million square feet, which is still 3 percent below the most recent peak
in 2005.


Office construction regained upward momentum in 2006, climbing 22 percent to 203 million square feet. Several large projects reached groundbreaking last year, including the $1.8-billion Goldman Sachs headquarters in New York, the $1.6-billion office portion of the Freedom Tower structure in New York, a $232-million office building in San Francisco, and a $215-million office building in Chicago. Market fundamentals remain generally supportive of new construction.  

According to CB Richard Ellis, the downtown office vacancy rate for fourth quarter 2006 was 10.8 percent, compared to 12.7 percent the previous year, while the suburban office vacancy was 13.6 percent, compared to 14.6 percent the year prior. However, the first quarter 2007 vacancy rates indicate that the rate for absorption for office space has slowed – the downtown vacancy rates held at 10.8 percent, while the suburban vacancy rate rose to 13.9 percent.

With the sluggish 2007 economy, office employment is growing more slowly this year. As a result, market fundamentals will continue to flatten or slightly deteriorate, causing some major projects to be reconsidered.  

At the same time, there are still a number of major projects that are reaching groundbreaking in 2007, and this momentum will lift office construction another 6 percent to 215 million square feet. Large projects that reached the construction start stage in early 2007 include a $550-million office tower in New York, a $550-million data center in San Antonio, Texas, and a $420-million office tower in Charlotte, N.C.  

The evidence that bank lending standards are tightening will begin to exert more discernible dampening on new office construction towards the end of 2007. 

Hotel construction in 2006 soared 66 percent to 81 million square feet. The volume of major projects that broke ground last year was extraordinary. Leading the way were three massive projects in Las Vegas – the $1.3-billion Palazzo hotel tower, the $1.3-billion Encore at Wynn hotel tower, the $1.1-billion Pelli hotel towers (as part of the huge Project City Center), the $594 million Foxwoods Casino Hotel tower in Ledyard, Conn., and three projects in Atlantic City, N.J. – the $271-million Bay View Hotel tower, the $200-million Borgata Hotel tower, and the $125-million Trump Taj Mahal tower. Convention center hotels have also been a popular hotel type, with the largest 2006 entries located in San Diego ($244 million) and Baltimore ($190 million). 

The impetus behind the hotel-construction surge has been the strong growth in hotel occupancies and revenues. Smith Travel Research estimates that full-year 2006 industry occupancy was 63.4 percent, up from 63.1 percent in 2005. Revenue per available room continued to see strong growth, climbing 7.5 percent in 2006, and on a par with 2005 (up 8.5 percent) and 2004 (up 7.8 percent). 

These healthy fundamentals have set the stage for another year of elevated construction. For 2007, hotel construction is expected to reach 80 million square feet, a slight 2 percent decline, but still the second highest amount so far this decade.  

The current year should see more large projects reach groundbreaking, although not quite to the same extent as last year. These projects include the $1.2 billion hotel portion of the massive Fontainebleu hotel/condo in Las Vegas, plus additional large projects in Los Angeles ($298 million), San Antonio ($237 million), Chicago ($195 million), and Orlando ($186 million).

Manufacturing Buildings

In terms of square footage, the tenuous upturn for manufacturing construction appears to have stalled. After falling back 10 percent in 2005, contracting in 2006 made just a partial rebound, rising 6 percent to 82 million square feet. Although healthy economic conditions in recent years should have led manufacturers to increase plant capacity, these efforts seem to have been undertaken cautiously. At the same time, the dollar value of construction starts jumped 24 percent in 2005 and another 32 percent in 2006. 

The recent strength for this structure type in dollar terms drew support from groundbreaking for a large number of ethanol plants – which, by the buildings’ very nature have substantial dollar value but negligible square footage. In 2006, the construction start statistics show that there were 26 ethanol plants with a minimum valuation of $50 million that reached groundbreaking.  

Petrochemical plant construction is also on the rise, climbing 60 percent in 2006 and marking a dramatic change from the subdued contracting earlier in the decade. This growth has continued in 2007, boosted by the start of a $1-billion refinery expansion in Garyville, La.  

Other large projects that have reached the construction start stage in 2007 include a $600-million Kia Motors manufacturing facility in Georgia, a $165-million cement plant in Georgia, plus numerous ethanol plants. As a result, new starts for manufacturing plants in 2007 are anticipated to rise 4 percent in square footage and 20 percent in dollar volume.

