Architecture Firms Struggle with the Economic Outlook for 2008
With sufficient caution and by asking the right questions, we should get through it without much damage

by Kermit Baker, PhD, Hon. AIA
Chief Economist

Summary: As we enter 2008, the outlook for the economy has become more uncertain. The debate among economists has changed from one of whether the economy will weaken, to one of how much it will weaken as we move through the year. As such, there is more concern now about when we will see a downturn and whether it will be a soft landing or a recession.

The national economy clearly has turned more negative in recent months. Inflation has begun to accelerate, fueled by oil prices that are hovering around $100 a barrel. The housing market continues to spiral downward, and recent defaults among homeowners have sparked a broader crisis in credit markets. The employment outlook recently has softened, and the national unemployment spiked up to 5.0 percent in December, after staying below this level for all of 2006 and the first eleven months of 2007. In response, the University of Michigan’s Consumer Sentiment index dropped to 75.5 in December, after beginning the year at 96.9.

In the face of an economy with a growing number of liabilities, we have a nonresidential construction industry that is enjoying very healthy conditions. The U.S. Commerce Department reports that spending on nonresidential facilities increased an estimated 18 percent last year. Even with the rising costs of many construction materials and products, as well as increases in construction labor costs, inflation-adjusted spending on nonresidential facilities grew at a double-digit pace, about four times as fast as is estimated for the broader economy.In the face of an economy with a growing number of liabilities, we have a nonresidential construction industry that is enjoying very healthy conditions

The AIA’s Architecture Billings Index (ABI), which measures current design activity and therefore future construction activity, indicates that the industry ended the year with a lot of momentum. The overall ABI reading was 55.4 in December (any reading above 50 indicates growth), while the index for commercial and industrial facilities was 62.1, one of the strongest readings in the 12 years that the AIA has been computing this index.

Reading the tea leaves
All of this apparently conflicting information makes it very difficult for an architecture firm to plan for the coming year. Who is one to believe? Your marketing team, who says that inquiries for new work are coming in at a strong pace? Your financial team, who says that project backlogs are high and that the firm’s financial position is healthy? Or the pundits, who say that the U.S. economy is headed for recession, probably in the first half of this year?

Businesses need several quarters or years of healthy business conditions before they invest in new or renovated facilities

It’s possible that everyone is right. Construction economists point out that nonresidential construction is a sector that “falls late in the business cycle.” What this means is that when an economic expansion begins, we don’t see a lot of investment in new facilities. Businesses need several quarters or years of healthy business conditions before they invest in new or renovated facilities. Once they reach this point, however, we generally see strong levels of construction even if the economy has begun to weaken.

Our current business cycle is an excellent case in point. The current economic expansion began at the end of 2001, after a relatively short and mild national recession. However, government figures indicate that the current nonresidential construction expansion didn’t begin until around the second half of 2005. In 2006 and 2007, when the economy was seeing healthy but slower growth, spending on nonresidential facilities was accelerating.

Although nonresidential construction activity generally sees slower growth at the beginning of an economic cycle and stronger growth at the end, it also can turn very quickly

Although nonresidential construction activity generally sees slower growth at the beginning of an economic cycle and stronger growth at the end, it also can turn very quickly. Again, our most recent cycle is a good example. The ABI was very strong through the end of 2000. The overall reading was 54.9 in December of 2000, with readings above 50 every month in 1999 and 2000. However, in January of 2001, the ABI dropped 10 points to 44.9, and stayed below 50 for almost every month over the next three years. Other construction industry indicators also turned fairly quickly. When the ABI turned negative in January 2001, the McGraw-Hill Construction measure of contract awards for nonresidential buildings showed a year-over-year decline by the end of the second quarter, and the U.S. Commerce Department’s measure of nonresidential construction activity began its downturn in July of that year.

As most architecture firms have learned the hard way, an otherwise seemingly healthy design project can turn sour with almost no notice. If a client runs into some unforeseen problems—financing issues, a tenant backing out of a lease, or even sudden weakness in the market—a firm may be asked to stop work midstream. A recent AIA survey of architecture firms found that on average for about 10 percent of projects by dollar value, design was never completed; in 11 percent, there were major construction delays; and in 10 percent, the projects never were constructed. The message is that current design backlogs can disappear if conditions change, and that design billings don’t guarantee construction activity on a timely basis.

Preparing for the unknown
Given that we are entering a period of economic uncertainty, there are several questions that firms should be asking themselves to assess their risk.

• Which projects are the most vulnerable; which are the most solid? Some projects likely have higher risk factors than others. Speculative projects, particularly those for which financing has not been finalized, and larger projects that require more approvals are likely to be at the upper end of the risk continuum. Are the projects relying heavily on construction materials that are likely to see more price volatility in the coming months?
• Are other design firms running into problems on projects? When conditions in the construction market begin to sour, there often is a domino effect that hits a broader cross-section of projects. Keeping a close ear to the ground on what is happening to your peers can give some advance warning of emerging issues.
• Are my clients facing any problems? Tracking the financial condition of clients should help get a sense of issues they are facing and help to anticipate problems that might arise on projects. Also, frequent contact on project status should help identify early concerns.
• Are inquiries for new projects really viable? When the economy begins to soften, a higher share of project inquiries don’t materialize into projects. It’s prudent to scrutinize project inquiries more carefully during these times to assess their likelihood of converting into viable projects.
• What are options for diversification for my firm? During a downturn, there are advantages to diversification, both geographical and by building sector. Some regions of the country are likely to be harder hit than others, so having projects in multiple areas provides insurance that some projects will be moving forward. Likewise, working in multiple building sectors (e.g., office and educational) increases a firm’s ability to move back and forth among projects when one sector is stalled.

Outlook is a concern, but by no means dire
While most design firms are likely to face a slowdown over the 2008-2009 period, it is unlikely to turn into a full-fledged downturn like the profession faced in the early 1990s, or even like the downturn earlier this decade. Both of those cycles were characterized by huge levels of overbuilding, so when the slowdown hit, there was significant excess inventory to work off before new projects could begin. This time, the market is much more in balance: office vacancy rates and hotel occupancy rates are at healthy levels, rents for retail space are favorable, and other measures of the health of the nonresidential market generally are positive.

The AIA Consensus Construction Forecast Panel projects a very modest increase in nonresidential construction activity this year, and a very modest decline next year before an expansion begins later in the year

The most recent outlook by the AIA Consensus Construction Forecast Panel projects a very modest increase (net of inflation) in nonresidential construction activity this year, and a very modest decline next year before an expansion begins later in the year. Therefore, the consensus is for this cyclical trough to generate almost no decline in real construction activity. If this forecast is even close to accurate, this would be one of the mildest downturns in the nonresidential construction sector in many decades. The downturn earlier this decade saw a decline in excess of 25 percent across the entire sector and about twice that rate for office buildings and hotels. Not only should this cycle be much less severe, but the architecture profession is much more sophisticated now and better able to cope with economic cycles.