New Residential Plummets, Plateaus

Sept. 28, 2010

Residential construction put the brakes on 2007, forcing a 1.8-percent drop in total construction spending that was forecast to grow 5.2 percent. The decline in housing starts was twice as large as expected before the year began, caused by underestimated fraud in the residential mortgage market and underestimated share of homes bought with little or no downpayment and initially discounted mortgage rates.

This year, the two-year housing recession will end and begin to recover. Spending for both heavy and nonresidential building projects will increase more than 10 percent for the third consecutive year in 2008. The four-year acceleration of growth in public construction will begin to ebb, but private construction spending will resume growing after a steep two-year decline. All told, total construction spending should grow 7.1 percent this year.

Contractors and their suppliers will be operating in the second year of subpar economic growth in 2008, which means better pricing and availability for nonconstruction purchases such as office supplies. But supply conditions will tighten for specialized materials, labor and construction services during the third year of strong growth in nonresidential construction. Economic growth and especially the expansion of construction spending will accelerate over the course of 2008.

The brief spike in interest rates for mortgages and other construction loans last summer is now largely reversed. Although rates will not be a major constraint on construction activity, most financially marginal jumbo home and commercial mortgage applicants will not obtain loans. Much of this would have happened anyway as lendors increase scrutiny of income statements and balance sheets late in the building cycle, but they are still concerned about the quality of real estate assets: both the asset value if a sale is necessary and the borrowers' ability to repay the loan. Several brief episodes of credit-rate spikes and shortage of lendable funds are possible next year in the residential and commercial markets.

Short-term changes in financial markets do not impact public-construction spending. Public facility managers have their funding committed well before construction begins. Financial markets would affect public activity only if the problems spread to the broader economy. The Federal Reserve Board acted quick enough to prevent that last summer.

The key funding sources for public construction are all now stronger than average, but they will slip back to average over the next two years. State budget balances, including budget stabilization funds, were an above-average 8.2 percent of annual expenditures at the end of the fiscal year ending June 20, 2007. This was down from a very high 10.9 percent a year earlier. Slower growth in tax receipts and rising spending will cut the balance to an estimated 6.0 percent next June, which is about average. This is still high enough to support an above-average growth in state construction spending through 2008.

States are again underestimating tax receipts for the fiscal year ending in June. Initial spending plans incorporated only 1 percent real growth, after a 5.3-percent gain over the prior year. More spending, some for construction, will be added next spring when the revenue underestimate become apparent.

Similarly, key funding sources for institutional buildings are currently strong. Rapidly rising equity prices have boosted investment fund returns. In mid-October, the Dow Jones Industrial Average was 17 percent higher than a year earlier. Taxpayers are passing a larger share of bond issues in an economy with jobs and income still growing.

Hotels were the fastest-growing project type in 2007 with an estimated 61.6 percent increase in construction spending. Hotels will be the hottest project type again in 2008, although spending growth will fall to 21.8 percent. The value of new hotel starts rose 41 percent in the first eight months of 2007 compared to the same period in 2006, according to Reed Construction Data. One factor is the boost from the development of resort and casino hotels that are themselves destinations.

Construction spending for nursing home/assisted living facilities jumped 21 percent year-to-date through August. Expect a larger gain this year based on the 59-percent rise in the value of construction starts over the same period. Privatization and industry consolidation have opened up access to new sources of capital and set off a building boom.

Highway-construction spending increased only 6.2 percent in 2007 — about half of the gain in 2006 — and not enough to cover project cost increases. Credit the weak spending to Highway Trust Fund problems. High prices cut the volume of fuel sales and thus cut tax receipts. The forecast for 2008 assumes that Congress and many state legislatures will add to their highway funds with higher fuel taxes or general-fund tax receipts. But they will not do this fast enough to prevent more project delays and cancellations. Expect highway spending to increase 8.3 percent with most of the gain going to cover higher costs.

Regionally, heavy construction will expand rapidly in the West and the Northeast due to additional public funding. Growth in nonresidential building work will be weak in the Northeast, where project starts have already begun to slip lower. Precarious public finances in the industrial Great Lakes may force spending cuts. Large public budget reserves in the Northeastern, Plains and Southwestern states may permit supplemental spending appropriations.

The residential share of total construction spending will drop below 45 percent in 2008 from an unusually high peak share of 57 percent in 2005. The residential share will move back toward 50 percent in the following few years.

U.S. gross domestic product is expected to increase 2.6 percent in 2008. Growth will increase progressively from around 2.5 percent in late 2007 to about 3 percent by the end of 2008. This will be the second year of subpar economic growth. As a result, expect unemployment to rise toward 5.0 percent and "core" inflation to stay near 2 percent. Exports and business investment will be the fastest-growing sectors with consumer spending slightly lagging overall GDP growth. Exports are being driven by the depreciating U.S. dollar and still-strong economic growth elsewhere in the world.