Institutional Buildings

The institutional building sector showed renewed expansion in 2005 and 2006, as the stronger economy boosted the fiscal health of state and local governments, which are tied to tax collections. In 2006, institutional building grew 3 percent to 534 million square feet, and another 2 percent gain to 543 million square feet is forecast for 2007. 

The educational building category has shown renewed expansion in 2005 and 2006, reaching 229 million square feet last year. By segment, noteworthy gains were registered by high schools (up 14 percent) and colleges/universities (up 6 percent). The states reporting the greatest amount of educational building square footage in 2006 were Texas, Florida, California, Ohio and Georgia. 

The long-term demand for classroom space remains considerable. Furthermore, in the November 2006 elections, several large school construction bond measures were passed. Most notable was the $10.4-billion measure in California, with funding directed at elementary and high schools, as well as the state’s university system.  

In Texas, voters approved school bond measures totaling $2 billion in such localities as Houston, Dallas-Ft. Worth, San Antonio and Round Rock. In Wake County, N.C., voters approved a $970-million construction bond measure. With support like this, the educational building category in 2007 is expected to climb another 2 percent to 234 million square feet. 

Construction of healthcare facilities reached a new peak in 2006, as starts climbed to 110 million square feet. The hospital segment provided much of the upward impetus, with steady gains for the past three years – including a 5 percent increase in 2006. The clinic and nursing home segment has shown a more varied pattern, rising 10 percent in 2005 and then retreating a slight 1 percent in 2006.  

For the current year, contracting for the overall category is expected to recede 2 percent to 107 million square feet – still a very strong level of construction. To become more competitive, a number of major hospital chains have undertaken huge capital expansion programs, which are continuing. And, the moratorium on specialty hospitals has been lifted, which could generate greater clinic construction over the next few years. 

Most of the smaller institutional categories registered growth during 2006. The public building category increased 1 percent to 34 million square feet, helped by increases for detention facilities and armories/military buildings, and a 20 percent gain is forecast for 2007.  

Amusement-related starts climbed 7 percent to 72 million square feet last year, the result of more convention-center work and miscellaneous amusement projects such as theme parks, and this volume should be maintained in 2007. Transportation terminal work advanced 10 percent last year, and steady contracting is expected for 2007. In contrast, church construction in 2006 slipped 7 percent, and another 3 percent decline is predicted for 2007.

Single-Family and Multifamily Housing

Single-family housing starts achieved a record level of 1.626 million units in 2005, as several factors worked together to create extraordinary conditions on both the supply and demand sides of the market. In 2006, however, these conditions weakened, causing the market to unravel. Starts fell 18 percent in 2006 to 1.331 million, and 2007 will see another 19 percent decline to 1.075 million. 

The record volume of single-family starts in 2004 and 2005 reflected the strength of investor-led homebuyer demand. According to the National Association of Realtors, homes purchased for investment purposes comprised 28 percent of sales in 2005. However, as overheated markets witnessed slower price appreciation and in some cases price declines, investor-led demand took a hit. It’s estimated that home sales for investment purposes plunged 29 percent in 2006, greater than the 10 percent drop shown by new and existing home sales combined. 

Furthermore, the greater use of unconventional mortgages had brought more homebuyers with marginal financial qualifications into the market, and demand from this group has been sharply curtailed with rising foreclosure rates and the crisis in the subprime mortgage market. Guidelines issued by federal bank regulators at the end of June – requiring lenders to underwrite loans based on a borrower’s ability to make payments on a loan’s adjusted rate (not just the low introductory rate) – will provide more restraint on overall homebuyer demand. 

The latter half of 2006 saw a glut of unsold homes emerge that has persisted into 2007. The months’ supply of new homes for sale climbed to 8.3 months in March, the highest reading in over 16 years, before easing back to 7.1 months in May. The months’ supply of existing homes for sale reached 8.9 months in May, the highest reading in the eight years this series has been reported.  

The cost of financing has also moved up – after starting 2007 at 6.2 percent, the 30-year fixed mortgage rate reached 6.7 percent at midyear. With these negatives, single-family housing is not likely to see much improvement in the near term. The worst of the decline for single-family housing starts may have passed, but renewed expansion is still a few quarters away, and will be initially modest. 

Multifamily housing starts reached an 18-year high in 2005 at 525,000 units, and during 2006 this category slipped just a modest 2 percent to 514,000 units.  

At mid-decade, the for-sale side of the multifamily housing market (condominiums and townhouses) had charged ahead, thanks to mortgage rates that were remaining expectedly low. The rental market also showed improvement, as affordability issues on the owner side of the market bolstered the demand for rental apartments.  

