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.

The 2003 model

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.

What’s to come?

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.

Can’t argue supply and demand

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.

What other experts say

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.

Deflation a threat

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.

The architect’s take

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.

Renovations rocking

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.

Management a must

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.

Nonresidential Construction Trends & Outlook

Billions of $

Annual % Change

2001
2002
2003
2001
2002
2003

Source: U.S. Commerce Dept.

Total Nonresidential Spending
298.1
276.2
286.7
0.4
-7.3
3.8

Commercial
126.7
104.9
108.5
-4.2
-17.2
3.4

Office
52.0
37.9
40.4
-6.4
-27.1
6.6

Retail
60.3
56.3
57.0
-0.1
-6.6
1.2

Hotel/Motel
14.4
10.7
11.1
-11.5
-25.9
3.7

Industrial
29.0
17.2
18.2
-8.7
-40.8
5.8

Institutional
142.3
154.1
160.0
7.2
8.3
3.8

Healthcare
19.2
21.2
21.8
3.2
10.6
2.7

Private
15.1
16.5
16.7
4.7
9.2
1.2

Public
4.1
4.7
5.1
-2.0
16.0
8.3

Education
68.4
77.5
84.6
11.8
13.3
9.1

Private
12.6
13.7
14.3
11.0
8.5
4.4

Public
55.8
63.8
70.3
11.9
14.4
10.2

Religious
8.3
8.5
8.8
3.6
2.2
3.5

Other Private
9.3
8.3
7.9
-10.4
-11.1
-5.0

Other Public
37.2
38.6
36.9
7.4
3.7
-4.4

All PRIVATE N-R Buildings
201.0
169.1
174.4
-3.4
-15.9
3.1

All PUBLIC N-R Buildings
97.1
107.1
112.3
9.5
10.3
4.9

CII Takes It on the Chin in ’02 But Should be Off the Mat By ’03s End

Following a stagnant 2001—and a decidedly down 2002—total nonresidential construction spending in 2003 should show some improvement, but at best, will still be a year of transition. For example, the growth rate for both privately and publicly funded work will come in well below the annual average for the past decade.

Some perspective

The value of nonresidential construction spending declined by an estimated 7.3% between 2001 and 2002. This was the first loss recorded for the sector since 1992.

But the nonresidential sector as a whole kept growing during 2001 only because of impressive gains in publicly financed projects. Spending for private nonresidential construction work fell by 3.4% during 2001 and a breathtaking 15.9% during 2002, making it the worst year for private work since the 18.8% plunge recorded between 1990 and 1991. Publicly funded building, on the other hand, grew by 9.5% in 2001 and by an even-stronger 10.3% in 2002. Consequently, the private share of total nonresidential construction activity shrunk from 67.4% in 2001 to just 61.2% during 2002.

In the seven-year period between 1994 and 2000, overall nonresidential construction spending grew at an average annual rate of 9.6%. We’re not likely to see this kind of growth in 2003, or 2004 for that matter. But the projected 3.8% increase in total nonresidential construction is a step in the right direction.

Commercial

After recording annual growth that averaged 12.1% between 1993 and 2000, overall commercial construction spending —office, retail, hotel—declined by 4.2% during 2001. In 2002, spending fell off the table with an estimated full-year loss of 17.2%. Spending in both the office and hotel sub-sectors declined 25% to 30% between 2001 and 2002, while spending for retail buildings was down a relatively modest 7%. We’re looking for total commercial spending to inch ahead over the second half of next year, but the projected full-year increase of 3.4% will still pale in comparison to the “glory” days of the mid- and late-1990s.

Industrial

The industrial sector has been a basket case for some time now, owing largely to the fact that manufacturing and warehouse space worldwide—not just in the United States—is grossly overbuilt. With U.S. capacity utilization rates extremely low for most manufacturing industries and industrial vacancy rates for warehouse and manufacturing space at the highest level in almost a decade, there’s little prospect for any sort of strong gains in industrial construction spending until mid-decade. But following declines during five of the past six years—including the loss of a heart-stopping 40% during 2002—the industrial sector should begin to stabilize during the next six months, albeit at an abysmally low level of total construction activity. But by the end of the year, we believe the market should be able to record a modest gain in spending of about 6%.

Institutional

In contrast, the institutional sector is likely to see the factors that propelled its growth during the past several years diminish in the year ahead. The good news is that this dip won’t be enough to stop total construction spending in the sector from growing again during 2003—as it did during every single year in the 1990s. However, the projected gain of just under 4% will be the slowest for the market as a whole since 1994.

Guarded optimism

All in all, 2003 is shaping up to be a year that will be not great, but not so bad compared to 2001 and 2002. Underlying this comparative optimism about the prospects for a second-half recovery in 2003 is the bold assumption that the U.S. economic recovery as a whole will gather strength as we move through the year. A big part of this assumes a successful resolution of the “Iraqi problem.” Despite the uncertainty, these are reasonable assumptions. So our “best guess” is that the nation’s nonresidential markets will enjoy somewhat brighter days by the time we reach the closing weeks of 2003. At the least, it will certainly be better than these closing days of 2002.

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