by Kermit Baker, PhD, Hon. AIA
Chief Economist

Despite several concerns with the fundamentals of the nonresidential construction market—including rising short-term interest rates, ongoing inflation in key construction materials prices, and recent concerns over the economic outlook—the AIA Consensus Construction Forecast Panel is expecting solid levels of activity through the remainder of 2006 and through 2007. After adjusting for inflation, the AIA panel is anticipating a 6.3 percent increase in nonresidential activity in 2006, and an additional 6.2 percent next year with growth evenly balanced between the commercial/industrial and institutional sectors. If achieved, this would be the best two-year period for nonresidential construction activity since this market grew by about 30 percent in 1997–1998.

Construction Consensus Forecast—Second Half 2006

Questions looming in the economic outlook
The optimism of the AIA Consensus Forecast Panel comes despite recent evidence of softening in the broader economy. The Federal Reserve Board has raised short-term interest rates by four percentage points since 2004, which has cooled off the stock market and other interest-sensitive sectors of the economy, such as housing and auto sales. Overall inflation in consumer and producer prices has begun to increase while it continues for several key building commodities.

For the 12 months ending in May 2006, prices of materials and components for construction activity increased 7.8 percent, slightly up from the 6.1 percent for the 2005 calendar year as a whole, but down from the 10.1 percent increase in 2004. For some construction commodities, the increases over the past 12 months have been breathtaking: almost 87 percent for copper and brass mill products, over 26 percent for gypsum products, almost 13 percent for aluminum mill products, over 11 percent concrete products, and significant increases for virtually all petroleum-based construction materials (asphalt, plastic construction products, and plastic composites).

There are concerns over the broader economy that extend beyond inflation. Payroll employment growth has slowed in recent months. After increasing by an average of 165,000 a month during 2005, growth accelerated to 176,000 during the first quarter of the year. However, so far in the second quarter, payroll growth has slowed to an average of 100,000 per month. Payrolls at construction firms have followed a similar trend. Average monthly increases were about 25,000 for 2005 and kept at that level through the first quarter of this year. So far, second quarter increases have averaged less than 10,000 additional jobs per month.

Slower job growth and rising oil prices have taken their toll on the consumer’s sense of well-being. Consumer sentiment scores as measured by the University of Michigan trended down throughout 2005 before rebounding slightly at the end of 2005 and through the first quarter of this year. However, second quarter figures eased again, with average readings back to where they were during the fourth quarter of last year.

No Katrina kick yet
As of six months ago, one of the keys to increased construction activity for 2006 and 2007 was rebuilding after Hurricane Katrina. However, the rebuilding in the affected areas has gone much more slowly than anticipated, as can be documented with residential construction trends. Almost 136,000 homes were lost in the Katrina affected areas of Louisiana, according to Red Cross estimates. In 2004, there were almost 5,800 new housing permits in these areas. In the nine months since the hurricane, there have been fewer than 2,500 new housing permits in these areas, so construction levels are not even back to pre-Katrina levels, much less at levels that serve to replace any homes lost.

The situation is not much better in Mississippi. Over 64,000 homes were lost in this state to Katrina, and there were over 3,600 new homes permitted in 2004 in the area eventually affected by Hurricane Katrina. In the nine months since, fewer than 3,000 new homes have been permitted in these areas, so residential construction in these areas is barely back to its pre-Katrina pace, with almost nothing added to compensate for lost units.

Regional construction outlook generally positive
The Federal Reserve Board recently released its overview of regional economic conditions. According to this report, all 12 Federal Reserve Districts indicate that economic activity continued to expand from mid-April to early June, but there were some signs of deceleration. Activity moderated in four districts—Atlanta, Kansas City, Richmond, and San Francisco—and the New York District noted increased concern about the outlook for the second half. Seven districts—Boston, Chicago, Cleveland, Dallas, Minneapolis, New York, and St. Louis—said growth was similar to the pace reported six weeks ago. The Philadelphia District, however, reported an improvement in overall economic conditions.

According to the Fed report, residential real estate markets continued to cool across much of the country—with most districts reporting slower homebuilding and sales of existing homes. In contrast, commercial real estate activity continued to strengthen in most districts. A few reports noted concern about too much building.

