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LASN's 2004 Forecast: North American Construction: Growth on the Horizon

Article by Sean Stowell, LASN; charts and statistics by research department; analysis by George Schmok.

For the past few years, residential has been the leading market in the construction industry. In 2004, nonresidential construction will be handed the baton as the new market leader, according to Edward Sullivan, chief economist for the Portland Cement Association, Mr. Sullivan gave his outlook on U.S. construction at Reed Construction Data's 8th Annual North American Construction Forecast, October 15 at the National Press Club in Washington, D.C.

According to Sullivan, the economy will continue to gain strength in 2004. A five percent growth rate is expected for the third quarter, and four percent or more is expected throughout 2004. With this strong economic growth comes rising interest rates. Sullivan said mortgage affordability will start to cool residential construction activity, meaning an emergence in nonresidential activity.

Total cement mirrors total construction activity very closely, Sullivan said. He expects a one percent decline in 2004, followed by a nearly one percent gain in real construction activity in 2005.

"We have sustained consumer spending strength and the investment environment has improved dramatically," Sullivan said. "Even other economists are saying the third and fourth quarters of 2004 are going to be very successful--in excess of three and-one-half to four percent. Unlike the past, where all you had was consumption added to economic growth, you now have consumption in the investment sector supplementing consumer spending to achieve these growths."

Sullivan sees the economy recovering in 2004, correlating with a rise in mortgage rates. This also suggests downward pressure on consumer spending. He predicted that small, consistent, sustained gains in job creation throughout 2004.

Sullivan suggests the construction market will be flat in 2004; as interest rates begin to rise, nonresidential construction will become the market leader.

Major Projects and Trends for 2004

In a panel discussion looking at the building sector's strengths and weaknesses, Durrant chairman and CEO Gordon Mills; URS vice president, Charles Rodenfels; Skidmore Owings & Merrill design partner, Gary Haney; Thornton--Tomasetti co-chairman and managing principal, Richard Tomasetti; vice chairman and CEO of HOK, Charles Davis; and Parsons Brinckerhoff vice president, Michael Schneider, all shared what emerging trends their companies are experiencing.

Mills sees much opportunity for growth in 2004. Criminal justice, community colleges and health care are a few of the strongest market sectors expected for 2004 he said. Business area transformations that are being seen include integration of design and delivery, where there is close collaboration of everyone involved in the process to aid in the transfer of knowledge.

Rodenfels noted that government buildings such as the Herbert Hoover Building and the Pentagon are receiving a great deal of attention in terms of renovations and improvement of infrastructure. This appears to be a growing trend going forward and there is federal funding coming available to support these renovations.

Haney said his firm has focused on diversity and pursuing projects that would allow them to exhibit their strength in design and technical excellence. Last year, 27 percent of their volume was financial, corporate mixed-use projects. Airport and transportation accounted for 24 percent; government projects 24 percent; health and science was 13 percent; and education is now seven percent, and he expects this to double next year.

Haney reported that tall buildings continue to be in demand. Currently there are developments in process to make these buildings safer, including structural improvements to resist progressive collapse, responsive building skins, wider stairs, concrete cores and improved fireproofing.

Tomasetti said today they are seeing more consideration for making high-rise buildings in urban environments with mixed uses. These combined projects are offering new opportunities for material specialists because the industry is seeing more use of mixing the appropriate amounts of concrete and steel in both residential and office buildings. Combining these elements in office buildings is motivated by security concerns.

Davis observed that in many cases, speed of design and delivery are now more important than cost in many of the projects they are undertaking. HOK has remained active in the hospitality business and also have had ongoing work in the retail and mixed-use commercial business.

He reported that things continue to be slow for corporate offices and interiors. HOK's backlog in the middle of the country has doubled since the beginning of this year. Regionally, Southern California is strong, but the East Coast and the Bay Area of Northern California are a little slower to recover.

Schneider said the "three C's" his company are facing are commoditization, consolidation, and commercialization of the practices in the design, engineering and architecture industry. The position of the design and construction industry is becoming stronger and clients are not only looking for one-stop shops, but also looking for the ease of shifting risk or shifting responsibility. This is true not only in the design and construction stage, but in the operations and maintenance stages as well, according to Schneider.

Housing Sector No Longer Strong in Today's Economy

David Seiders, chief economist for the National Association of Home Builders, reported the housing sector is no longer a strong growth engine for the economy, but there is growth in the remodeling sector and multifamily is expected to improve as job growth helps fill vacancies.

