by Kermit Baker, PhD, Hon. AIA
Chief Economist

Summary:The long-awaited economic recovery seems to be well-underway, and even the residential construction sector looks like it has hit bottom and is moving back up after almost four years of deep declines. Nonresidential construction, unfortunately, is still mired in a steep downturn. Overall nonresidential construction spending declined over 10% between October 2008 and October 2009. The buildings portion of the nonresidential sector has performed even worse, given the federal stimulus program’s focus on infrastructure investment, which pushed up spending on streets and highways by 5% over this period, and conservation and development projects (such as dams, levees, and breakwaters) by 23%.

As such, private nonresidential construction spending declined by over 20% over the past year, with key categories such as retail and office facilities off by more than 30%. These steep declines have been somewhat balanced by much more moderate declines in many institutional building categories, such as educational facilities (down 5.6%), religious structures (down 2.8%), public safety facilities (up 5.0%), and transportation facilities (up 7.7%).

The coming year is likely to see further declines in the nonresidential sector. According to the AIA Consensus Construction Forecast Panel, nonresidential construction activity will decline another 13.4% in inflation-adjusted dollars (akin to a square footage concept) in 2010, before finally posting a modest advance of 1.8% in 2011. The commercial and industrial sectors are expected to be uniformly weak in 2010, with declines close to 20% in most major categories. Institutional construction will fare better, with a modest decline of just under 2% projected for 2010 before reversing for a 3% gain in 2011.

The nonresidential construction downturn didn’t begin for this cycle until the latter part of 2008, though design firms were reporting deteriorating conditions since the beginning of that year. The AIA’s Architectural Billings Index (ABI), which measures design activity at U.S. architecture firms, declined sharply into negative territory in February of 2008, and has remained negative every month since. Research by the AIA has concluded that design activity leads construction spending activity by 9 to 12 months, so the construction downturn in late 2008 was anticipated by the ABI. The steepest part of the design downturn was during the fourth quarter of 2008 and the first quarter of 2009. Given the timing relationship between design and construction, the steepest part of the construction downturn should be occurring in late 2009.

The commercial/industrial portion of the ABI has been much weaker than the institutional portion. In the 22 months since the national ABI fell below 50 (indicating a decline in architectural billings), the commercial/industrial index has been below for eight months (indicating a very steep decline in billings for that month), and above 45 for only two months (indicating a more modest decline). In contrast, the institutional index had been below 40 for only five months, and above 45 for 11 months. At present, the institutional index is signaling that this sector is closer to recovery than is the commercial/industrial construction sector.

Economic recovery finally underway, but construction still depressed
The downturn in the economy moderated significantly in the second quarter of 2009, with an annualized decline of 0.7%, before turning positive with a growth rate of 2.8% in the third quarter. While this emerging recovery appears that it can be sustained–particularly because there is plenty more federal stimulus finding to come–it hasn’t done much to date to improve the employment picture. U.S. businesses have reduced payrolls by almost 1.5 million since the slowdown moderated at the beginning of the second quarter, and by over 400,000 since the economy began growing at the beginning of the third quarter.

However, the construction sector has seen less of a moderation in job losses. In the second quarter of 2009, construction sector payroll losses accounted for less than 20% of total losses in the economy. By the third quarter, they had increased to almost 25%. So far in the fourth quarter (through November figures), construction payroll losses have accounted for two-thirds of all losses in the economy. As a result, the unemployment rate in the construction sector is much higher than national averages. While the national unemployment rate climbed from 4.5% in early 2007 to 10% in late 2009, the unemployment rate for construction firms was hovering close to 20% in late 2009.

Most expect that the current economic recovery will be moderate by historical standards because the recovery in consumer spending is likely to be restrained. High levels of unemployment have restricted the income that households have available, but even these stratospheric unemployment rates do not capture those employees that have been cut back to part-time, those with salary freezes or reductions, or those with furloughs or other involuntary unpaid leave. Even households not facing the prospects of unemployment may cut back their spending fearing other forms of salary reductions.