Business investment spending will expand 5.2 percent in 2008, about twice as fast as the whole economy. The pace of investment spending will increase over the year and continue into 2009. The 2008 increase will be two points less than in the 2004-06 period of above-average economic growth, but slightly above the 2007 gain. The leading growth areas will be commercial buildings; equipment for machinery and technology factories; private infrastructure, especially power, transportation and telecommunications; and possibly motor vehicles.

Credit rates will remain slightly below average, relative to inflation, which will pro -vide a small boost to investment spending, including nonresidential construction. In spite of the recent turmoil in financial markets, inflation is expected to remain less than 2.5 percent, which ensures approximately steady interest rates through next year. Favorable credit conditions will not be enough to quickly reverse the recent plunge in housing starts. Lenders have closed the subprime mortgage market because of their large fraud losses; it will not reopen in 2008.

Housing starts have been declining for more than 18 months but are now near the bottom. Expect a slow recovery to begin this winter, but the housing market will remain depressed for several more years. Only about 40 percent of the peak-to-trough decline will be recoveredby the end of 2009. New home sales are being restrained by a surplus of two million existing homes for sale, the belief by prospective homebuyers that home prices will fall further, and the virtual shutdown of the adjustable rate, subprime mortgage market. Housing starts have already begun rising in local markets that missed the 2004-05 boom and the 2006-07 bust. The housing recovery will be delayed until late 2008 or into 2009 in the boom/bust markets in California, Arizona, Nevada and Florida.
2008 Construction Spending OutlookSpending to Grow 7.1%
$ Bil. Annual % Change
2008 2006 2007 2008
Source: U.S. Commerce Department Forecasts: Reed Construction Data
Total construction spending will increase 7.1 percent in 2008 after a 1.8-percent fall in 2007, the first in more than a decade. The pace of growth will accelerate during the year. Subtracting expected project cost inflation, construction spending will expand slightly faster than the rest of the economy. Monthly construction spending fell 5 percent from a peak level in March 2006 to about the end of 2007, due entirely to the collapse of the housing market. Resumed growth in total construction begins at the end of 2007 when the slide in residential jobsite activity nears the end for this housing cycle.
Total Construction Spending $1,255.6 5.6% -1.8% 7.1%
Residential, new $376.3 -1.7% -21.9% 4.0%
Residential improvements $185.5 7.4% 1.4% 5.8%
Nonresidential $441.2 12.7% 16.5% 10.7%
Nonbuilding $252.6 11.7% 11.6% 11.7%
Heavy Construction Trends & Outlook
$ Bil. Annual % Change
2008 2006 2007 2008
Source: U.S. Commerce Department Forecasts: Reed Construction Data
Heavy construction spending will increase 11.7 percent in 2008 — about the same as in the previous two years — but more than half of the gain will be due to higher cost, especially for cement, metals, energy-based products and, increasingly, skilled labor. Much of the added construction spending in 2008 will be for private power and transportation facilities financed by recent record high corporate profits.
Total Heavy Construction $252.6 11.7% 11.6% 11.7%
Highways & Streets $82.4 12.2% 6.2% 8.3%
Power $56.7 10.9% 21.7% 18.5%
Transportation $36.2 8.1% 12.8% 19.0%
Communication $28.7 14.4% 20.0% 10.3%
Water & Sewer $42.7 12.4% 6.2% 6.0%
Conservation & Development $5.9 18.5% 5.4% 5.4%
Nonresidential Construction Trends & Outlook
$ Bil. Annual % Change
2008 2006 2007 2008
Source: U.S. Commerce Department Forecasts: Reed Construction Data
Nonresidential construction spending will increase 10.7 percent in 2008 following the 13- percent rise in the value of new project starts in 2007. 2008 will be the fifth year of rising construction spending with a further rise likely in 2009. Casino and resort hotels, large shopping malls, and nursing homes/assisted-living facilities are the fastest-growing markets.
Total Nonresidential $441.2 12.7% 16.5% 10.7%
Education $106.0 8.2% 13.7% 8.2%
Commercial $91.4 7.5% 14.1% 6.0%
Office $72.8 19.1% 19.3% 11.8%
Health Care $53.6 14.9% 15.7% 17.1%
Amusement & Recreation $23.0 19.3% 10.4% 14.5%
Manufacturing $39.3 14.5% 6.5% 7.4%
Lodging $35.5 40.6% 61.6% 21.8%
Public Safety $11.5 7.2% 28.3% 14.8%
Religious $8.2 -0.6% -1.7% 8.7%