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

Summary: Despite continued problems in credit markets, design work at architecture firms continues apace at near record levels. The gains in billings in July were matched by an upturn in inquiries for future work, indicating that design firms should see solid workloads for the next several months. However, the July numbers don’t reflect emerging concerns in credit markets that may yet threaten nonresidential design and construction activity. Until these problems are resolved, architecture firms would be well-served to monitor the financing status of projects very closely. Additionally, the recent interest in merger and acquisition (M&A) activity that has hit design firms is largely driven by the desire to open new markets for future growth.

July brought another strong upturn in business conditions at architecture firms. The AIA’s Architecture Billings Index for the month was an even 60; the highest reading since September of 2005, while the index score for inquiries for new work was above 66. Firms in all regions are reporting strong billings, with those in the Northeast and West recording particularly positive conditions. Commercial and industrial firms saw a solid increase in business conditions in July, and institutional firms—which are typically more stable—reported a climb in the billings index score for this sector to above 60 for the first time since late 2005.

Credit concerns loom
The generally favorable economic reports in recent weeks have been overshadowed by turmoil in credit markets. The problems began earlier this year as loans to homebuyers with poor credit histories (the subprime lending market) saw increasing default rates because the adjustable rate mortgages of these borrowers began to rise, generating monthly payments beyond levels that they could afford. Concern over these loans has expanded well beyond high-risk residential loans, and currently is affecting:

• Low risk residential markets (e.g., “jumbo” loans that borrowers take for more expensive housing)
• Second mortgages that homeowners take for remodeling projects
• Bond issuances for institutional projects
• Commercial loans for speculative office and multifamily rental projects.

Although most analysts feel that problems in the credit markets for nonresidential projects will be resolved favorably given the strong fundamentals in these sectors, it does appear that there may be delays in some projects until these financing jitters are calmed.

Once the credit market picture is clearer, the overall health of the economy will be easier to determine. The strong GDP number for the second quarter (an inflation-adjusted 3.4 percent when seasonally adjusted and annualized) is a source of optimism. The increase in house prices in recent years has supplied homeowners with a lot of equity to supplement their income, but with house prices stabilizing and even declining in some markets, consumers will be spending less. The result is that the economy will continue to feel the effects of a slowdown in the residential sector.

Interest in mergers/acquisitions grows
In recent months, there have been several high profile mergers and acquisitions of U.S. architecture firms. Among our Work-on-the-Boards panel of architecture firms, about one in six indicated that they had either acquired another firm, merged with another firm, or actively considered one of these two activities within the past two years.

When asked as to the most important reasons for the recent interest in merger and acquisition activity, more than 40 percent of firms put “opportunities to open new markets to promote future growth” at the top of the list. “Greater project diversity to hedge against economic cycles/construction cycles,” “general desire of firm to be bigger and more dominant,” and “acquired firm has unique credentials that are desirable to acquiring firm” also were each listed by at least 10 percent of respondents as the most important reason for this renewed M&A activity.

Residential firms were more likely than other types of firms to list “hedge against economic cycles,” and “efficiency and profitability associated with larger firms” as the most important reason. Commercial/industrial firms were more likely to list “desire to be bigger/more dominant” and “client desire for multiple disciplines at design firms.” Institutional firms were more likely to list “unique credentials of acquired firm,” and “current strong financial health of architecture firms.”