2007 Forecast: Outlook Positive

Domestic nonresidential construction boom to continue; few express skepticism
By Ann Lallande
December 1, 2006
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Pop the corks.

The consensus among economists at two outlook conferences for the U.S. construction industry—one hosted by Reed Construction Data of Norcross, Ga., the other by McGraw-Hill Construction of New York—in Washington, D.C. during October—is that the domestic boom in nonresidential construction will continue through 2007 and remain strong in 2008. The U.S. economy, though slowing, appears headed for a soft landing while the global economy continues to outpace domestic growth. U.S. residential construction will continue its decline through 2008, but the forecasters do not expect the market to tank and impact the growth in nonresidential construction.

Or wait.

Edward Sullivan, chief economist at the Portland Cement Association in Skokie, Ill., is not as sanguine. He sees the glass half empty. “Inflation is expected to remain stubbornly high ... interest rates are expected to rise at a faster pace than previously expected, [and] real consumer spending will grow at a sub-3 percent rate during 2007 and beyond,” he says. “Slower economic growth translates directly into slower growth for nonresidential construction activity.”

On the plus side, “nonresidential construction has yet to hit its peak growth,” says Jim Haughey, chief economist at Reed Construction Data. He anticipates that nonresidential starts, which increased 11.8 percent in 2006, will peak in the spring but remain strong enough to post an advance of 6.7 percent next year and grow an additional 4.4 percent, year-over-year, in 2008.

Spending in the sector will outpace starts, growing by 12 percent in 2007 to top $402.5 billion, according to Reed’s U.S. Construction Outlook 2007-2008. It will cool slightly in 2008, but still post an 8.1 percent increase over 2007—a rate that remains “comfortably ahead of inflation,” the publication states—and ring up at $435.3 billion.

Residential construction is taking a hit. Domestic starts peaked at 2.265 million in January and then dove to 1.665 million in August, Haughey says. He expects starts to drop to 1.433 million in 2007.

Between 2005 and year end 2007 housing starts will drop 25 percent, says David A. Wyss, chief economist at Standard & Poor’s. “That sounds pretty bad,” he acknowledges, but he considers it mild compared to other housing downturns. In 1991, for example, starts dropped by nearly 50 percent, falling below one million starts a year. The trough in this cycle is expected to bottom out at around 1.5 million starts, he says.

Economy, at home and abroad
The economy as a whole “is downshifting from a very rapid rate of growth,” says Martin Regalia, vice president and chief economist with the U.S. Chamber of Commerce. Gross domestic product slowed from a hot 5.6 percent rate of growth at the beginning of the year down to 1.6 percent in the third quarter and bouncing back a bit to 2.7 percent in the fourth quarter.

It is headed for a “stable, soft landing,” Wyss says. He expects GDP to grow at 2.5 percent over the next two years, inflation to hold steady at 2.5 percent and unemployment to remain below 5 percent. “This is pretty darn good by historical standards,” he says.

Wyss anticipates that the Federal Reserve Board, which raised interest rates 17 times between May 2004 and June 2006, will begin cutting rates next summer. Over the long term, he calculates that the economy will begin to grow again at an annual rate of 3.5 percent.

The global economic outlook is equally benign, says Nariman Behravesh, executive vice president and chief economist at Global Insight, based in Waltham, Mass. It expanded at a rate of 3.9 percent in 2006 and he expects the rate of expansion to slow to 3.2 percent, with growth broadly shared around the globe.

Indicators bode well for the global economy, Behravesh says. “Worldwide inflation has been tamed,” he says, with an annual rate of growth just below 2 percent. Oil prices have slid to $60 a barrel down from $78 a barrel in July. He expects they will remain below $67 a barrel for the next four years. In addition, he observes, monetary policy around the world remains relatively loose.

Behravesh tempers his forecast with some caveats. Oil markets are tight and capacity is “very limited,” he says. If a supply disruption were to occur, the cost per barrel could soar to $100 per barrel or even to $150.

Behravesh wonders if the Chinese government can finesse a slowdown in its economy, which grew at rate of 11.3 percent during the second quarter. “There is a growing risk that China’s blunt macro policy instruments will trigger a pronounced downturn,” he says. That would negatively impact “most Asian economies along with commodity exporters such as Australia, South Africa, Brazil and Canada.”

