Spending Mix Turns Favorable

Growth will begin 2005 at a 4.0-percent annual pace, slip to under 3.5 percent by the end of the year, and be set for a 3.0-percent-plus gain in 2006 with only a modest rise in inflation and interest rates from the current level. Rapid improvements in labor productivity, another name for a jobless recovery, are keeping the non-inflationary growth potential at a minimum of 3.5 percent and perhaps as high as 4 percent. The slowdown in economic growth in mid-2004 was a reaction to oil price and Asian export surprises and not a signal that the economic expansion is ending soon.

Business-investment spending grew at nearly a 15-percent annual pace late in 2004 and will keep expanding at a double-digit rate well into 2005. Currently, the largest investment growth rates are for industrial machinery, off-road vehicles, corporate computer replacement, and telecommunications networks.

Credit costs are trending up now, but still slowly because of the brief dip in economic spending in mid-2004. Both mortgage rates and the prime rate will remain historically low for much of next year. Just as important, credit standards will be eased in an expanding economy, cutting credit costs for some marginal borrowers. The pace of interest-rate increases engineered by the Federal Reserve Board is likely to speed up significantly by the end of the 2005.

The housing market was stronger than expected in 2004 thanks to a delayed start to credit tightening by the Federal Reserve Board, the depressed state of the manufactured-housing industry, and contractors who put remodeling work on hold to start more new homes. New housing activity will be declining from mid-2004 until into 2006, but will remain above the long-term demographic demand trend for new housing units. Starts may not decline in the Northeast, Florida and California where supply restrictions have caused a buildup of unmet demand.

The residential share of total construction spending remains above the long-term average in 2005 although it will be declining over the course of the year. Expect the residential share to decline further in 2006 to nearly 50 percent.

What's Hot, What's Not   Hot Markets for 2005 Security-related projects in nonresidential and heavy markets Biotechnology labs Residential major replacements and additions Big-box retail buildings and mid-size shopping centers Healthcare facilities, including related offices Manufacturing, but it's still depressed K-12 schools Hotels Cold Markets in 2004 Starter homes Multifamily buildings Power (the building boom spurred by deregulation is over) Highway (Federal highway bill is still on hold)

Tables:

• Nonresidential Construction Trends & Outlook
• Heavy Construction Trends & Outlook
• 2005 Construction Spending Outlook

Real construction spending after inflation will expand between 2 and 2.5 percent in 2005, a decline from the approximate 4.5-percent gain expected in 2004. Nominal construction spending, including inflation, will fall from an estimated 8.7-percent increase in 2004 to a 4.5-percent gain in 2005.

The spending mix, however, turns favorable this year. Residential spending soared 12.5 percent in 2004, buoyed by persistent cheap mortgage rates and large gains in lumber and steel costs. But it will increase only 0.3 percent in 2005 as mortgage rates rise and cost increases ease.

But spending for nonresidential buildings will increase more quickly in 2005, with an 11.3-percent gain projected following the 4.9 percent in 2004. This will be the first significant gain in inflation-adjusted activity in four years. Also, spending growth for nonbuilding projects will expand from 3.6 to 6.6 percent. This will be the first gain in inflation-adjusted activity in three years.

These trends are expected to continue into 2006 with a further decline in residential activity and further expansion in both nonresidential and heavy-construction activity.

The economic environment for construction will be favorable in 2005 as the economic expansion matures. But the environment will change significantly from 2004. Growth in gross domestic product (GDP) has already slipped from above 5 percent to between 3.5 and 4.0 percent, where it will average through 2005. Credit costs will rise, but only to the average range—not enough to dominate construction-spending trends.

Construction-materials cost inflation will ease to an annual rate between 2.0 and 2.5 percent; this will be slightly more than overall inflation in the economy. This means that most of the sustained price rises experienced in 2004 will hold although the extreme spot prices for panels, framing lumber, and steel will not be repeated.

