Subscribe"Good times" has been the theme song for the U.S. construction industry for the past several years.
A strong housing market buoyed overall activity, even during the uncertain times after 9/11. Recovery in segments of the nonresidential market started in 2003 and added to the industry's growth. However, recent data have the industry wondering whether the good times are over. How low will housing go? Are there better opportunities in other market segments? Indeed, are there any markets that offer a positive outlook?
It is clear that the United States is experiencing a slowdown in the housing market. June data showed new home sales down 3% nationally, and data revisions removed all of May's gains as well. Builders have been discounting to maintain sales growth, which is not a viable long-term strategy.
Investors have reacted to fears of a housing downturn by bidding down home building stocks in general. Share prices for the home building industry as a whole have declined 50% over the past year, according to the Dow Jones U.S. Home Construction Index.
The trepidation of investors is borne out by recent data from the American Institute of Architects (AIA). They report that billings at architectural firms declined for the second straight month in June, the first back-to-back monthly decline since 2003. The growth in inquiries for future projects also declined to its slowest rate since 2003.
The smallest firms reported the weakest activity, while larger firms did better. Indeed, firms with billings greater than $5 million reported both strong billings and inquiries. This is illuminating in that smaller firms tend to be residentially focused, while larger firms are more diversified. In fact, the best performance was seen by firms specializing in the commercial/industrial and institutional sectors.
Where the Opportunities Lie
Is housing no longer the place to be? Not necessarily, although the best opportunities lie elsewhere in the near term. The housing market is transitioning from one driven by extremely low real interest rates and rapid home price appreciation to one driven by more traditional household formation. Home price appreciation has been too strong, and when combined with rising interest rates, has reduced the affordability of homes.
However, the reduced level of starts in our forecast would still be considered a good housing market by historical standards. Our forecast of 1.76 million housing starts in 2007 would be higher than any year in the late 1990s - indeed, through 2002 - all of which were considered good years for housing. The housing slowdown is likely to remain orderly, barring a shock to the economy or markedly higher interest rates.
Additionally, the reduced pace of homebuilding will provide some breathing room for building materials prices, at least those primarily used in residential construction. For example, the Random Lengths composite lumber price has been falling through most of the year and is off 8.3% from its year-earlier level. Global Insight is forecasting continued lumber price declines throughout the year.
Furthermore, not all regions of the country are impacted similarly. Sales declines have been consistent and large in the Northeast, but the South and West have held up better. Housing markets in much of the Midwest did not see the rapid home price appreciation of coastal states. This, plus the return of manufacturing growth, indicates good prospects for this region. Rapid population growth and relatively low-cost housing also make communities in Nevada and Arizona good bets as well.
Conversely, builders should have second thoughts about entering or expanding in markets that have seen over-rapid price appreciation. The risk of a bubble is high in certain Florida markets, while high home prices and diminished employment growth opportunities also indicate warning signs for some New Jersey communities.
Even so, it is the nonresidential sector that offers the greatest opportunity for growth in the near term. Activity levels in most segments of this sector will continue to improve as the economy maintains momentum and existing capacity is filled or requires upgrading.
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The State of the Office Construction Market
The bellwether office segment is experiencing strong absorption and declining vacancies. Most major office markets have increasing demand for space, while new construction has remained very modest. Downtown and suburban markets posted their eighth straight quarter of positive absorption during the first quarter of 2006. Washington, DC; Chicago; and Phoenix led the way.
Vacancies remain tighter downtown than in the suburbs. Nationally, downtown vacancy declined 40 basis points to 12.3%, as suburban vacancy dipped to 14.3%, from 14.6%. Downtown construction activity remained low at slightly more than 750,000 square feet delivered in the quarter. This trend of restrained new construction, combined with increasing demand, should enhance the rental performance of downtown office markets.
As vacancies decline and rents improve, new office construction will follow. Indeed, we believe we are close to that point and that office construction this year will more than double its
6.7% growth rate in 2005.
Over the five-year forecast horizon, the office outlook is quite strong from sea to sea. However, certain markets are better positioned than others. Arizona, New Mexico, and Nevada all offer above average opportunity. Indeed, 7 of the top 10 office markets are in these states.
Lodging Leads the Way into Recovery
Lodging was an early arrival on the recovery scene. Construction in the hotel industry picked up as early as 2003, with much of the early investment spent on renovation of existing capacity, as opposed to new construction. However, increasing revenue per available room (RevPar) and declining vacancy rates have spurred new construction by most of the major hotel chains.
Most of the hottest hotel markets will be in the Southeast. Florida offers a number of attractive tourist destinations that become even more appealing as Americans travel closer to home, given high energy costs and a slowing economy. Similarly, we project Myrtle Beach, South Carolina, will be among the lodging construction leaders. While these markets represent tourist destinations, the rapidly growing business environments in the Southeast will be powering hotel construction in a separate set of metros in Georgia, North Carolina, South Carolina and Virginia.