Additionally, even households that are not concerned with disruptions to their income are generally much less wealthy than they were a few years ago. Declines in stock values and house prices mean that households are feeling less comfortable with their financial situation, and as a result are saving more and spending less. Generally, economists have found that a one dollar decline in wealth produces a three to five cent decline in spending each year. This “wealth effect” had just the opposite effect during boom times; as household wealth increased, they were spending more and saving less. Until stock values and house prices fully recover, household spending will remain at depressed levels.

Outlook calls for 2010 construction spending to remain depressed
The construction sector remains an important factor in the timing and strength of the national economic recovery. During typical years, homebuilding, the construction of nonresidential buildings, and improvements to these structures account for 9% to 10% of activity in our economy. In 2009, these sectors probably accounted for only just over 5% of our economy, and in 2010 they likely will fall even lower as housing remains at depressed levels and nonresidential construction spending levels remain weak. So, while weakness in the economy is hindering a more robust construction recovery, a depressed construction sector is slowing the broader economic rebound.

Construction Consensus Forecast

Compare consensus to the forecast of various panel members above.

No need to click, just hold your mouse over the panel member.

note:
• 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.

• All forecasts are presented in inflation-adjusted dollars. Forecasts submitted in current dollars are deflated by the AIA to be comparable with the inflation-adjusted forecasts.
• The AIA Consensus Forecast is computed as an average of the forecasts provided by the panelists that submit forecasts for each of the included building categories.
• Panelist data cover a range of concepts (e.g. construction starts vs. spending put-in-place) and sources (proprietary contract awards vs. construction spending from the National Income and Product Accounts vs. construction spending from the U.S. Census Bureau).
• There are no standard definitions of some nonresidential building categories, so panelists may define a given category somewhat differently.
• Panelists may forecast only a portion of a category (e.g public buildings but not private buldings). These forecasts are treated like other forecasts in computing the consensus.

While the economic recovery is reaching a growing list of sectors in the economy, nonresidential construction has by and large not benefited from any upturn. Until the AIA’s ABI begins to move above the 50 level on a consistent basis, any general upturn in construction spending is likely to be at least 9-12 months off. Industry fundamentals reinforce this view that more progress needs to be made before our economy can support a general upturn in construction activity.

In the commercial sector, even though the market was generally not oversupplied when the downturn began, demand has been weak enough to generate excess capacity in most areas of the country. This has caused the value of commercial properties to plummet, falling more than 35% since their high in mid-2007. Falling properties have furthered the credit problems in this industry, since lenders are hesitant to lend if the underlying asset is losing value.

Depressed levels of consumer confidence caused by pressure on both income and wealth have caused retail activity to trend down. In particular, consumers have shifted expenditures toward discount stores and away from luxury retailers. Weak levels of home building, which generate demand for retail activity to support these new communities, have also diminished the need for new retail facilities. The AIA Consensus Forecast panel is projecting a 17% decline in retail and other commercial construction activity in 2010 before turning to a modest 3% pace of growth in 2011.

The consensus outlook for office construction is similar: a projected 19% decline in inflation-adjusted spending in 2010 before rebounding to a 12% gain in 2011. The seven million payroll job losses–or more than a 5% decline in payroll employment since the recession began–have diminished the need for office space. CB Richard Ellis reported that national office vacancy rates stood at 17.2% in the third quarter of 2009, up from 14.0% a year earlier, further indicating reduced need for office space until our economy begins to create more jobs. Hotel construction likewise is projected to show a big decline in 2010 (almost 24%) followed by a recovery in 2011 of 5%. Declines in business travel have hurt the hotel market, but declines in personal travel have been even more devastating in many areas, particularly for resort and casino markets. Hotel revenue is projected to be off around 20% in 2009.

The institutional construction market is projected to perform much better than commercial activity during 2010. Health care, in particular, is forecast to show only a modest decline after suffering through a weak year in 2009. The uncertainty surrounding health care reform has limited investment in some health care sectors, which likely will free up once this issue is resolved. Education construction also has seen an unusually weak year in 2009, with further declines projected in 2010. Weakness has largely been due to problems in municipal budgets, but availability of credit has also been an issue. However, school enrollments are projected to see healthy growth over the coming decade, ensuring that education spending over the longer-term will see healthy growth.