Seiders said housing production remained steady through the recession and has had some growth. It also propelled other parts of the economy that are closely related, such as furniture and appliances. From this, Seiders said, the housing sales and production mechanism is probably driving close to 20 percent of the U.S. economy.

According to Seiders, house price performance has generated a large amount of wealth for America's homeowners, who represent 68 percent of all U.S. households. Though house prices have been raising steadily the rate of appreciation has slowed.

"We're a little worried about the refinance market as it continues to lose steam as interest rates climb," Seiders said. "We're not concerned about equity accumulation and people using it to help support spending on remodeling or other consumer goods. Frankly, the process of the household balance sheet restructuring through a refinance is healthy and that will endure with us as we go ahead with the rest of the expansion."

Seiders believes the U.S. can retain the levels of home sales and housing production that have been generated in recent years. However, he said he would be surprised if we could continue to post growth in these areas without reasonable job growth. He is looking for this part of the sector to fall into place very soon because the 30-year mortgage rate is now heading toward 6.75 percent, compared to historic lows just above five percent in June of this year.

"We can't keep counting on housing to continue this heroic growth," Seiders said.

Residential remodeling is performing very well, according to Seiders. He said this $180 billion market, as recorded in the first quarter of this year, is growing. He expects a four to five percent growth in this sector in 2004.

Retail, Industrial and Office Space Subject to Unique Economic Cycles

Real estate markets go through two different cycles, according to Glenn Mueller, managing director of real estate investment strategy for Legg Mason and professor and investment strategist at Johns Hopkins University Real Estate Institute.

The first is physical cycles that are determined by demand and supply for real estate, and financial cycles, where changes in capital flows through real estate affect the prices of buildings.

Each of these economic cycles affect how much new construction will occur, and, according to Mueller, we are at a very unique time in the U.S. because this country is in a reverse of what a typical cycle is for this economy. Mueller added that health facilities and retail markets are the bright spots in the real estate field. These sectors are performing well and will continue to move along. This success has been attributed to the consumer, who through this downturn has continued to spend.

"Going forward, office demand is coming back," Mueller said. "Right now, our projection is that by 2005 we should return to the long-term average of two percent growth and see some new demand coming along, while hotels remain depressed at a 35 percent vacancy rate."

Mueller mentioned that retail continues to do well in most regional markets, and with continued urbanization, the U.S. could expect to see more neighborhood community centers in the near future.

Solid Performance Predicted in Regional Outlook

Signs of economic pickup will lay the foundation for solid performance in real estate going forward, said Ray Owens, vice president and senior economist for the Federal Reserve Bank.

Looking at vacancy rates in the central business districts, it is noted that they continue to increase. There has been some leveling in the suburban market due to a very minor improvement in the labor market, and this is a hint that things are starting to level out in this area, Owens said. Class "A" space is showing the most improvement according to Owens. It is known from past cycles that improvement, in the office market has been led by improvement in the best quality class "A" space.

"Class 'A' space looks more encouraging and we continue to see improvements in the central business district," Owens said. "The Class 'A' market, if it's leading the pack as it has done in the past, suggests there's hints of a turning point in overall vacancy rates. This improvement in vacancy rates is really what is driving it at this point."

Owens added that up until now, the main improvement in vacancy rates have come about with the adjustment on the supply side. The central business district and suburban markets are beginning to see increases in the space under construction, resulting in a more solid situation than previously had in absorption rates. Going forward, improved conditions for office rents are expected.

Solid performance is expected with signs of economic pickup combined with sharp curtailments of new construction, Owens said. He added that risks remain, and much of the improvement in commercial real estate may be tied to improvement in labor markets and though there are some encouraging signs in the labor markets, continued sluggish growth could limit an eventual pickup in demand growth.

"The need for space may not be as rapid as what we saw after the last recession that occurred in the 1990s," Owens said. "Nevertheless, the turnaround in net absorption is powerful evidence that the conditions are improving."

Owens provided anecdotal evidence across regions consistent with these findings:
  • Boston: Things are holding steady. This region was seeing positive net absorption.
  • New York: Seeing some improvement led by strong recent activity in Class "B" and overall vacancy rates have declined.
  • Philadelphia: Conditions were steady and virtually unchanged in recent months. Rental rates continue to decline somewhat.
  • Cleveland: There are signs of improvement.
  • Richmond, VA: Things were generally flat, but there has been improvement in some areas. Positive absorption is being seen for the first time in quite awhile.
  • Atlanta: Small improvements in net absorption.
  • Chicago/Midwest: Not much change, but conditions continue to soften.
  • Arkansas/Mississippi/Kentucky: Commercial construction is doing a little better in these parts
  • Minneapolis: Things continue to be quite slow, but seeing signs of improvement in the market.
  • Kansas City: Slight weakening in July and early August after previous signs of stabilization and the vacancy rates were inching higher.
  • Dallas: Contacts there are more optimistic about commercial real estate markets.
  • San Francisco: High vacancy rates continue to characterize a few areas and there is little construction.

