by Kermit Baker, PhD, Hon. AIA
Chief Economist

We’re expected to get close to 5 percent real growth in nonresidential construction activity this year. After six years of recession-like conditions in the industry, 2006 is shaping up as the year that will launch a nonresidential expansion, picking up some of the slack from a cooling residential market. We should see the best year for this sector since 1998, with growth evenly balanced between the commercial/industrial and institutional sectors.

All major sectors will see at least modest improvement, with no single sector expected to generate a disproportionate share of the gains. The commercial/industrial sector should continue its long-awaited recovery, paced by solid gains in the office sector. On the institutional side, both the education and health-care sectors are projected to see substantial growth this year.

These conclusions are the consensus outlook from the AIA Consensus Construction Forecast Panel. Leading nonresidential forecasters supply their predictions to the AIA twice a year. The AIA has been organizing this effort for almost a decade.

Construction Consensus Forecast—First Half 2006

Economy staves off numerous challenges
The upturn in the economy has been the principal force behind the improvement in nonresidential construction activity. Even with constant threats of domestic terrorism, ongoing international tensions, and devastating hurricanes, the economy hardly showed any signs of faltering this year. Our economy grew an estimated 3.7 percent after adjusting for inflation in 2005 and should come close to matching that pace this coming year.

Like the overall economy, construction also held up, even in the face of strong international demand for construction materials as well as supply disruptions that caused fluctuations in oil prices and the availability and pricing of other construction materials. In fact, despite the considerable personal toll, the late-summer hurricanes are likely to offer extra growth in nonresidential construction activity once rebuilding gets under way in earnest. The hurricanes delayed some projects and caused others to be scrubbed in the affected regions during the second half of 2005. However, this delayed and lost activity will be more than offset by gains from rebuilding beginning around the second half of 2006 and continuing for several years.

Rising short-term interest rates may present the strongest challenge to the nonresidential construction expansion. The Federal Reserve Board has raised short-term rates by more than three percentage points since early 2004 in an effort to keep inflation in check. Some further hikes this year are expected, especially because the incoming chairman of the Fed, Ben Bernanke, has a reputation for being at least as diligent in fighting inflation as Chairman Greenspan.

Although nonresidential activity is headed up, the prospect of a residential slowdown seems increasingly likely. Homes are moving more slowly, and price gains have been easing since this past summer in many markets. A weak residential market usually leads to softness in key nonresidential sectors, but this time these historical relationships look likely to shift. Low mortgage rates have produced record-breaking homebuilding numbers in recent years, but a weak business investment environment held back nonresidential activity. Much of the anticipated nonresidential growth is catch-up from under-spending in recent years.

Regional economies seem to be strengthening in the South and West and stable or softening in many areas of the Northeast and Midwest. In the Northeast, the most recent Federal Reserve Board district summary (the Beige Book) reports that demand for commercial space in the Boston district remains flat and picked up a little in Philadelphia and New York City, although the New York City’s suburban markets slackened.

In the Midwest—a region vulnerable to the downturn in the U.S. automotive industry—office vacancy rates were reported as falling in St. Louis, with some signs of improvement in the Kansas City district. The Atlanta and Dallas districts in the South reported strong conditions, as did San Francisco in the West.

Balanced growth expected in major nonresidential sectors
The AIA Consensus Panel expects balanced growth this year: in the range of 4-5 percent overall for nonresidential construction, and also in that range for both the commercial and institutional sectors. Industrial construction is expected to advance around 10 percent.

Increases in office construction, as well as in the smaller hotel sector, are the drivers behind the optimism on the commercial side. Office vacancy rates, reported at 14.4 percent nationally in the third quarter of last year, continue to fall, according to reports from CB Richard Ellis. They are down from 14.8 percent in the second quarter and 16.3 percent from a year ago. Markets with office vacancy rates below 14 percent typically are considered as able to support more construction activity. Of the 50 markets tracked nationally by CB Richard Ellis, 23 have office vacancy rates below 14 percent, with 7 of these reporting rates below 10 percent. Of the markets with vacancy rates below 10 percent (Orange County, Calif.; Manhattan; Nashville; Palm Beach, Fla.; Honolulu; Ventura County, Calif.; and San Diego), most are coastal areas with high land costs.

The projected strong growth in industrial space also results from a significant downturn in available space. CB Richard Ellis’ national industrial availability index stood at 10.1 nationally in the third quarter of 2005, down from 10.2 in the second quarter and 11.2 a year ago. Areas with availability indexes below 7.0 (Salt Lake City, Long Island, Los Angeles, Palm Beach, Houston, Northern New Jersey, Cincinnati, and Mid-New Jersey) reflect the stronger industrial economies across the country.

The two largest institutional construction sectors—education and health care—are expected to provide most of the growth to this category this year. For education facilities, not only are demographics favorable for growing school enrollments, but rising house prices across most of the country have produced higher property-tax revenues in many jurisdictions, thereby generating more funds for school construction.

Health care, the second largest institutional sector, is also projected to see reasonably healthy gains this year. Increases in employment—1.75 million workers were added to payrolls in 2005—have increased the number of families with employer-assisted health plans. Given continued consolidation in major hospitals and growth in HMOs and other health plans, much of the growth in construction facilities is likely to come from smaller-scale health facilities.

Overall, look for 2006 to be a positive year for nonresidential construction activity. Given the projected slowdown in residential activity and the general sluggishness in consumer spending, nonresidential construction is likely to be viewed as one of the key drivers to the economy for 2006 and well into 2007.

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