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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   September 2003

Running Hard While Standing Still

The Outlook for the Economy and Construction

It is remarkable to note how much has happened in the past six months and yet how little has changed. To pick just four events, the U.S. did go to war with Iraq and won a lightning victory with none of the spillover or casualties that had been feared. Congress passed an enormous tax cut in less time even than in 2001. The Fed continued to lower short-term interest rates to a level not seen since the 1950s. And the stock market measures have climbed 10 to 20% or more. Yet the economy seems to be stuck right where it was. What gives?

Similarly, construction has worn two very different expressions in the last few months. If your business is tied to the housing sector—whether multi-family, new single-family, or resales, you’ve had a lot to smile about. But the nonresidential segments are nearly all looking sad. Whose countenance will change first? Will the new tax law or other policy developments make a difference?

Single and Multi-Family Residential Markets

In 2002, all residential markets were strong. Census Bureau figures on the value of construction put in place show that new single-family home construction was up by nearly 7% on top of a record 2001. Yet that was actually the laggard in residential markets. Multi-family construction put in place gained more than 7% and improvements to existing housing rose nearly 9%.

So far this year, the smile has actually brightened. Overall, residential construction is up by 9% for the first five months, compared to the same period in 2002. New single-family construction has grown 12%. Improvements have risen by 4% and new multi-family construction is 3% ahead of last year’s January-April period.

Going forward, the outlook is still sunny for single-family construction. Seasonally adjusted sales of new homes blew away past records in May, totaling 1.16 million, a whopping 18% above the May 2002 level. Year-to-date sales for the first five months are up 11%, with gains in all four regions. Inventories were the lowest ever, relative to current sales, just 3.5 months’ worth, implying strong homebuilding ahead. That dovetails with the National Assn. of Home Builders’ June survey of builders’ sentiment, which showed continued optimism, and with building permits, a reliable indicator of near-term construction, which were 3% higher in January-May than last year. The median new-home sales price in May was nearly 8% higher than a year before. Even though mortgage rates have risen from the 45-year lows they set a few weeks ago, they are likely to remain lower than they were at the same point last year, keeping the same-month comparisons of home sales favorable.

The latest quarter-point reduction in the Fed’s target for short-term rates may not reduce mortgage rates further but it will lower home-equity loan rates. That’s important for the home-improvement market. In addition, the high level of home resales (the third-highest rate on record in May, the National Assn. of Realtors reported last month) means lots of repairs and improvements, both by sellers trying to make their homes more salable and by buyers making them more to their taste.

But the third residential segment, new multi-family construction, has lost a lot of momentum and seems headed for negative territory. As noted, value put in place was over 7% higher in 2002 than in 2001 and 3% higher in January-May 2003 combined than in the same months of 2002. But permits for the first five months of the year were just 1% ahead of January-May 2002. Rising vacancy rates have cropped up in most metropolitan areas. Low mortgage rates and down payments enable tenants to move out of multi-family housing. Young adults who can’t find a job are moving back in with parents instead of renting. And the rising number of long-term unemployed persons also undermines the rental market. On the supply side, real estate investment trusts (REITs), which were an attractive investment when the stock market was sinking, are now less attractive, both because stocks have been performing better and because the new tax law provides more favorable treatment to stock dividends than to

REIT dividends. Thus, one source of funds for multi-family construction, as well as the pool of demand, appears to be shrinking.

A strong residential construction market also benefits nonresidential contractors and engineers, since a new subdivision requires land clearing and grading, streets and sidewalks, underground water, sewer and perhaps electrical or communications conduits, and often local schools, playgrounds and retail. Home sales and refinancing activity supports the market for mortgage, insurance and real estate offices and for landscaping and home improvement retailers and contractors.

Public Markets

Last year, the value of public construction rose 5%. But this year, public construction has risen only 0.6% from last year’s first five months. 