Canada Is the Big Winner in 2004

Economic indicators in Canada are positive for 2004, supporting strong housing starts and increased institutional and engineering construction, as reported by Roger Grant, vice president of product management for RSMeans, a product line of Reed Construction Data. Grant drew his conclusions from the work of Reed Construction Data's CANADATA forecasting group.

The economy in Canada took some hits because of some non-economic events that happened, such as SARS, a potential outbreak of mad cow disease in Alberta, and major forest fires in British Columbia that affected that province's ability to fund projects.

Looking at 2004, Grant projects economic growth to be over three percent. He said growth will be moderate, but stable and positive, based on the key assumptions of growth in the U.S. and a Canadian dollar below 75 cents U.S.

Residential construction, like in the U.S., is very strong with more than 205,000 starts expected this year, spurred by low mortgage rates, favorable demographics and migration into Canada. Rental lease rates are starting to drop and vacancy rates are starting to rise in apartments in the Toronto market, evidence that some overbuilding in condos is starting to occur and should affect demand. Housing, similar to many of the construction markets in Canada, is fairly cyclical and appears to be near a peak.

Grant said the one bright spot in the commercial sector, as in the U.S., is the retail market. Actual 2003 starts are expected to be near 16 million-square-feet, which is up significantly from last year's forecast of just over nine million-square-feet.

The picture is much brighter in the institutional sector in Canada. According to Grant, there is some pent-up demand, particularly in health and welfare projects, with many of the provinces in a fiscal position to address some backlogged requirements. In the school market, while demographics are lowering demand on the elementary side, there are increasing demands in higher education. There is a rise in philanthropy benefiting cultural projects. This trend is expected to continue for the next several years with many major projects in the pipeline. Next year's institutional starts have been projected at 35.5 million-square-feet.

Industrial, commercial, engineering and institutional construction strength is building in these sectors in the latter half of 2003 and it is expected that this trend will hold going into 2004. As a result, Canada will continue to lead in North America, with construction growth nearing fiver percent in 2004.

Despite all of the variables in the economy that can affect construction, optimism for a strong rebound in the new year remains for the North American construction industry.

Mexico Improving

Grant reports that Mexico is emerging from a sharp cyclical recession and is looking for reforms to strengthen its economy. He classifies Mexico into three economies. The maquiladoras, those working in the border regions, produces more than half of the exports of Mexico and much of the country's growth that has taken place over the last 10 years. This sector is somewhat depressed because of the slow recovery in the U.S. While Mexico is the United States' second largest trading partner, China has been steadily gaining share and is the number two importer in the U.S. This has negatively affected Mexico's border economy. In the last two years, 300 manufacturing plants have relocated from Mexico to China.

The second area is modern Mexico, which comprises Mexico City, Guadalajara, Monterrey and other major cities. Much of what is produced there is consumed within Mexico. Fairly normal growth and significant demand are present there, but shortages in funding remain. The third and largest component is the subsistence economy with significant demand but limited funding available. Overall, the loss of manufacturing business from the U.S. slowdown is the key factor that has kept growth rates low-only near one percent for 2002 and 2003.

Mexico has very low personal tax rates, which makes it difficult to raise funds for infrastructure, housing and educational construction. The reforms proposed by the Fox administration are designed to address this situation and reduce the reliance on the state controlled energy sector for funding. To attract outside capital, Mexico must keep relatively high interest rates, which has an affect on the country's ability to generate funds for internal construction. High energy prices are providing some additional government funding for construction projects however.

Approximately 52 percent of construction in Mexico is housing-related; 60 billion of that is self-construction in the subsistence economy. Grant said there is clearly significant pent-up demand in residential building. The residential market had a strong year in 2002, with growth declining one and-one-half percent in 2003. Based on availability of funding, total residential construction is expected to grow about three and-one-half percent in 2004.

In the commercial sector, office vacancy rates for new buildings in Mexico City are expected to approach close to 28 percent by the end of the year. There has been quite a bit of overbuilding, according to Grant, and rental rates are expected to drop drastically. As a result, there are few new projects being started. Based on the expected recovery in the U.S. the maquiladora economy is expected to see growth in factory and assembly plant construction.

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December 14, 2019, 7:47 am PDT

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