2009 Economic outlook
Access to credit has improved at the beginning of this year, so the projected further decline in nonresidential construction is primarily due to weaker space demand.
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The commercial construction boom that began in the spring of 2004 ended in the middle of last year due to the worldwide collapse of the credit bubble and accompanying recession that quickly cut demand for additional space. The latest building cycle was stopped by problems in the economy several years short of the usual end due to overbuilding. In comparison, the previous building boom of 1994 to 2000 persisted for 6
The construction outlook abruptly soured in the second half of 2008. Spending for nonresidential construction expanded at a 12% annual pace from July 2004 to July 2008, then growth dropped to less than a 6% pace through October 2008, with declining spending now expected through late 2009.
Private commercial construction got the quickest and hardest hit from the credit freeze. The value of starts in October 2008 plunged 44% from September 2008 for the sum of hotel, office, retail, and warehouse. Projects ready to start were held up to redo financing and/or wait for a clearer view of the recession’s scale. A large share of the October drop was recovered in November. This suggests that the abruptness of lost financing arrangements—rather than lower space demand—was very significant in October. These projects, unlike public and institutional projects, depend considerably on rolling over short-term loans in the credit market for financing.
Access to credit has improved by the beginning of 2009, so the projected further decline in nonresidential construction is primarily due to weaker space demand. Public and institutional construction did not entirely escape a direct hit from the credit freeze. Instead of stopping projects about to start or already underway, the impact was the postponement and cancellation of scheduled 2009 starts. There was no downturn in starts at the end of 2008.
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Retail and office construction
Commercial (retail) construction spending dropped 11% in the 12 months ending in October 2008. The value of retail starts fell 3.5% from mid-2007 to mid-2008 as record high energy prices forced a reduction in real income and the volume of consumer spending. This existing weakness in this market led to a 5% plunge in retail starts from July to October with declines continuing well into 2009.
Inflation-adjusted consumer spending recorded an unusual decline in the final quarter of 2008, which will keep construction activity shrinking well into 2009. Note that most of the reported fall in consumer spending is due to falling prices for energy and other goods and still-weakening auto sales. The volume decline at other retailers was minimal.
Real estate investors now see retail as the least attractive commercial market. In the past year, the retail vacancy rate has risen from 10% to 15% and rental rates have dropped about 4%. The vacancy rate will rise several more percentage points by the end of summer, and rental rates will keep slipping at the same pace into 2010.
Office construction spending was 10% higher at the end of 2008 than at the end of 2007, but will slip slightly through early 2010. Developers stick with office projects longer than retail projects because rents adjust to worsening economic conditions more slowly, and the more stable public and nonprofit sectors provide a significant share of office tenants.
Starts of government office buildings were rising through last summer before the impact of the recession hit public budgets. The small decline in nominal job-site construction spending includes a 10%-plus fall in the square footage of office project starts by the middle of 2009. Substantial layoffs are underway in office-based industries. The finance and professional and business services industries cut 410,000 jobs from July to November with larger cuts expected early in 2009. In the past year, the office vacancy rate rose from 15% to 17%, and office rental rates fell marginally after a five-year rise.
The hotel construction boom ended last spring. Construction spending nearly quadrupled over three years but did not grow in the five months through October 2008. This market is now dominated by large destination hotels, often built together with condos, retail, and office space or casino or resort facilities. This is a different market than 60-room motels by the Interstate exit.
The traditional lodging market is suffering the recession in parallel with the retail market. But construction spending for the destination hotel market, while stalled, is not expected to decline significantly in 2009, though project starts will drop more than 10%. These hotels cater heavily to foreign visitors.
Education construction spending, adjusted for inflation, grew through the middle of 2008 and will slip slightly for two years. Construction expansion will resume in spring 2010. Education was not directly impacted by the credit freeze because very little short-term financing from the money markets is used in project funding. The recession has a delayed impact on education construction because project managers do not have to consider the availability of paying tenants in their building decisions.
The recession will trim the K-12 market more than the university market. Already, K-12 spending has fallen slightly, while university spending continues to expand rapidly. The K-12 market was weaker when the recession hit because enrollment growth has been marginal for several years, while college enrollment has continued to expand much faster.
Also, K-12 construction spending relies almost entirely on tax receipts for financing. The purchasing power of income tax receipts began to decline early in 2008. This spread to sales tax receipts late in 2008 and will spread to property tax receipts, largely through delinquent payments, early in 2009. Some states and large cities will experience 10% to 20% falls in the buying power of income tax receipts as taxes on capital gains income plunge. By contrast, university construction budgets rely substantially on student fees, gifts, federal grants, and investment funds. Fees and grants will be more stable than tax receipts. Gifts and investment earnings are already dropping sharply, but fund balances are typically enough to support projects underway or scheduled to start quickly.
The K-12 enrollment bulge is now in the 10th grade, so more complex high school buildings will get a larger share of the K-12 construction budget in the next few years.
Spending on private school projects will slow and recover first because investment earnings and tuition income react more quickly to changing economic conditions than do property tax receipts.
Health care spending
Construction spending for hospitals, assisted-care facilities, and medical office buildings has been steady in nominal dollars, but declining in inflation-adjusted dollars for more than a year, though the nursing home sector has been expanding. This weakness was due partly to shortages of skilled tradesmen, specialized designers, and contractors comfortable with these complex projects. The worldwide cutback in facility construction has lifted this constraint. Nonetheless, credit access delays and higher borrowing cost are expected to cause a brief drop in healthcare construction activity early in 2009. Overall, healthcare construction will fare relatively well during the recession because its largest source of income—patient charges—will continue to expand.
