Understanding Market Changes in 2008

By all accounts, the residential construction market for 2007 experienced challenges — and those challenges will continue into 2008. The collapse in the sub-prime lending market, an abundance of standing inventory, price corrections, and an overall lack of consumer confidence factor into what has become a significant downturn. While there are some aspects of the market that will always remain unique to residential construction, it does provide strong indicators as to how the commercial market will fare in the not-too-distant future.

Historically, the residential construction market leads the commercial market by 12 to 18 months. By most measures, the residential market began its downturn around the end of the first quarter or start of the second quarter of 2007, meaning we should see the commercial market impacted sometime between spring and fall of 2008.

One of the first indicators of a commercial decline is the shift in trade contractors from residential to commercial. Some trades cannot transition from one to the other due to the unique demands of commercial work, but others will.

Site work crews are typically first to transition, and do so as early as three to four months into a residential decline. We are already seeing this trend. As the residential market tightens, crews that handle clearing, grading and paving begin seeking commercial work, resulting in increased competition for contracts. Residential trade contractors typically work at a lower cost structure than commercial crews, resulting in lower bids that drive down pricing. It's the simple economic principle of supply and demand.

Other trades follow the shift to commercial, including drywall contractors, mechanical trades and electricians. Some of these trades must focus on light commercial as opposed to heavy commercial, but the shift still has a significant impact on the market as a whole.

Owners and project managers will need to increase their scrutiny of contractors as market dynamics change. Some contractors now entering the market, while having applicable skill sets, are not accustomed to the requirements of commercial work. Using earthworks as an example, the requirements for compaction and backfill services are far more rigid for commercial work. The same level of inspection simply does not exist in residential. Low price doesn't always equal best value. Owners should consider budgeting for testing and inspection because the cost of correcting improper work can be crippling.

What we will likely see in 2008 may best be described as a correction in the commercial construction labor market. In the fall of 2004, commercial labor costs began trending upward. The rise was dramatic and continued over the last several years. Simply put, there was more demand for construction labor than could be supported by the marketplace's workforce. Contractors became more selective about the work on which they bid, resulting in higher pricing. That is now changing.

2004 also brought run-ups in material costs. New housing starts continued to grow year after year, and the commercial side followed suit. Producers had a hard time keeping up with the demand, which dictated that pricing would rise.

There were other influences that drove materials price increases such as hurricane damage across the southeast and unprecedented foreign demand, but simple growth across the board led the trend.

Anticipating a 2008 downturn, manufacturers will shift production to match the changing marketplace. For example, drywall manufacturers will shift production from residential 1/2 inch to commercial 5/8 inch. As a result, prices decrease as manufacturers flood the market with additional product.

Lumber has already dropped in price with the downturn in residential construction. Light construction relies on lumber in some degree, but lumber producers do not have the same opportunities to shift production to commercial uses.

One of the saving graces for the lumber industry is the boom in apartment construction. As mortgage rates increase, demand for rental property grows, resulting in increased apartment construction.

The downturn in residential construction was heavily impacted by the lending market. Lenders are often accused of operating in a herd mentality, sometimes offering questionable products because competitors do the same. As the residential bubble began to burst, lenders could no longer collateralize mortgages.

Now, lenders are becoming more conservative in supporting commercial construction. A year ago, most hotel projects could easily be financed. Now equity requirements are being increased as the market tightens.

One of the best ways to account for the lag between residential market performance and that of the commercial market is the impact of the financial industry. A typical commercial project takes 12 to 18 months to construct. Once a project has started, the money most often remains available throughout the construction cycle. As the residential market moves into a downturn, the financial market becomes conservative; however, previously secured financing is still disbursed, creating the lag in the commercial construction market.

Even in an overall economic downturn, there will be sectors that continue to perform. Government work will continue throughout 2008 and beyond. Whether at the municipal, state or federal level, governments will be in the best position to capitalize upon the reduction in material costs and the rise in available labor. Because governments are less reliant on the lending market, they are in a position to better weather the downturn. The effect of government spending is greater market stability and the potential for more contracts to be let as spending dollars go further.

Another solid sector will be healthcare. The demand for healthcare facilities is on the rise and projected to continue for years to come. The marketplace has nowhere near the capacity to meet the healthcare needs of aging baby boomers. The need exists for hospitals, clinics, outpatient services, and assisted living facilities.

One of the major challenges of working within each of the government and healthcare sectors is the unique expertise required. The nuances of managing government contracts and the highly technical requirements of working within the healthcare sector mean that not all contractors can easily make the transition.

Program management companies will ultimately experience greater demand during the downturn. Because there will be expanded focus on sectors like government and healthcare, specialized expertise is required to deliver projects on time and on budget.

Beyond program management, we anticipate an increase in mid-project intervention services as lenders begin turning up the heat on developers whose projects fall behind or look to be headed toward falling behind schedule. The risk of having developers default on loans will increase throughout 2008 as a function of a tightening market, yet lenders are in no position to allow construction loans to remain outstanding — especially following the residential downturn. They simply cannot take on the added risk.

Smart contractors will adjust expectations for the next two years and manage their business accordingly. They cannot expect to achieve the same year-over-year growth that many have enjoyed over the last several years.

What general and trade contractors do now will determine how successfully they weather the downturn. That means streamlining staff levels and slowing reinvestment in new equipment.

The decision must be made between bidding on work to keep crews productive, often reducing profit margins just to obtain the work, or cutting overhead and staff. Bidding on projects that don't cover costs provides no benefit to a company and depresses the industry as a whole. Ultimately, cost stability will be achieved, but only when contractors bid realistically.

While there are significant factors that will impact the 2008 residential market — elections, evolving global demand for materials and a rebounding residential mortgage industry — the single greatest factor in the residential market is consumer confidence. If the general consumer confidence levels out or rises, the market will rebound. The commercial market will follow in 12 to 18 months.