Features

January/February 2008

Industry Pullback But No Plunge

Neither boom nor bust predicted for commercial construction markets in 2008

By Bruce Buckley

The national hospitality market should see a slowdown in 2008, despite the start of mega projects like the 1.8-million-sq-ft Fontainebleau Hotel and Casino in Las Vegas.

These are sobering days for the construction industry. A year ago, many industry observers forecast that construction starts after years of record highs were headed for a slight cool-down in 2007. After peaking at $682.5 billion in 2006, the slumping residential market was expected to drag total construction starts down. Current data suggest that the 2007 market correction was even deeper than predicted, with overall declines expected to continue through 2008.

McGraw-Hill Construction, which publishes this magazine, estimates that the industry experienced an 8% decline in construction starts in 2007, and another 2% drop is forecast for 2008. Total construction start values are expected to hit $626.7 billion for 2007 and $614.1 billion in 2008.

Last year, MHC predicted that starts in 2007 would drop 1% as the single-family home market weakened and other sectors, such as institutional work, remained strong.

Robert A. Murray, vice president of economic affairs at MHC, says turmoil in the subprime mortgage market that emerged in ugust created a major concern for the construction industry and the overall economy. He adds that tightening lending conditions will impact development in both residential and commercial real estate.

As a result, Murray predicts downturns in the previously resilient multifamily and commercial segments, as well as continued weakness in single-family home construction. “The credit crunch is the biggest threat to the construction industry going into 2008,” he says.

Home, Not-So-Sweet Home

Single-family home construction remains the main drag on overall construction starts, experiencing a 25% plunge in 2007, according to MHC estimates. Tightening lending standards coupled with a large inventory of unsold homes has eroded demand heading into 2008 and beyond, according to analysts.

Murray says he expects housing prices to bottom out in mid-2008, paving the way for a future rebound. Still, 2008 could see single-family housing starts drop 3% to $198 billion, the first time values have fallen below $200 billion since 2001.

Bernard Markstein, senior economist and director of forecasting at the National Association of Home Builders, agrees that starts could rebound slightly in mid-2008, but he says the market will still see an overall 13% drop for the year.

Markstein says that recently hot markets like California, southern Florida, Phoenix, Las Vegas, the Washington, D.C. area and several East Coast resorts have the most oversupply and will take the longest to bounce back. While most of the rest of the country is in good balance on inventories, Markstein says that the uncertain lending market has a chilling effect across all regions.

“Some areas aren’t quite so bad in terms of inventories, but all areas are feeling the tightening lending standards,” he says. “As a result, even good areas like Texas, the Carolinas and the Northwest that haven’t seen overbuilding and have good job growth are showing weakness because it’s harder to get a loan.”

Ed Sullivan, chief economist at the Portland Cement Association in Skokie, Ill., is even less optimistic. PCA is not expecting a recovery in housing until mid-2009.

PCA’s 2008 Cement Outlook forecast suggests that “low home sales, increased foreclosures and persistently high inventories imply a deeper and more prolonged retraction in new home starts activity.”

Multifamily housing is also feeling the credit crunch. In 2007 the value of starts dropped 12% to $61.4 billion, and another 8% slide is expected in 2008, according to MHC forecasts. NAHB predicts similar drops in the sector with a 7.6% decline in 2008.

A Measured Pullback

Commercial construction also appears to be heading down the other side of the hill. MHC’s Murray says that after record value increases of 27% in 2006 and 7% in 2007, the sector has peaked. Although the United States continues to have solid employment numbers, the credit crunch could have an impact on commercial work. MHC is forecasting that construction could drop 6% to $91.1 billion in 2008.

“Our take is that as a result of the credit crunch, there will be some dampening on the commercial side,” Murray says. “The marginal projects will be affected but not those with solid financials. What seems to be shaping up is a measured pullback in commercial building for 2008, as opposed to a precipitous decline.”

After several solid years of growth, office starts are expected to retreat in 2008. Office projects took off in 2006, growing 22% to 205 million sq ft, and the good times continued through 2007, with starts estimated at 215 million sq ft, according to MHC. Although vacancy rates have remained low in many markets, growth in office workers is slowing, Murray says. That, combined with lending concerns, should result in an 8% decline in starts for 2008, he says.

Although historical data suggests that as housing declines, so goes the retail sector, Murray says that stores and shopping centers have been remarkably resilient. But the sector saw a starts drop from 304 million sq ft in 2006 to 301 million sq ft in 2007.

In 2008, however, the impact will be more pronounced as retail starts will drop to 270 million sq ft, Murray says. He adds that several major retailers such as WalMart and Home Depot have slowed their expansion efforts.

Hotels are also set for a slowdown after booming in recent years. In 2006, hotel starts jumped 68% to 82 million sq ft, then held steady in 2007 at 81 million sq ft. Prime destinations continued to kick off major projects in 2007 such as the 1.8-million-sq-ft Fontainebleau Hotel and Casino in Las Vegas and the 1.2-million-sq-ft Hilton Orlando Convention Center Hotel in Orlando.

Although revenues per available room have been solid, they are retreating and Murray expects the sector to see starts drop to 70 million sq ft in 2008.

Some Stability in Forecast

While commercial work will be challenged in 2008, Murray says that institutional work should remain largely stable, with start values growing 4% to $118.7 billion.

The educational building sector has stayed steady with 230 million sq ft of starts in 2006 and 222 million sq ft in 2007. Murray says that school districts continue to pass construction bond measures, particularly in California, while colleges and universities have increased capital spending, thanks to a healthy stream of endowments. Murray forecasts 232 million sq ft of starts in 2008.

Growing demand from baby boomers for health services has driven health-care work to record levels in recent years, but it appears to have peaked. In 2006, starts reached a record 109 million sq ft, up 1% from the previous year, according to McGraw-Hill Construction. The market began to cool in 2007, dropping to 100 million sq ft with clinics and nursing homes seeing the sharpest declines.

With projects now falling under greater financial scrutiny in light of the current credit crunch, Murray expects a further retreat to 98 million sq ft in 2008.

After experiencing a 40% surge in 2007, thanks in part to considerable development of ethanol plants, the manufacturing sector will retreat by 11% in dollar volume to $16.5 billion in 2008, MHC predicts. Murray says that while ethanol production has greatly expanded, the distribution systems aren’t in place to deliver product, and many developers are beginning to temper plans.

While much of the private sector worries about the credit crunch, the public sector appears stable as many state and local governments remain fiscally strong, Murray says. Public works will realize a 3% gain to $120.95 billion in 2008, according to McGraw-Hill. Infrastructure Growth Highways and bridges are predicted to be a major contributor to growth, as renewed interest has been expressed in Congress for infrastructure improvements after the Interstate 35W bridge collapse in August in Minneapolis. Public-private partner-ships also continue to offer additional revenue sources. Murray says the sector will see a 5% increase in construction starts to $56.9 billion in 2008.

Although the construction industry appears to have finally reached the end of its boom, Murray hesitates to call it a bust. Compared to historical cycles when work would surge and retreat, Murray says the construction industry has seen much more stable activity overall in recent decades. Despite the bubble-burst in residential construction, nonresidential work remained largely sound, he adds.

“The stable construction cycle has hit a speed bump over the last couple of years,” Murray says. “The boom and bust for single-family housing has called that stable construction notion into question. [But] if you look at nonresidential building, it’s been a more moderate pattern . I would say that for nonresidential, we seem to have learned from the lessons of the past and that stable construction pattern still holds.”