Keep the Faith

An unfortunate engineer and an economist travelling in South America on business were captured for ransom by a group of rebels. After two weeks and no response, the rebel leader informed the pair that they would be executed. As was tradition, a last request was proffered. The economist noted he was on his way to present a five-year forecast to executives at a locally based corporation when he was captured. His last request was to present this forecast. The rebel leader agreed, turning to the engineer for his last request. The engineer in turn responded: "May I be killed first?"

Given current conditions, many readers may share this engineer's feelings, but despite the not-so-bright horizon, CSE presents its forecast anyway. In all seriousness, we hope this information— culled from the insight of Daryl Delano, Reed Business Information's economic guru, and from Reed Construction Data's recent North American Construction Forecast—most notably the forecast of Glenn Mueller, Ph.D., a professor at John Hopkins University's Real Estate Institute—proves useful in helping M/E/P firms develop plans for struggling free of this economic morass.

Throughout this Reed Construction Data forecast recap are a series of graphs depicting a skewed bell curve. The curve is a model, developed by Mueller, based on a 30-year economic cycle and is fairly reflective of the nation's economic ups and downturns. It is comprised of 16 points that indicate various stages of economic growth and decline on a time vs. building type occupancy curve. On the charts (see adjacent page), "1" indicates the absolute bottom, with the country in full recovery with no new construction and declining vacancies. On the other hand, stage 6 indicates the start of growth and stage 11 represents the peak of the economic cycle. Stages 12 through 14 represent continued construction, but increasing vacancy, with 14 and beyond indicating decline and movement toward the bottom of the cycle.

Mueller's model forecasts where the major construction market sectors—industrial, office, retail and hotel construction—will lie come the second quarter of next year, as well as where the nation's major cities will stand in respect to these markets. To get an accurate feel for when such growth spurs might start—around position 8 on the curve—one has to be aware of where these markets are in the cycle.

Mueller estimates that in the second quarter of 2003, hotels, suburban offices, senior housing and outlet-oriented retail will be at stage 2. R&D and industrial will fare slightly better at stage 3, as will power center retail and downtown offices, at stages 4 and 5 respectively. But all will still be below any real growth phases. Warehouses, first-tier regional malls and multi-family housing, however, should begin to see the light of day. Health care should remain the strongest market and continue to wax. On the wane, however, will be second-tier malls, according to the economist.

In further analyzing the cycle, Mueller makes some significant points: On the demand side, there's a projected U.S. population growth rate of 2.4 million per year for the next 10 years, Due primarily to two factors: immigration and the "echo boom." At this rate, he says, a city the size of Denver would need to be built every year.

The college-age echo boomers will soon be entering the workforce, meaning a need for new apartment space. On the other hand, their parents—the baby boomers—are at their highest income earning years, meaning there may be a wave of second-home purchases, according to Mueller, especially with favorable mortgage rates and uncertainty about the stock market. Toward the end of this decade, Mueller adds, baby boomers will start to hit retirement age, possibly creating another new market for more sophisticated senior living facilities.

On the supply side, Mueller notes things appear to be in a constrained mode. Capital for construction will be economically driven, which means a low amount of speculative building; there are more research watchdogs on the lookout for bad investments; and construction labor is increasingly becoming hard to find. Combined with increasing material cost and infrastructure problems constraining growth—roads in the east and power and water in the west—not much in a building boom can be expected, hypothesizes the real estate tracker.

Addressing the office market in greater depth at the conference was Ray Owens, vice president and senior economist for the Federal Reserve Bank. He noted net absorption, which had been negative at about 30 million sq. ft., is now working its way back. Class-A space is showing improvement. Looking at recent absorption rates vs. total supply, Owens also noted that there is a 13-year supply of sublet space on the market. The amount being absorbed is currently quite low but rising, and the amount available is being capped somewhat by a sharp decline in construction, so that ratio is soon likely to flip in a favorable correction. Vacancy rates are moving up, but are still several percentage points below what was seen during the early 1990s. Owens says that even with a sluggish economic recovery, prospects for improvement in the commercial market appear in place for 2003.

"We still have a lot of discouraging information, but there's still enough in the numbers to see some recovery and that we may have hit the bottom," says Owens.

Also at the forecast conference, business analyst Ron Insana, co-anchor of CNBC's Business Center, answered general questions on the economy. One of his greatest fears concerned the threat of deflation. Currently in full force in Japan, deflation is a danger in the United States. Spending stops, as consumers defer purchases in anticipation of prices dropping further. Eerily, there are remarkable similarities in the current U.S. economy to Japan of 10 years ago, and even to circumstances predating the Great Depression, says Insana.

Significant safeguards, of course, have been built into the U.S. economic system to avert such a catastrophe, and Insana notes, in Japan's case, it was inaction for almost five years on the part of the Bank of Japan that let the problem take root. But specific markets can suffer. Telecommunications, for example, is a market suffering from both deflation and overcapacity—a problem, he says, that may prove hard to overcome.

Wrapping things up at the forecast conference was an architect's panel addressing general industry trends.

Three markets that should remain strong, according to Leo Daly III, chairman and CEO of Leo A. Daly, Washington, D.C., are federal government work—likely in the form of courthouses and government facility retrofits; aviation, in the form of security-related upgrades; and, not surprisingly, health care. "It [health care] is still hot. In fact, we have trouble finding professionals to serve the jobs," says Daly.

One sector where Daly anticipates a decline is the educational market, particularly the university side, as donations are starting to slow down.

Hugh Hardy, of Hardy Holzman Pfeiffer Assocs., N.Y., noted the same trend is occurring on the cultural side. And in New York, much of the city's focus remains on what to do with the real estate that formerly held the World Trade Center. As a result, planning has taken center stage. Along a similar vein, greater consideration is being given to projects involving renovation and redevelopment of older and more historic buildings and neighborhoods.

In the Midwest, Rod Kruse, a partner in the Des Moines, Iowa-based firm of Herbert Lewis Kruse Blunck, notes his company, which specializes in educational design, has definitely found a hot niche in renovation work, particularly creative reuse projects. For example, the firm converted a former gym into a fine arts teaching facility, and a former drive-in restaurant into a chiropractor's office. In fact, he notes that 50% of his firm's educational projects involve retrofit work.

Another trend on the educational front that Kruse shared is that many universities he's dealt with are starting to lean toward design-build as the preferred method of delivery.

Education remains a staple of Atlanta-based Perkins and Will, and the firm's chairman/CEO Henry Mann is upbeat about the sector as a whole. But as Daly noted, financing is an issue. "There's plenty of demand," he says. "The problem is client access to capital."

Another positive Mann notes, thanks to recent action by California's legislature, is that there should be a number of opportunities in that state to do seismic retrofits, as the state has mandated that all health-care facilities be so equipped.

In sum, 2003 appears busy, based on these firms' backlog, which logically should translate into corresponding work for the M/E/P community. Kruse, however, warns this take may be somewhat skewed, as the firms represented on the panel are all well managed and established practices not necessarily reflective of the whole design community. For example, he has noted a number of layoffs of designers in Des Moines. That being said, he suggested now is a good time for many firms to carefully examine their management system so there is a scheme in place to be able to execute even in tough times.