Nonresidential construction to stay strong in '06

The economic environment for construction remains strong in 2006. The fourth year of economic expansion will be a much better environment for the nonresidential than the residential construction market. After a brief post-hurricane rebound early in the year, GDP growth will resume slowing, dropping to a 3.0–3.5% pace by the end of 2006 and slowing further in 2007. This will be accompanied by rising credit costs that reduce the affordability of new homes as well as by lower vacancy rates for commercial buildings and improved tax receipts to finance institutional buildings. The labor market will progressively tighten in 2006 but only spot shortages of skilled labor are expected. The unemployment rate will slip below 5%, and recent price surges in energy and other commodity prices will begin to creep into wage rates.

The evolving economic environment will drive rapid expansion in nonresidential construction in 2006–07. 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 do so for several years. Rents have begun to rise slowly from the recently depressed level and will continue rising for several years. Investment returns on rental buildings are already high enough in some markets to get financing for project starts; the favorable development environment will quickly spread to lagging markets.

Nonresidential construction activity increased 2–3% after inflation in 2005, with much larger gains expected during the next few years. The improving market follows the pickup in building starts that began late in the year after more than a three-year decline. The new home construction market peaks in the current quarter, ending a four-year, 65% increase. Housing starts are expected to slip about 12% from February 2005 to spring 2007. Inflation and a changing housing mix will limit the decline in construction spending for new homes to about 5%. The residential remodeling market continues to expand strongly. The heavy construction market expanded 2–3% after inflation in 2005 after three years of decline. Much stronger increases in the next few years result from added federal funds, improved state and local government budget balances, and strained capacity for private infrastructure.

Post-hurricane repairs and replacements in the Gulf of Mexico region account for 0.3% of 2006 construction spending. Most of the cleanup and temporary repairs and much of the private infrastructure, utility, and manufacturing replacement was completed late in 2005. Rebuilding could be substantially higher in 2006. However, we expect that a large share of the destroyed homes and nonresidential buildings in the New Orleans area will be replaced by vacant buildings in Baton Rouge, Houston, and other nearby cities. Public funds are not yet in place to restore enough of the public facilities, including subsidized housing, to bring most of the evacuees back. The consequence of dispersed and delayed rebuilding is that most contractors will experience only nuisance level materials price and availability problems during the rebuilding period.

The condo market is being restrained by the same worsening affordability problems that have stalled the single-family market. Note that condo construction is more volatile than single-family construction because of its relatively higher share of "buy-to-rent" sales. So condo starts may expand early in 2006 and later decline more rapidly than single-family starts. Start trends in each local market will depend on the number of condo conversions. This is not just apartments; condos are being created from hotels and a variety of nonresidential buildings.

The national 9.9% rental vacancy rate limits the need for new apartments. The vacancy rate will decline significantly in 2006 as financially marginal households, shut out of the single-family market, and hurricane evacuees are forced to rent apartments. But the decline will not be enough to prompt an increase in apartment starts. Real estate investors see better return opportunities in the office and hotel markets.

Commercial construction growth slows

Growth is slowing in the commercial construction market after several bursts of spending early in the business expansion, spurred by rapidly rising retail sales and the catch-up of postponed expansion or renovation during the slow economy in 2001–03. Shopping centers—not malls—are currently the only rapid growth sector, with construction spending up 40% from a year earlier. These are being built to serve newly developed residential neighborhoods. Strong, although slowing, growth is expected for shopping centers into 2007. Warehouse construction activity is steady, with few projects in the pre-construction phase. However, the scramble for supplies during the last hurricane season appears likely to prompt distributors and manufacturers to hold more safety stock and increase demand for warehouse space.

