june 29, 2007

After a Strong 2007, Nonresidential Construction Growth Projected to Moderate in 2008

Panel sees slowing in commercial, stability in institutional markets next year

by Kermit Baker, PhD, Hon. AIA
Chief Economist

Summary: Nonresidential construction activity is expected to have a strong year in 2007. Despite continued weakness in the residential sector, there have been solid gains in most nonresidential construction sectors so far, and robust conditions are expected to continue for the remainder of the year. The AIA Consensus Construction Forecast Panel is projecting growth of 7.2 percent in nonresidential construction activity (after inflation adjustments) this year, with an almost 9 percent jump in commercial activity, and a healthy 5.4 percent increase in institutional facilities. Next year is projected to see much slower gains, but gains nonetheless. Commercial construction is expected to edge up another 1.1 percent, with institutional activity growing by 4.5 percent, producing almost a 3 percent gain in total in activity for 2008.

Outlook has growing list of concerns
Supporting this growth in nonresidential construction has been a healthy national economy. Businesses have been adding jobs at a solid pace, given that we are six and a half years into this economic expansion. The national unemployment rate is 4.5 percent, very low by historical standards. Even with all this growth to date, businesses continue to reinvest in their operations. Businesses have been increasing their investment at the pace of 6 percent to 7 percent per year since early 2004, about twice the rate of growth in the broader economy. One result of this added investment is that U.S. products and services are becoming more competitive in international markets. U.S. exports have been growing at a very healthy pace in recent years; enough so that our trade balance has been slowly declining in recent quarters.

Construction Consensus Forecast—2008


Compare consensus to the forecast of various panel members above.

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• Portland Cement Association figures represent billions of 1996$, all other sources show billions of 2000$.
• Moody's Economy.com figures for Healthcare represent Public Healthcare only.


However, there is a growing list of concerns in the economic outlook. The housing market continues to deteriorate and is not only slowing the economy directly, but rising concerns over falling home prices may encourage consumers to cut back on their spending in the future. Also, there is growing concern that inflation may begin to accelerate in our economy. High oil prices continue to add pressure to inflation, and long-term interest rates have begun to trend up recently. Inflation in building commodity prices has been a major source of disruption to the construction industry in recent years, but fortunately fluctuations in commodity prices have begun to moderate recently.

Part of the reason for settling commodity prices is the weak housing market. Materials heavily used in the residential sector—lumber, OSB and plywood, and wall board—have all seen double-digit price declines over the past year. Also, other materials used heavily in the nonresidential sector that have fluctuated significantly in recent years—such as concrete, copper, and aluminum—have all seen much more moderate price increases recently. However, there are a few materials that have seen double-digit price increases over the past year, including asphalt paving mixtures and steel mill products. Overall, though, materials used in nonresidential construction have increased a tolerable 3.2 percent over the past year.

Strong start for 2007
Though most members of the AIA Consensus Construction Panel were expecting a good year for nonresidential construction in 2007, so far this year activity has largely exceeded even the most optimistic outlooks. The U.S. Commerce Department reports that nonresidential construction spending increased 12.7 percent in April of this year, compared to April 2006 figures (the government figures don’t account for increased costs of construction). The commercial construction markets were particularly strong, with lodging construction up almost 60 percent over this period, office construction up 25 percent, and other commercial activity (stores, banks, etc.) up almost 13 percent. The institutional sectors haven’t been able to match the growth on the commercial side, but their numbers also have been impressive. Health-care spending increased almost 15 percent over the past year, education construction was up almost 12 percent, and public safety facilities increased by over 17 percent.

The recent readings by the AIA’s Architecture Billings Index (ABI) point to healthy activity for the remainder of the year. The ABI reading for May jumped to 55, up from 52.7 in April. Computed as an index where any score above 50 indicates growth in design billings at U.S. architecture firms, the ABI strongly suggests growth for the remainder of the year and into 2008, since design activity at architecture firms has traditionally led nonresidential construction activity by 9 to 12 months.

Commercial to moderate in 2008
However, the strong run-up in nonresidential construction activity that began in early 2005 looks to be entering a new phase of the cycle beginning next year. On the commercial side, all major sectors are projected to see slower growth in 2008, while the institutional sectors will continue to experience moderate growth levels.

Spending on the construction of office buildings will climb over 11 percent this year before inflation adjustments, according to our Consensus Forecast Panel, before slowing to a 3.5 percent increase next year. The national office vacancy rate was at 12.8 percent at the end of the first quarter, according to reports from CB Richard Ellis. Though at a very favorable level, there are signs that it may be reaching bottom for this cycle in many markets. The first quarter figure was up from 12.6 percent nationally at the end of 2006, and office vacancy rates increased from 13.6 percent to 13.9 percent in the usually more volatile suburban locations. This overall uptick was the result of almost 12 million square feet of office space constructed nationally, but less than 10 million square feet of net absorption nationally during the quarter.

Retail construction activity has seen more modest gains recently. Spending is projected to increase 3.5 percent this year and may experience a small decline next year according to our forecast panelists. Retail construction is the sector most closely connected to residential activity, since stores generally are added shortly after housing subdivisions are completed. With housing expected to see another year of weak activity next year, retail construction activity is expected to moderate also. Some of the major retailing chains, such as Wal-Mart, Home Depot, and Kohl’s, have recently scaled back on their expansion plans.

Hotel construction has been the strongest nonresidential construction sector recently, with spending activity projected to climb by over 26 percent this year. However, once this current spate of projects is completed, activity is projected to level off, with almost no gains forecast by our panel for 2008. Much of the current surge has been fueled by a round of casino construction, which is expected to slow in the near future. McGraw-Hill Construction reports data from Torto Wheaton Research indicating that the national hotel occupancy rate has been climbing, and will reach 68.7 percent this year. However, occupancy rates are expected to ease off somewhat moving forward.

Institutional to stabilize near current growth rates
Institutional construction sectors are projected to show less volatility in 2007 and 2008 than commercial facilities. Institutional construction spending is expected to increase just over 5 percent this year before barely easing back to 4.5 percent in 2008, according to AIA panel members. Additionally, the consensus growth for the major institutional construction categories is in the 4 percent to 5 percent range of growth for 2008.

Even with rising long-term interest rates, the financial position of state and local governments is strong enough to support continued growth in educational construction. Also, according to McGraw-Hill Construction, the education market has benefited more than any other sector from the recent interest in sustainable “green” design. As a result, AIA panel members expect a 4 percent increase in education construction in 2008, coming on top of 5.9 percent growth this year.

Health care is expected to see even stronger growth. With recent emphasis on increasing health-care coverage, including several state mandates for universal or near-universal coverage, health-care construction has become one of the fastest growing institutional construction categories. Panel members are projecting an 8.5 percent increase in spending this year, followed by an additional 5 percent gain next year.

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