The high-flying Las Vegas hotel market will cool somewhat over the forecast period. While it will continue to be an attractive construction market, its pace will slow from the roughly 20% compound growth of recent years to something closer to 12% over the next five years.
The weakest hotel markets are on the Gulf Coast. While there will be reconstruction activity in the wake of Katrina, the convention and tourist businesses have been substantially damaged and will take time to recover. Conventions, in particular, are booked with long lead times, and the recovery will be slow.
Increasingly, new hotel construction relies on multi-use development. Hotels often included modest restaurant and retail space. Now, new construction features expanded retail space as owners recognize that their customers have significant disposable income and the intent to spend it. Tourists regard shopping as a vacation activity, and business travelers view shopping as a convenient distraction or as a requirement to pick up forgotten necessities.
Retail and restaurant space still leave the hotel exposed to occupancy rates. Consequently, many new hotels include an ownership condominium component. Such units are attractive to buyers, since hotels can offer amenities not associated with conventional condominium complexes. They are also attractive to hotel owners, since they provide upfront cash when sold to offset construction costs and a stream of future revenue independent of conventional room occupancy - thus, diversifying risk.
Manufacturing: A Sleeping Giant?
The manufacturing sector may be the biggest surprise. This sector was pummeled in 2002 and 2003, with new construction investment falling over 40%. However, the economic recovery took hold in manufacturing in 2005, aided by business investment in machinery and a lower dollar that improved trade competitiveness. Manufacturing output is expected to increase nearly 5% in 2006, and the construction industry will be a primary recipient. Not only is existing capacity being absorbed, new construction is required to upgrade or build facilities with the most productive manufacturing equipment and techniques. New construction starts will continue to be robust, with 28.3 million square feet begun nationally in the first quarter, up from 25.4 million square feet in the previous quarter.
While the heartland is considered the manufacturing belt of the country, most new construction will not be found there. Indeed, the automotive sector is moving toward the South, and the weakest manufacturing construction markets will be in the outmoded areas of Michigan, including Detroit, Flint, and Saginaw. The high-cost Northeast will also suffer. We project that population dislocations resulting from Hurricane Katrina will slow the demand for new manufacturing facilities in coastal Louisiana, Mississippi, and Arkansas.
The Midwest will benefit, however, in metros producing goods in high demand. The outlook for Peoria?and selected other Iowa and Illinois metros - for example, is quite good given projected high demand for agricultural and construction machinery.
Meanwhile, 7 of the top 10 manufacturing markets move to New Mexico and Nevada. These areas benefited from NAFTA with the location of warehousing and transportation of goods from Mexico. The infrastructure, plus the lower cost of land and business activity, has encouraged the relocation of plants that might otherwise have gone to California.
Retail Construction Lagging
Retail construction will see slowing growth in 2006 and beyond. It never experienced the downturn in 2002-03 that other commercial/industrial segments did, and so has less momentum for recovery. We expect growth will slow to 5.3% in 2006, before slowing even further in 2007-08. Growth in employment, compensation, and disposable income?the main drivers of consumer spending?remains strong. However, consumers are cutting back on big ticket purchases in response to rising interest rates, reduced home equity appreciation, and soaring energy prices.
There are also important structural changes within the retail industry. New construction is weighted towards "big box" stores over smaller fare. For example, Wal-Mart plans to add 270-280 supercenters in this fiscal year and Lowe's plans to add 150-160 new stores per year in its fiscal 2006 and 2007. Meanwhile, Musicland is closing 341 stores, nearly half of its space. The Casual Corner Group is closing all 525 of its stores, and Radio Shack will close over 500 stores this year.
This is not to say that smaller retailers offer no opportunity. However, the widespread use of Internet shopping has made shops that depend on small, commodity-type goods such as music and video discs vulnerable. Meanwhile, the rise of discount superstores like Wal-Mart has made it more difficult for niche discounters of apparel and like merchandise to survive.
Retail trade tends to follow population, except in special cases such as high-volume business and tourist destinations. Accordingly, the best growth opportunities for retail exist in key destination metros in Florida, South Carolina and Nevada.
Good retail opportunities also exist in the expanding economies of Raleigh-Cary and Wilmington, North Carolina; Charleston, South Carolina; and the Virginia metros surrounding Washington, DC.
What Does It All Add Up To?
The bottom line for your bottom line: Don't completely discount the housing industry, but pay attention to individual market opportunities. You should consider focusing resources in nonresidential activities. If you have the products, you should be looking at the lodging, manufacturing, and office sectors. If you do not have the products, then you need to pursue a strategy of partnership or acquisition that will give you a presence in what will be the construction growth engine for the next several years.