by Kermit Baker, PhD, Hon. AIA,
Chief Economist

After a reasonably strong performance during the second half of this year, 2006 looks to be easily the best year for nonresidential construction since 1998. Overall nonresidential construction activity is expected to increase 7.9 percent next year after adjusting for inflation, on top of a 3.7 percent increase this year. Commercial construction activity is anticipated to grow by over 9 percent next year, with double-digit gains in office and hotel facilities. Increases in institutional construction activity are expected to be a more modest 4.4 percent next year, with gains of 6 percent or more in the education and health-care facilities sectors.

These are some of the key conclusions from the most recent AIA Consensus Construction Forecast Panel. The leading national nonresidential construction forecasters are uniformly very optimistic about the nonresidential outlook for 2006, with all members of the panel anticipating gains of 3.5 percent or more next year. All members of the panel expect to see significant gains in nonresidential construction activity this year, although the current consensus for growth has eased somewhat from the optimism of our last survey in late 2004.

AIA Consensus Construction Forecast Panel—
Second Half, 2005
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U.S. economy moving ahead, but cautionary signals develop
Rising oil prices, rising federal deficits, and unfavorable weather conditions have all contributed to an erratic first half for nonresidential construction activity. McGraw-Hill Construction reported a 9 percent decline in nonresidential construction contract awards through the first five months of the year, while the Commerce Department reported a 3.5 percent increase in nonresidential spending over the same period. Neither of these figures is adjusted for inflation.

Indicators of the health of the broader economy reflect these problem areas. Our economy is growing at about a 3.5 percent pace through the first half of the year, after increasing 4.4 percent last year. We’ve added just over a million payroll jobs to the economy in the first half of the year, just below the pace of growth in payrolls for 2004. In an effort to rein in inflation and prevent the economy from becoming overheated, the Federal Reserve Board has been raising interest rates. Short-term interest rates have increased from 1 percent at the beginning of 2004 to about 3.25 percent at present, and are likely to be at or near 4 percent by the end of the year. However, the steady progression in short-term interest rates has not translated to higher long-term rates. Yields for 10-year Treasury bonds have held fairly steady over the past several quarters and are actually lower now than they were a year ago. This offers attractive financing opportunities for the construction industry.

Still, actions by the Fed pushing up short-term rates are likely to keep economic growth within bounds and limit overall inflation in our economy. However, price swings are likely to continue to be prevalent in some sectors. Oil prices show no signs of retreating, and within the construction industry we are likely to see continued fluctuations in commodity prices like we have seen in steel, cement, insulation, wallboard, and lumber in recent quarters.

Commercial construction recovery picks up strength
After four years of decline, commercial construction activity finally began its recovery last year. This year, our forecast panel is expecting gains of over 5 percent in this sector, with growth accelerating to over 9 percent next year.

The office market is expected to grow somewhat faster than the overall commercial sector. Rising office employment is reducing office vacancy rates and encouraging additional construction of office buildings in many key markets. Office vacancy rates stood at 15.4 percent nationally in the first quarter of this year, according to CB Richard Ellis, down from 16.0 percent in the fourth quarter of 2004 and 16.8 percent in the first quarter of last year. Suburban locations have seen the greatest declines, with vacancy rates nationally falling from 17.9 percent to 16.3 percent between the first quarter last year and the first quarter this year.

Hotels are the other commercial segment generating enthusiasm from our forecasting panel. Last year, hotel occupancy rates rose to 61.3 percent from 59.1 percent in 2003, and revenue per room rose 7.8 percent over the same period according to Smith Travel Research. Occupancy rates were highest for luxury hotels, adding more pressure to the upper-end of the market. Our forecast panel expects a 12.7 percent increase in office construction next year, on top of 5.5 percent this year.

Retail facilities are expected to see solid, if unspectacular, gains for the remainder of this year and next. A strong home-building market throughout the first half of this decade generated steady opportunities for retail construction, so our panel is expecting mid-single-digit growth in this sector through 2006.

Institutional construction lags commercial activity
Institutional construction levels tend to remain more moderate through the construction cycle. The broad range of facilities covered in this category (education, health care, religious, public safety, and amusement and recreation, among others) coupled with the wide array of funding sources used helps to ensure that year-to-year swings are within a much narrower range than commercial construction.

Staying true to form, our forecast panel is expecting fairly typical levels of construction activity over the next 18 months for these facilities. Growth in construction is expected to be just around 2 percent this year, before accelerating slightly to more than 4 percent next year.

The largest pieces are also expected to be the healthiest next year. As health-care costs account for an increasingly large share of our economy, spending on health-care facilities likewise will grow. Our forecast panel expects this sector to grow by more than 6 percent in 2006. Strong demographics, coupled with an improvement in the state and local budget situation, also will generate a 6 percent increase in education construction activity, according to our panel. The other institutional construction categories are expected to see more modest increases next year, but well into the positive range for all categories.

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