Educational construction and highways and streets account for more than half of public construction. Last year the state and local educational segment rose 12%, with elementary/secondary construction climbing 14% and higher education up 1%. So far this year, the state and local educational segment was flat, as K-12 construction has fallen 3% and higher education has risen 9%. But these figures are likely to reverse again. K-12 school districts have benefited both from record bond approvals at the polls in the past year and from rising residential property tax receipts in many districts. In contrast, public universities have been caught in the spending squeeze that is afflicting most categories of state and local spending.

The other major public construction segment, highways and streets, last year surpassed the record it had set in 2001 by 1% as pavement construction remained flat and bridges soared 10% (puns intended). For the first five months of 2003, highway and street spending was down 3%, with pavements sinking 6% and bridges rising another 13%. Federal-aid highway spending will be close to level for the next several months but state- and locally-funded expenditures will probably slip. Longer term, the outlook depends heavily on whether the public works committees in Congress can prevail over the Administration, the appropriators and the tax cutters.

The rest of the public sector will have a hard time holding the line, as state budget-balancing requirements will force cuts in a broad range of construction expenditures. In some cases, other priorities are taking money from new construction. For instance, state and local transportation facility construction rose 5% last year but has dropped 2% so far this year. Quite likely, some of the drop is because money was rechanneled into security personnel and equipment. In addition, the sharp cutback in air travel has depressed landing fees, concession revenues and taxes used to support airport expansion.

Because public projects take so long to break ground and so long to finish, the construction put in place figures are likely to tail off slowly as current projects finish up but then stay in the doldrums for several years until state receipts recover.

Private non-residential markets

This part of the construction world was a near-total disaster last year, shrinking 13%. There were only three bright spots: health care construction put in place climbed 14%; power, principally electric, was 6% higher; and private educational construction was up 1.5%. Unfortunately, the lights are rapidly going out on the electric power business and little else has moved to fill the void.

In the first five months of 2002, overall private non-residential construction is again down 10%. Health care has jumped another 16% but educational construction has fallen 6% and power is off 3%, dragged down by a 6% drop in electric.

Health care shows no signs of slackening, as business, governmental and consumer outlays will continue to fuel the entire health care market, including construction of hospitals, clinics and other outpatient facilities, and even drug and medical-device factories, labs and research facilities. A survey by Hewitt Associates suggests that HMO premiums for the coming year will stage another double-digit rise, and a likely expansion of Medicare now making its way through Congress also portends more healthcare spending. In contrast, private educational spending is likely to tail off until the donors who have bankrolled many facilities start feeling their portfolios are flush again. And power-plant construction will continue to decline as current projects wrap up, with nothing to follow for several years to come.

Meanwhile, some of the worst-performing sectors in 2002 have slowed their rates of decline in the first five months of 2003 but are still in bad shape: factories -43% in 2002,  -28% so far in 2003, offices -29% and –21%, lodging -29% and –11%, warehouses -24% and –14%, and shopping centers -16% and -4%. All of these types of construction, along with communications -8% and –19%, are likely to remain weak for the next several months, with very gradual improvement as the economy returns to health. A spate of reports since mid-June, including employment, manufacturers’ orders, industrial production and capacity utilization, the Fed’s “Beige Book” survey of regional economic conditions, and Manpower Inc.’s quarterly survey of hiring plans, all suggest that near-term growth will be modest at best and unevenly distributed by industry and region. 

The expanded small-business expensing and so-called 50% bonus depreciation may give a small boost to durable-goods orders but only if buyers believe they can put the equipment to profitable use. The biggest gainers from the faster writeoffs are leasehold improvements but they depend on having retail and office tenants to make them.

Wages and materials or equipment prices paid by contractors should remain well-behaved, as they were last year, with several notable exceptions: health-insurance, workers’ comp and other insurance and surety costs; natural gas and products dependent on it like plastic pipe; and perhaps oil.

The Last Word

The economy will dictate whether demand for non-residential construction picks up. Nobody puts up an office building or factory for the fun of it. And the new tax law makes it less taxing to buy equipment but doesn’t reward folks who can’t put it to profitable use. Thus, many contractors will have to depend on the residential market, at least indirectly, until other parts of the economy pick up.


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