High commodity prices have underwritten growth in many countries and these economies would suffer if the market weakens significantly.



Cost of construction materials remains high
In fact, material costs account for much of the disparity in nonresidential construction between the rate of increase for starts compared to the growth in spending. “Construction suffered from more inflation than the rest of the economy,” Haughey says. The core rate of inflation in the United States hovers between 2.5 percent to 3 percent, Regalia says, but in the 12-month period ending in August, the cost of construction materials experienced a 9 percent increase and will likely rise another 7 percent in 2007, Haughey says.

Copper prices, which quadrupled over the past four years and rose 63 percent since January, reached a high of $8,700 a metric ton. John Mothersole, a principal at Global Insight, blames low inventories, production that was slow to ramp up and supply disruptions caused by the 25-day strike this summer at La Escondida in Chile, the world’s largest copper mine.

Inventories continue to be low, but gains in production are outpacing growth in consumption, Mothersole says. Prices remain “at elevated levels,” he says, but they have peaked and will fall to $5,950 a metric ton by the end of 2007.

Volatility of steel prices will persist, but Haughey expects the rate of increase to slow. The Chinese dramatically expanded steel production and now make 3.7 times more steel than the U.S., Mothersole says.  He expects the price of structural and rebar steel to fall below $500 a short ton, but prices for specialty and high-alloy products will stay high because of limited furnace capacity.

The outlook for cement is mixed, no pun. Both Haughey and Mothersole predict slower-paced price increases. Mothersole projects a 10 percent increase in price in 2006, and no increase in 2007, as demand growth slows and supply is boosted, in part because of increased imports from China and Mexico. “The pace of material price escalation is beginning to slow,” Mothersole concludes.

Sullivan agrees that demand for Portland cement will wane, increasing at a rate of 1.3 percent in 2007, down from the 2.3 percent rate of growth in 2006. “To date, supply has far outstripped potential demand growth,” but, “PCA does not believe the gains in import volume can be sustained.” He cites a resurgence of tight shipping conditions and, as a result, steeper freight rates.

Mothersole considers the shipping bottleneck a temporary condition that will ease as capacity under production makes it to the high seas. That will keep materials flowing around the globe and to the U.S., he says.

Sullivan’s recommendation seems to be proceeding with caution. The soft economy will temper improvement in nonresidential vacancy rates and dampen price gains in leases, he says.

In the public sector, “slower job creation implies slower growth in state revenues,” Sullivan says. Recent state experiences with fiscal distress combined with a slowdown in revenue collection will make states more cautious about committing to construction projects. In addition, “rising construction costs will reduce the ability of states to undertake the number of planned public projects,” he says.

Nonresidential construction looks up
The brighter picture holds that high corporate profits, readily available, low-cost credit and increased state and local tax revenues will fuel nonresidential construction spending, Haughey says.

Haughey sees upticks in each segment of the sector. Spending on construction for lodging, though unable to match a surge of 54 percent in 2006, will post a year-over-year gain of 20 percent in 2007. Construction spending for office space will grow by 15 percent in 2007 and another 19 percent in 2008.



Estimates regarding the strength of the market for retail space vary. Haughey expects retail construction spending to increase 11 percent next year. Construction of new stores is tied to residential starts, says Robert Murray, vice president of economic affairs with McGraw-Hill Construction. As a result, retailers will scale back their construction plans and the market will see retail square footage drop by 7 percent next year, he says.

Dollars invested in institutional construction remain on the upswing, Haughey says. He expects the healthcare industry to up its construction spending by 18 percent next year and a growth of 12 percent each in public safety and amusement and recreation. Educational and religious communities are expected to increase their outlays by 10 percent.

Whether the forecast is for sunshine or clouds, Murray sees a silver lining. He perceives an evolution in the construction industry toward “longer, higher, and more stable cycles.” Residential and nonresidential sectors tend to offset each other, with one advancing as the other declines. As a result, “the more things change, the more they stay the same,” Murray concludes.

 

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The author is a freelance write from Annapolis, Md., 410/757-4454, alallande@comcast.net.