Retail Sector Leads Recovery

The evolving economic environment will drive rapid expansion in nonresidential construction in 2005–06. In non-single-family residential building, the accumulated increases in office employment, retail spending, manufacturing production, and travel will create a physical need for more private leased building space.

Already, vacancy rates are declining and are expected to continue to decline for several years. Rents have begun to rise slowly from the recently depressed level and will continue to rise in coming years. Investment returns on rental buildings are already high enough in some markets to enable developers to obtain financing for new project starts. This favorable development environment will quickly spread to lagging markets.

Improving public budget balances and portfolio investment returns will also revive the stagnant market for public and non-profit building.

A shift away from big boxes. Commercial construction spending recovered to the mid-2001 peak level late in 2004, with a 30% annual rate surge in spending in the spring and summer, mostly for big-box discount stores, which continue to take business from shopping malls, and for smaller neighborhood shopping centers built on the heels of new residential developments.

As residential development slows and the strong economic expansion begins to shift consumer shopping preferences away from discounters to more upscale retailers, this white-hot growth pace will cool in 2005, subsiding to below 10% for most of the year. The lagging commercial sectors in 2004 — parking, restaurants, auto dealers, and stand-alone specialty stores — are all expected to expand significantly faster than in 2004.

Lodging boom has legs. Increased occupancies and a heightened interest in hotels as profitable investments led to an abrupt upturn in lodging construction spending in 2004, with the sector growing at a 25% plus pace over the last four quarters.

Occupancy rates have been and will continue to be boosted by the quickly expanding travel market, which initially was mostly comprised of business travel, but now also includes leisure as well. Airline passenger revenue miles are now 10% above a year ago and about back to the pre-9/11 peak. Investment funds are flowing into the hotel market, partly because investment returns have been sub-par for a considerable period in the office market, as well as in the stock and bond markets.

New starts are now replacing renovation as the market driver. Initially, the added investment funds bid up the prices of existing hotels, justified by a 15%-plus increase in hotel revenue per room. This quickly made building a new hotel less expensive than buying and renovating an older one.

Office recovery accelerates. Through September 2004, office construction spending only regained a third of the 40% plunge in the last recession and has declined marginally, after inflation, since last February. Nonetheless, this is the beginning of a sustained recovery driven by the creation of more than 500,000 new office jobs in the last year in the sector. Monster.com reports that the most-wanted job skills now are finance, IT, sales, and administrative support — all office-based positions.

The initial increase forecast in office construction spending is relatively heavy, with soaring corporate profits financing small projects and in renovation work for larger buildings.

Lenders are now poised to finance speculative buildings in some markets. Most of the construction activity on buildings now in the development phase will occur later in 2005 and in 2006.

Manufacturing shows signs of life. Spending for the construction of manufacturing facilities jumped 9.4% in July and August, but this only reversed a similar decline in June. Spending has declined in 12 of the last 13 quarters. However, a strong and relatively quick rebound is expected in 2005 following a rise in factory production earlier this year.

A strong resurgence is quite certain, but how quickly this takes place remains unclear because no sustained improving trend is yet evident. Factory capacity utilization is still too low to spur major plant additions. But, excluding the electronics sector, capacity utilization is now nearly 78%, which is high enough to expect a pickup in renovation work, as idle space is brought back into use.

Capacity utilization will reach 80% late in 2005. This will be high enough to set off at least two years of expansion at a 20%-plus pace. This is still a sick market. Peak spending in the current expansion will be about 20–25% below the peak in the last expansion. The strong economic recovery can only temporarily mask the loss of manufacturing business to Asia.

School construction stall ends. Reduced spending on K-12 buildings in a strained budget environment made for a flat year in education construction spending in 2004. After having increased at an 11% annual pace for 10 years, spending has been stuck in the $71–76 billion range nearly two years.

Rising school enrollments and soaring income and sales tax collections at the state level, which will be reflected in the new fiscal year beginning July 1, will assure a return to strong spending growth starting in 2005, and kicking into high gear again in 2006. Enrollment trends suggest that higher education projects are likely to expand the fastest in 2005–06, with K-8 projects expanding more slowly.

Healthcare sound through '06. Healthcare spending growth, which peaked at over a 12% annual rate in 2002 but has declined slightly since, will be below 10% by 2005. But increased cash receipts from lagging corporate and government insurance plan reimbursements assure several more years of about 10% expansion in healthcare construction.

However, beyond 2006, there is a risk of significantly lower growth in healthcare construction funds. Recall that the surge in the growth of HMOs in the early 1990s stalled the expansion of healthcare spending and caused a stall in healthcare construction spending in the mid-1990s. Another patient/taxpayer revolt over soaring costs could be brewing.

A look ahead into 2006. The expansion potential remaining for private, mostly leased buildings in the non-single-family residential market in 2006 should lead to continued double-digit growth. Commercial (essentially retail) building activity will near its previous peak, while spending for healthcare and education will remain strong. Total construction spending growth for all building types, though, will slip under 10% per year, mainly because housing will level off.

Total construction spending
Annual percent change in spending in current dollars

Nonresidential recovery well under way
Construction spending, billions of dollars, annual rate Ratio: 2005 Q4/2000–03 Peak