There were signs, however, that the condo boom began to wind down in 2006. Several major markets that had earlier witnessed very strong condo development began to show reduced activity, including: Washington D.C., down 25 percent; Miami, down 22 percent, and Atlanta, down 10 percent. At the same time, New York City (the largest multifamily market) was down just a slight 1 percent, and gains of 20 percent or more were reported in such diverse markets as Chicago, Dallas-Ft. Worth, Las Vegas, Los Angeles, Orlando and Seattle. 

Additional evidence that the condo market has passed its peak can be found in the existing home sales data from the National Association of Realtors. Condo sales reached a high in 2005 when they grew 9 percent to 896,000 units. In 2006, sales fell 11 percent to 801,000 units, a level that was not only below 2005 but also below 2004 (820,000).  

At first, there were signs that the rental side of the multifamily market was the beneficiary. However, with more condos being shifted to rental units, the rental vacancy rate began to rise, finishing 2006 at 9.8 percent, to be followed by 10.1 percent in the first quarter of 2007. The current year is also seeing more widespread weakening for condos, with declines in such previously strong markets as New York, Chicago and Los Angeles. As a result, it’s forecast that multifamily housing in 2007 will slide 14 percent to 440,000 units.

Public Works/Electric Utilities

The public works sector registered healthy expansion in 2006, climbing 16 percent to $110.7 billion. This strength is the result of an improved fiscal posture of the states, environmental mandates, and the long-awaited passage of the new multiyear federal highway bill, SAFETEA-LU.  

In 2007, the public works sector continues to be supported by a greater volume of transportation projects, given the increased funding called for by SAFETEA-LU. The environmental categories are expected to see a slightly slower rate of increase in 2007, following the surge of work in the prior two years. And, site work and miscellaneous public works projects, including outdoor sports stadiums, are expected to recede this year after the 34 percent jump in 2006. As a result, public works in 2007 will advance by a more restrained 3 percent. 

Highways and bridges received a boost in 2006 from SAFETEA-LU, which provides 38 percent more funding over the six-years it is authorized (2004-2009) than the prior six years of its predecessor. In 2006, highway and bridge construction climbed 14 percent to $50.8 billion, helped by the 5-percent increase in appropriations passed by Congress plus the improved fiscal position of the states.  

However, while the current dollar amount of highway and bridge construction has shown healthy growth, in real terms the volume of construction has been eroded by higher costs. The composite price index for highway work compiled by the Federal Highway Administration jumped 17 percent 2005 and another 21 percent in 2006.
 The 2007 prospects for highway and bridge construction, in current dollar terms, remain favorable. After continuing resolutions kept federal funding at status-quo levels from October 2006 through early 2007, Congress agreed in February to a 10 percent increase for the federal-aid highway program.  


One major project reported as a construction start this year is the $1.4-billion suspension span of the San Francisco-Oakland Bay Bridge, plus there will be additional work for such ongoing programs as the Trans-Texas Corridor. As a result, highway and bridge construction in 2007 is estimated to rise an additional 6 percent to $53.9 billion. 

Environmental public works in 2006 grew 6 percent to $33.3 billion, following a 16 percent surge in 2005. Two categories continued to see strong expansion last year, with river/harbor development up 17 percent and sewers up 10 percent. However, water supply construction fell 5 percent from its heightened amount in 2005. The environmental group in 2007 is expected to rise 5 percent to $34.8 billion, as sewer construction rises more slowly after five straight years of expansion. 

Of the environmental categories, river and harbor development received considerable visibility since Hurricane Katrina devastated the Gulf Coast region in August 2005. The river/harbor development category jumped 20 percent in 2005 to $7.2 billion, and another 17 percent in 2006 to $8.5 billion, due largely to spending by the U.S. Corps of Engineers on hurricane-related repair and reconstruction.  

For 2007, contracting is expected to remain at $8.5 billion. The $1.3 billion allocated in the 2007 supplemental federal spending bill for the Corps of Engineers to upgrade New Orleans levees will help contracting for this project type stay at a high level. 

Electric utility construction in 2006 soared 76 percent to $13.6 billion, substantially moving beyond the lackluster activity of 2003 through 2005, when contracting averaged $8.0 billion per year.
 In 2006, a number of massive power plants reached the construction start stage, covering a range of generating sources. The top five power plants by size were all coal-fired facilities, but 2006 also saw a number of gas-fired plants.  


The outlook for electric utilities in 2007 calls for a pullback from the exceptional volume reached in 2006, as contracting slips 7 percent to $12.7 billion. This would still be the second highest amount for this category over the past five years.


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