Commercial real estate activity strengthened in nearly all districts, with mostly positive reports about office markets. Commercial building “improved” in the Cleveland District. Office markets were steady or stronger in the New York City metro area, with scattered signs of accelerating rents. The Philadelphia District said vacancy rates have continued to decline in the region’s office markets. The Richmond District reported “fairly strong” office markets. Demand for office space “edged up at a steady pace” in the Dallas District. Office vacancy rates fell and rental rates rose in most major markets in the San Francisco District.

Boston reported that downtown office real estate markets were improving but mostly at the expense of suburban markets. Demand for commercial real estate in the Chicago District continued to expand, but the pace of new commercial construction slowed, according to contacts, who said rents were too low to justify new construction. The Kansas City District reported that commercial construction remained strong, but received a few reports that high material costs were resulting in the scaling down or postponement of some projects. Construction firms in the Philadelphia District reported that rising costs have caused some construction projects to be rebid or redesigned to reduce the amount of costly materials used. Some builders in the San Francisco District continued to face cost increases and minor project delays as a result of tight availability of skilled workers and selected materials, such as steel and cement.

The Philadelphia District reported growing demand for industrial space and an increase in construction of industrial buildings both on a speculative and build-to-suit basis. Demand for industrial properties was said to be gradually improving in the Dallas District. The Richmond District also reported growth in commercial leasing in the industrial sector.

Contacts in the Boston, Chicago, and Dallas districts expressed concern about the level of investment in some portions of the real estate market. The Boston District reported that New England—and Boston in particular—continues to attract large volumes of commercial real estate investment, resulting in price increases that require “ambitious assumptions” to justify the transaction. The Dallas District noted growing concern about overbuilding of condominiums and town homes in Dallas, and contacts “fear that it will end badly.” A contact in the Chicago District expressed concern about the potential for overbuilding of large distribution centers in Indiana.

Commercial/industrial sectors healthy; growth rate increasing for institutional buildings
Commercial and institutional buildings, which together account for two-thirds of nonresidential construction activity, have seen healthy gains so far this year. Our forecast panel is projecting inflation-adjusted gains of 5 percent this year and next for commercial facilities, and close to 17 percent this year followed by over 7.5 percent next year for industrial facilities.

Office construction—almost 11 percent of total nonresidential activity—has benefited from falling office vacancy rates nationally. Vacancy rates peaked nationally in early 2004 at almost 15 percent in downtown locations, and about 18 percent in suburban locations. The most recent readings from CB Richard Ellis show rates declining to 13.6 percent overall—12.3 percent downtown and 14.3 percent in the suburbs. Metro areas with the lowest office vacancy rates (Orange Co., Calif.; New York City; Palm Beach, Fla.; Honolulu; and Ft. Lauderdale) are heavily concentrated in coastal areas, whereas areas with the highest vacancy rates (Detroit; Dallas/Ft. Worth; Columbus, Ohio; Louisville; and Cleveland) are heavily concentrated in the interior regions, particularly the industrial Midwest.

Retail construction, the largest commercial sector accounting for over 20 percent of all nonresidential construction, has seen steady growth in recent years. With the unemployment rate falling and disposable personal income rising, our forecast panel is projecting an almost 4 percent increase in retail construction this year, and over 4 percent next year.

Hotel construction, at just over 3 percent of total nonresidential activity, has seen a dramatic improvement in construction levels in recent years. Our panel is projecting an increase of almost 11 percent this year, followed by another 6.5 percent next year.

Education construction is the largest institutional construction category, accounting for about 16.5 percent of total nonresidential building activity. Strong growth in enrollments, particularly at the high school and college levels, has pushed up construction levels. Our panel is projecting a 4.4 percent increase in educational construction levels this year, and an additional 7.4 percent next year.

Health-care construction, the other major institutional sector, accounts for over 7 percent of nonresidential construction activity. The aging of our population coupled with a modernization of existing health-care facilities—often spurred by industry consolidation—has produced strong numbers in recent years in this sector. Our panel is projecting a 6.3 percent increase this year in the construction of health-care facilities followed by an additional 5.0 percent next year.

The overall nonresidential construction sector is seeing the healthiest business conditions this decade. The AIA’s Architectural Billings Index indicates somewhat slower growth in design activity in recent months, which will translate into a slower pace of growth in nonresidential construction activity as we get into 2007. However, given that our broader economy continues to expand and given the current strong levels of construction activity in the planning and design stages, we can expect healthy levels of nonresidential construction activity to continue at least through next year.

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