As recovery begins, nonresidential construction will lag behind

The "delayed recession" in nonresidential construction means a slower recovery for the market as the economy begins to grow again.

By Bettina Chang, Editorial Intern October 1, 2009

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After months of foreclosures, bankruptcies, and layoffs, there finally appeared a glimpse of hope for the global economy. Newspapers reported that first China, Singapore, and South Korea; then France and Germany reported gross domestic product (GDP) growth in the second quarter of 2009. Consumer spending was higher than expected, and GDP in the United States was projected to grow 1.5% in the third quarter, according to Reed Construction Data (RCD), an Atlanta-based firm specializing in construction data, cost, and market analytics.

However, even if the recession slowed and data showed that construction markets were strengthening, economists warned that markets might not return to their previous levels for several years.

What do these economic conditions mean to consulting engineering firms? The following summary of economic data and forecasts from a variety of primary sources provides guidance that can help engineering firms plan for the future. Although consulting firms are mainly interested in nonresidential construction, this article follows the residential market because it can be a leading indicator of nonresidential market performance.

Construction market recovery

The United States is nearing, if not already at, the bottom of what economists like Nouriel Roubini of Roubini Global Economics LLC are calling a U-shaped recession. The economy was not expected to rebound quickly, as in a V-shaped recession, but will remain down with little or no growth for several quarters. RCD predicted in September that U.S. GDP would grow 1.6% in 2010 and 2.6% in 2011.

Jim Haughey, PhD, RCD’s chief economist, said that even if the economy showed a spike in growth, higher credit rates and materials costs and a slowdown of federal stimulus money would likely slow the long-term recovery for nonresidential construction. “[In the second] quarter, the GDP was juiced up a lot by Cash for Clunkers, but that program’s over,” said Haughey. “Now the economy will depend on housing to contribute to the continuing growth, but it’s going to be slow.”

Construction data provider McGraw-Hill Construction Dodge reported that residential construction grew 10% and nonresidential construction grew 13% in July. RCD predicted that housing starts would increase by 29% in 2010. These gains show that the market is stabilizing, but a full recovery has not yet begun.

“After a year or so, the housing market recovery will spill over into commercial markets,” said Haughey. “The decline in housing happened about three years before commercial, so we’re seeing a sort of delayed recession (in the commercial market).”

Haughey predicted that the nonresidential construction spending would continue to decline into the first quarter of 2010. On the other hand, FMI Corp. , a Raleigh, N.C.-based construction market research firm, reported that the nonresidential construction index was almost unchanged from the second to third quarter, and anticipated that the market had already hit a low.

Breakdown of nonresidential sectors

In the second quarter of 2009, nonresidential building was boosted by institutional structures such as hospitals, transportation structures, and churches. Although Dodge reported that healthcare construction soared 172% in July due to massive medical facility projects, Haughey said this rate could not continue and that new projects would be put on hold as Congress debated healthcare reform.

Transportation structures were aided funding by the American Recovery and Reinvestment Act (ARRA) of 2009 (also known as the stimulus plan), but the Associated General Contractors of America (AGC) reported that federal stimulus needed to be increased for nontransportation construction. FMI reported that only 21.9% of its panelists saw work coming in through ARRA funding, which replaced some of the work lost in the recession but also created fierce competition and bureaucratic problems.

“Stimulus work other than road work is just beginning, as expected, so there is very little hard data,” said Haughey. “Most of the money is yet to be assigned to specific projects… a criticism of the plan [was that] work would not start until late 2009 and most of the money would be spent in 2010 or even 2011.”

Commercial buildings registered a mixed performance in 2009. The manufacturing plant category had an especially weak July, falling 71% from the previous month. Meanwhile, retail stores, warehouses, and hotels posted gains, according to Dodge. For 2009 as a whole though, RCD predicted that spending would decrease for retail, which has been overbuilt, and hotels, which have been hit with loss of credit and rising vacancy rates. Haughey said that office buildings declined 16%, likely because of finance and professional service layoffs. (See “An impending commercial mortgage crisis?” page 41.)

Remodeling, repair, and maintenance

With new construction down, remodeling has taken an increased share of the construction market. According to the Joint Center for Housing Studies , the Leading Indicator of Remodeling Activity indicates that activity is at a cyclical low now, and will most likely increase even more in the near future. Remodeling accounted for more than half of the residential construction investment in the second quarter.

“Remodeling is never as volatile as new construction boom and bust. It might be delayed during a recession, but if your roof is leaking, the problem doesn’t go away,” said Haughey. “It looks like remodeling as a percent of total activity is trending up again.”

Programs in the 2005 Energy Policy Act and the stimulus plan provide tax credits for purchases of energy-efficient products, and some utilities are offering rebates for energy-efficient installations. With these incentives to retrofit buildings with more efficient systems, nonresidential remodeling may be poised to boost the market as well. (See “Green keeps growing despite recession,” page 42.)

The business of construction

In the third quarter, construction businesses saw their backlogs decline from nine months to eight months, according to FMI. Construction delays were at 20%, four times their normal rate, while there were five times as many cancellations as normal. These numbers are unchanged from before, but some believe that this is because more projects are being scrapped on the drawing table.

Haughey said that credit rates may have been low mid-year, but credit constraint would worsen by year end and stay serious for years. Both credit rates and materials costs will continue increasing in the next year or so. Similarly, the AGC reported that materials in 2009 are on a “limited-time sale,” especially diesel, copper, steel, and aluminum. The materials industry is subject to price spurts, transport bottlenecks, and fuel price swings. However, AGC predicts that the producer price index of materials will rise 6% to 8% after 2009, with higher spikes, which means that construction costs will rise as well.