The labor market will be slightly tighter for contractors as 2.5 million jobs are added across the economy. This includes significant hiring by motor freight carriers and manufacturers, the two key competitors for young male semi-skilled workers. But there is enough slack in the labor market to keep most contractors from having to scramble for help or raise wages to attract workers from other industries. The labor market will tighten further in 2006.

Most important, there will be less excess commercial and industrial space, higher corporate profits, cash balances, and business confidence in the private market and stronger government budget balances in the public market. These are the changes that always spur a surge in nonresidential and heavy projects late in every business cycle.

The strongest regional economies early in 2005 will be the Atlantic and Pacific states with the interior states lagging. This gap will narrow over the year as manufacturing continues to expand. The best metropolitan market opportunities include housing and renovation in the Northeast spurred by the region's high income growth; commercial expansion in the Washington, D.C., area to serve government and technology employers; rebuilding and residential and commercial expansion in Florida's coastal retirement centers; commercial and industrial space in Los Angeles to service expanding Asian trade; and more of everything in California's central valley, Phoenix and Las Vegas where relatively low costs are attracting the most migration, both foreign and domestic.

Nonresidential Construction Trends & Outlook$ BillionsAnnual % Change2005200320042005Estimate and Forecast: Reed Research Group, Source: U.S. Commerce Dept.Nonresidential-construction spending picked up strongly at the end of 2004 after a year of stagnant growth. Continued expansion will recover 80 percent of the recession decline by the end of 2004 and raise the 2005 spending total 11.3 percent. The 22.7-percent gain expected for lodging spending is being driven by the rising room rates, occupancy rates, and hotel asset values that began early in 2004. The 26.2-percent expected rise in spending for manufacturing facilities comes from expanding factory production absorbing surplus capacity early in 2005.Total Nonresidential316.2-1.54.911.3Education82.83.12.49.0Commercial72.8-2.06.69.7Office49.4-10.07.011.3Health Care36.66.910.510.4Amusement & Recreation22.21.50.29.6Manufacturing18.3-14.10.926.2Lodging15.6-0.215.622.7Public Safety9.6-4.2-2.68.4Religious9.22.1-2.911.1Heavy Construction Trends & Outlook$BillionsAnnual % Change2005200320042005Estimate and Forecast: Reed Research Group, Source: U.S. Commerce Dept.Heavy-construction spending will rise 6.6 percent in 2005 and is expected to be increasing at an 8-percent pace by the end of the year. Real growth after inflation will be about 4 percent after two years of no net gain. The turnabout will be driven by an increase in federal-highway funds, substantial improvement in government budget balances, and private capacity addition needs in the third year of the economic expansion.Total Heavy Construction179.1-5.33.66.6Highways & Streets68.31.94.93.7Power36.1-11.3-0.38.8Transportation27.2-1.82.25.0Communication15.0-31.01.717.4Water & Sewer28.00.67.67.6Conservation & Development4.50.47.46.22005 Construction Spending OutlookSpending to Grow 4.5 PercentBillions of $Annual % Change2005200320042005Estimate and Forecast: Reed Research Group, Source: U.S. Commerce Dept.Total construction spending will rise 4.5 percent in 2005. After inflation, real growth will be around 3.0 percent. The slower market growth in 2005 is entirely due to the downturn in the residential market. Both the heavy and nonresidential markets will expand faster, after inflation, in 2005 than in 2004. The pace of growth begins the year low and improves steadily. The 10-percent surge in construction-materials prices that occurred early in 2004 will be largely carried over into 2005; then materials prices are expected to increase only about 3.0 percent over the course of 2005.Total Construction Spending$1039.64.8%8.7%4.5%Residential, New$407.015.5%17.3%-1.3%Residential Improvements$137.36.6%-0.3%5.3%Nonresidential$316.2-1.5%4.9%11.3%Nonbuilding$179.1-5.3%3.6%6.6%Total Private Construction Spending$798.55.6%10.2%5.1%Total Public Construction Spending$241.12.7%4.2%2.6%