The assisted-care and medical office building sectors have become private commercial markets in recent years, and hence react to abrupt changes in the economic environment just like shopping centers. Construction spending for assisted-care facilities slowed sharply late in 2008 as developers’ financing arrangements were disrupted. The progressively thawing credit freeze will permit some bounce-back from this in 2009. Assisted-care developers have few concerns about the supply of tenants who are financed by Medicare or accumulated savings. Construction spending for medical office buildings plunged sharply at the onset of the credit freeze and is projected to decline 4% in 2009.
Hospital construction spending slowed in 2008 and will not expand in 2009. This will be the first “no growth” year in a decade. Hospital project starts did not decline through November and job-site construction spending continued to expand through October. However, hospitals have begun to trim their 2009 capital budget and have some work scheduled for a 2009 starts on hold, assuring no growth in job-site construction spending in 2009.
The manufacturing construction boom is over. Manufacturing construction spending tripled in the past four years, and will decline for at least two years at a double-digit pace, measured after adjusting for changing project costs. The recent boom was largely for process improvements in the metalworking, oil, and petrochemicals industries and for commodity processing. The recession ends the need for these investments for several years.
Factory production plunged at a 10% annual pace at the end of 2008 to trim excess inventories resulting from the abrupt drop in consumer spending. Factory capacity use fell to 75.4% in November, well below the usual 80% threshold for rising investment in factory capacity. The use rate will dip to the low 70s by the summer of 2009.
|2007||2007||2008||2009||July ’04 to July ’07||July ’07 to July ’08||July ’08 to Oct. ’08|
|$ millions||Annual % change||Annual % change|
|* Also includes preschool, libraries, museums, and administrative |
** Excludes federal buildings
|Amusement and recreation||21,610||13.8||7.4||-4.5||10.0||23.9||19.0|
|All nonresidential buildings||402,242||17.6||12.1||-0.5||11.8||12.2||5.7|
|Data sources: Historical: Census Bureau; Forecast: Reed Construction Data|
|Haughey is chief economist with Reed Construction Data. He has more than 30 years of experience as a business economist, including 20 years monitoring the construction market. He has a doctorate in economics from the University of Michigan.|
Recession cuts need for additional building space
The 2008-2009 recession will be more severe than the mild recessions in 2001 and the early 1990s, but less severe than the deep recessions in the early 1980s and the mid-1970s. The recession will be front-loaded—the panic from the surprise credit problems in September 2008 caused a larger-than-normal share of the inevitable spending cutback decisions to be made early.
Q4 2008 GDP will drop as much as 4% with several smaller declines following. The new Congress will enact another economic stimulus spending plan very quickly. The 2008 stimulus spending interrupted the recession in Q2 2008 with +2.8% GDP growth. The new plan will have a similar impact in mid-2009 and will contribute to ending the recession in summer 2009. Much of the stimulus will be added funding for public works, and some will be targeted to public buildings. Recovery from the recession will be unusually slow because credit costs will remain high for a recession period as lenders try to replace the capital lost to unpaid residential mortgages. GDP growth will remain sub-par (under a 3% trend) through 2010.
The decline in the nonresidential building market is not due to overbuilding, but to credit access and overall economic spending issues, so there is some additional growth left in this building cycle beyond 2010.
Recession worst in Midwest and Northwest
The current recession began in the industrial Midwest and the busted housing markets in the Southeast and Southwest several years ago, but is only now arriving in the oil states on the Gulf Coast with cancellations of energy industry expansion plans.
Each region’s economic condition is set by the health of its key industries. The Great Lakes economy, dominated by motor vehicle and other manufacturing, has declined further relative to the rest of the country in the final months of 2008. The expected emergency loan to the auto companies replaces private credit no longer available, but comes with spending cut mandates that will reduce industry labor costs in 2009 and further weaken the region’s economy.
Employment and income have weakened sharply in recent months in the Pacific Northwest (Idaho, Oregon, and Washington) because of the heavy reliance on manufacturing, especially lumber, and electronics—two of the weakest industries in the United States now. All three state governments have been forced to cut spending and increase taxes.
The New England and Mid-Atlantic states had better-than-average economic performance through October because of their heavy reliance on financial and professional employers. This is now ending with the beginning of significant finance industry layoffs in October, and business and professional services layoffs in November. These layoffs, unlike in manufacturing, are not typically recalled when business begins to improve, so the Northeast economy will be a declining trend for at least three quarters. New York has the most risk because the securities industry’s annual bonuses are the largest source of personal income in New York City.
|Annual percent change, last 3 months|
|Source: Federal Reserve Bank of Philadelphia|
|Great Lakes -3.3%|
|Rocky Mountain -2.5%|
|South Atlantic -2.4%|
|New England -1.3%|
|Gulf Coast +1.0%|
The Pacific, Rocky Mountain, and South Atlantic regions all are faring worse than the rest of the country at the beginning of 2009. Each region is suffering from manufacturing layoffs, declining tourism and leisure industry revenues, and very depressed housing markets, which is limiting spending in other construction sectors. This region has a net outflow of illegal immigrants, which reduces the need for additional building space and facility capacity.