In August, the AGC reported that job loss had slowed in other fields, but not for nonresidential construction, where employment shrank 1.3% in the previous month and 13.5% in the 12 months prior. Employment for architectural and engineering services related to nonresidential work fell 1% in the previous month, and 8.7% in the 12 months prior. Construction employment fell in 47 states since the beginning of 2009.

“In a technical sense, the recession is over if GDP is rising, but most people feel the recession is continuing as long as they hear about more job loss,” said Ken Simonson, chief economist of the AGC. “Nevertheless, with consumer spending rising, I think generally things will improve.”

The improvement will be protracted, as evidenced by data in construction and other markets as well. Once the federal government stops injecting stimulus money into the economy, the markets will have to hold their own, and construction companies will face rising costs for credit and materials. However, most signs point to a recovery in the making, and economists are optimistic about long-term growth.

Weathering the storm

As for now, consulting engineering firms must seek ways to do business in spite of depressed construction activity. In Consulting-Specifying Engineer’s 2009 MEP Giants report (August 2009), seven of the top 10 firms weathered a difficult fourth quarter to show growth in 2008. These firms emphasized that diversifying their projects was helpful because not all sectors were hit by the recession at the same time. However, diversification also led to more competition. Firms looked to strengthen client relationships and refocus on core business principles in order to stay afloat.

Many Giants entered the commissioning market as well. Retrocommissioning and retrofitting were more popular as new construction was too costly for many building owners. Data show an upturn in maintenance, repair, and operations work for consulting engineers. Green construction was also popular because of government funding incentives and the promise of long-term cost savings.

Regardless, the grim outlook of nonresidential construction markets means difficult times lie ahead for many consulting engineering firms. Firms will have to seek other ways to compensate for the slowdown of nonresidential construction as they wait for the economy to recover, which economists said may take more than a year.

U.S. institutional construction spending (% change)

Source: Reed Construction Data
Health 9 1 4 10
Education 8 2 -1 7
Public safety 27 8 -8 10
Total 8 1 0 8

“From this point on, we’ll see [GDP] growth of about 2% to 3% for the next year or so. It’s not likely that we’ll see two or three quarters with back-to-back GDP growth, which is typical after a recession,” said Haughey. “Still, the economy is probably recovering right now, and 2011 through 2013 look promising.”

U.S. commercial sonstruction spending (% change)

2008 2009 2010 2011
Source: Reed Construction Data
Hotel 25 -21 -6 9
Office 8 -14 -1 11
Retail -5 -24 5 15
Total 4 -20 1 12

U.S. nonresidential construction spending outlook (% change)

Source: Reed Construction Data
2006 12.8
2007 19.2
2008 9.1
2009 -3.8
2010 -2.4
2011 7.2

U.S. nonresidential construction spending outlook ($ millions, annual rate)

Source: Reed Construction Data
2006 Q1 323,008
2006 Q2 337,330
2006 Q3 348,971
2006 Q4 358,869
2007 Q1 375,373
2007 Q2 399,672
2007 Q3 421,992
2007 Q4 433,895
2008 Q1 435,451
2008 Q2 447,701
2008 Q3 449,821
2008 Q4 447,100
2009 Q1 438,446
2009 Q2 433,097
2009 Q3 426,700
2009 Q4 414,300
2010 Q1 410,540
2010 Q2 414,870
2010 Q3 420,250
2010 Q4 426,330
2011 Q1 433,365
2011 Q2 442,190
2011 Q3 452,770
2011 Q4 464,085


An impending commercial mortgage crisis?

While most economists agreed that the nonresidential sector was behind in recovery, some worried that the situation could worsen if commercial real estate faced a mortgage crisis like the housing crisis that precipitated the 2008 recession. As reported in the Wall Street Journal (WSJ) in August 2009, $700 billion of commercial-mortgage-backed securities (CMBS) were being tested by plummeting property values and growing vacancy rates.

As vacancy rates grew, properties weren’t making enough money to pay back loans. Credit rater Realpoint LLC told the WSJ that the CMBS delinquency rate was 3.14% in July, more than six times the level a year earlier. Additionally, low property values made it difficult for borrowers to extend existing mortgages or replace them with new debt. Like the housing market crisis, foreclosures could lead to more bank troubles before the economy fully recovers from the current recession.

WSJ reported that it was unlikely commercial real estate would benefit from an early stage of economic recovery. To avoid a catastrophe, building occupancy needs to rise, which means companies need to hire more employees and consumers must spend more money.

Green keeps growing despite recession

“Green” or sustainable construction is on everyone’s mind this year as the federal government allotted $43 billion for energy-related programs. State energy plans, smart grid test sites, renewable energy initiatives, and green retrofits for federal buildings were all recipients of stimulus money. In a down economy, engineering companies were eager to capitalize on government-funded projects, and building owners sought the rebates and long-term cost-savings from building green.

Consulting-Specifying Engineer’s 2009 MEP Giants expressed the benefit of the green construction market to their firms. “With energy resources at a premium, companies are paying close attention to their operation costs,” said Roy T. Gifford, vice president director of healthcare engineering services, HDR Inc., Pasadena, Calif. “Tax credits and other incentives are spurring increased interest in sustainable buildings.”

Despite a shrinking construction market, interest in sustainable building practices has allowed the green building market to steadily grow since it began as a $10 billion market in 2005. According to construction data provider McGraw-Hill Construction Dodge, green seems to be one area of construction insulated from the downturn. The green construction market is expected to grow into a $96 billion to $140 billion market over the next five years.