Office construction spending, adjusted for inflation, begins 2006, as it did 2005, about 40% below the exaggerated peak reached early in 2001. The initial market expansion expected in 2005 was postponed by the 12% surge in materials costs in 2004. Higher costs required additional construction financing and also made expected financial returns too low. Now vacancy rates 2% lower and rental rates 2% higher make the postponed projects financially acceptable. Together with improved confidence in continued gains in office space demand, building starts began to expand late in 2005 and the number of projects in the pre-construction phase increased. Washington, New York, and Los Angeles will again have the most new office space under construction in 2006.

Manufacturing construction spending has been stalled at a $28 billion annual pace for the last year, ending September 2005, but still 25% higher than the previous year. Construction spending picked up in almost all industries, with the largest gains in chemicals, electronics, and transportation equipment. The yearlong stall was caused by the rise in building costs that disrupted project financing, a slowdown in factory production growth during a period of inventory reduction, and slower growth in manufactured exports while the dollar briefly appreciated. These restraints are now relaxed.

Looking ahead, factory construction is expected to expand at a 15% pace through 2006. 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.

Hotel project construction declined 2% in 2005, after a 12% surge in 2004. The market expansion was interrupted when planned projects were postponed by the impact of higher materials costs on expected investment returns. Lodging construction spending is expected to resume growing rapidly early in 2006, spurred by the higher financial return projections from the 8% rise in revenue per available room over the last year. Spending is forecast to jump nearly 30% from fall 2005 to the end of 2006. While huge, this five-quarter increase is modest in historical perspective. Hotel construction spending doubled from the end of 1994 to the end of 1995, then doubled again in the next three years. Real estate investors currently project the best returns in downtown luxury, airport business, and resort hotels.

Caution: The hotel and condo markets now overlap in large metro and resort areas. Some of the hotel room demand forecast from economywide income and travel trends may be absorbed by new condos. Developers of joint hotel/condo projects can use condo down payments as quick, inexpensive construction loans, then rent the condos back as hotel rooms.

Education construction spending increased 7.1% in 2005. Growth will double to 14% in 2006 as the finances of state and local governments continue to improve. Recent construction increases have been primarily for high schools, colleges, and the cultural buildings that are included in the education category, such as libraries. However, the mix of projects reflects differing enrollment trends. The enrollment bulge is now in the eighth grade, so spending is declining for K-8 schools but increasing for high schools. Projects in the Northeast and Midwest are primarily renovation or replacement, since enrollment is stable or declining. Projects in the South and West are primarily to add classroom space.

College enrollment is growing more quickly than K-12 enrollment. This is not demographics but rather a higher university enrollment rate. September's college construction spending was 27% higher than a year earlier, with the largest gains for infrastructure and sports/recreation facilities—probably projects deferred during 2001–04.

The 10% annual growth trend in healthcare construction will continue for the fifth consecutive year in 2006. Healthcare construction spending is set by the amount of available funds from health insurance plans and government healthcare programs. Patient demand for healthcare services is irrelevant in the short term since patients do not pay directly for these services. Spending growth dipped slightly to 8.8% in 2005 because some project spending was delayed when the sharp rise in materials costs created a sudden need for additional construction funds.

Spending growth in 2006 is projected to rise to 12.5% because the additional health insurance premiums generated from expanding employment beginning in late 2003 are now available to be spent. Both employers and Congress are trying to reduce the annual healthcare growth rate by shifting some costs to patients, but so far there has been little impact on aggregate healthcare costs.

The hurricanes ended the year of stable construction materials prices that followed the 12% price surge from January to August 2004. Materials price inflation jumped an estimated 3–4% in the last four months of 2005. This increase was a combination of several separate price increases. This included already rapidly rising cement prices, temporary price spikes for lumber and panel board-up materials, sharp price increases for plastics and petrochemicals manufactured from natural gas feedstocks, paving, and roofing asphalt products derived from crude oil, and the inflationary impact of all of these price rises (plus those for gasoline and diesel) on all commodities. Next year, materials price inflation is expected to subside to a 3–4% pace, mostly due to falling crude oil prices and relatively weak lumber and panel prices.

Total construction spending
(% annual change in spending in current dollars)