National construction outlook: no growth

By THOMAS R. LOY
FMI Corp.

The United States economy has downshifted, but is moving ahead nicely. Non-farm jobs increased by 2.2 million in 1998, with 300,000 of those jobs added after the summer upset in the stock market.

But make no mistake, this is not 1997. The world is interrelated more tightly than ever, and we cannot progress too far ahead of the rest of our fellow passengers. Of course our factories are turning more slowly because major parts of the world are in very difficult economic times, and are buying less of our potential output. Of course our producers are being squeezed as desperate overseas producers try to stimulate sales with bargain-sale prices.

Some producers have reduced staff, which erodes consumer confidence, dampens spending and reduces production even more. But the underlying strength of our economy will prevent this spiral from progressing too far. A recession will not develop and later this year the pace of growth will begin to pick up again.

As usual, construction activity will parallel economic activity, lagging somewhat behind. Residential construction, which grew 9 percent in 1998, will drop 1 percent in 1999. Nonresidential construction, up 2 percent in '98, will decline 1 percent in '99. Nonbuilding structures, flat in 1998, will grow 3 percent in 1999. Overall, construction activity was up 5 percent in 1998 but will show no growth this year.

Residential construction

Single-family construction surprised nearly everyone by growing 11 percent in 1998, spurred by the lowest interest rates in a generation. Even though mortgage rates were still very low as the year wound down, single-family construction activity was dropping as confidence began to sag. Besides, nearly everyone who could possibly purchase a new house, had already done so. Single-family construction has far outpaced its demographic drivers, which puts a very high likelihood on a payback period of below-trend construction.

Single-family housing starts will decline 3 percent this year. The value per start will increase, however, because the low end of the market will drop off more than the high end. The net result will be a drop of 1 percent in the value of new single-family housing. That will nevertheless qualify 1999 as the second best year ever for single-family housing, even after correcting for inflation.

Multifamily construction was up 6 percent in 1998. Many rental units were vacated as first-timers bought their own homes, thus reducing the demand for multifamily housing. Investors still remember the lessons of the late 80s and early 90s and are, in general, avoiding the temptation to overbuild. Construction in this category will be down 1 percent this year.

Nonresidential construction

Construction of administration, public safety and other (PSAO) buildings will be the star (in terms of growth rates) of this years nonresidential construction, growing 8 percent from the 1998 level, which was, in turn, 7 percent above 1997. Public safety represents a large part of this category and includes prisons, courthouses and law enforcement buildings. Growth in this area reflects our concerns with effectively combating crime, adequately housing prisoners and efficiently administering justice. Other growing publicly-owned building types that are included in this catch-all category are transportation terminals (air and rail) and roofed sports stadiums.

Privately-owned office and professional building construction rose 14 percent in 1998. Vacancy rates, according to CB Richard Ellis continued the decline that began in 1992 and now stand at 9.2 percent nationwide. That is the lowest level since the survey series was begun in the mid Eighties. The firm reports that about half the new space brought to market was already leased. This is about 15 points above the no-tomorrow days of the late Eighties, but already 10 points down from the previous year. Investors must exert prudence and restraint to avoid a replay of the Eighties. Of the 57 geographic areas surveyed by CB, only 7 showed vacancy rates higher than a year before: four in the West and three in the Southeast.

The Western red flags were Albuquerque, Fresno, Las Vegas and Salt Lake City. The Southeastern areas were Atlanta, Charlotte and Palm Beach County. Restraint will predominate this year and office construction will grow at 5 percent. While this is much below the 1998 rate it is still one of the best growth areas of the year.

Improvements to nonresidential buildings increased by 2 percent in 1998 and will increase at the same rate in 1999. Additions, alterations and other improvements to retail facilities, hospitals, schools and offices make up a large share of the group and, with the exception of hospitals, each of these will show some degree of growth this year. Hospitals will decline, as in 1998, reflecting the lack of resolution that still surrounds our health care situation.

The only other major category of nonresidential building construction to show positive growth in 1999 will be schools and other educational facilities. It grew only 3 percent in 1998.

This was surprising on two counts: first because it was a big drop from the 14 percent growth shown in 1997, and second, because the privately-owned sector held up (showing a 12 percent growth) while the publicly-owned sector fizzled, with only a 1 percent growth. This drop results from a change in public perception of the need for school construction, combined with the increasingly tough choices required in establishing budgets, both on the consumer and governmental levels. A slight further softening will be seen this year, with growth of only 2 percent.

Construction of stores and other mercantile facilities declined 6 percent in 1998, the first decline in this category since 1991. The frenzy of building big boxes and category-killers is over. They will certainly continue to be built, but not with the ubiquity of recent years. The struggle for survival now takes center stage.

There will be no letup in pressure on the smaller stores, who will continue to renovate as one of their primary strategies. The economic slowdown will intensify the struggle and hasten its outcome. Construction of new stores will decline 5 percent this year, although, as mentioned before, store improvements will show growth.

Industrial building construction dropped 6 percent in 1998, an improvement over the 12 percent drop in 1997. Throughout most of the year, manufacturers continued to make heavy capital investments. Unfortunately for contractors, most of the investment was in equipment rather than buildings. The result was increased output at lower costs with a minimal increase in square footage. Although there clearly is a limit to how far this can be taken, we have not reached the point where it is no longer profitable, and this concept of increasing productivity in order to increase production will continue to receive major focus.

As the economy slows and markets contract both domestically and overseas, investments will decline, leaving even less capital for new construction. Industrial building construction will decline 8 percent in 1999.

Nearly all warehouses are used in moving goods to manufacturers, retailers or consumers. With both store and industrial construction declining, it is no surprise that warehouse construction declines, too. Warehouse construction was down 6 percent in 1998 and will be down another 9 percent in 1999.

Hotel construction, which grew 3 percent in 1998, will show the largest decline of the major construction categories. It will drop 11 percent this year, the first drop since 1992. Over the seven-year span from 1992 through 1998, this category averaged growth of 22 percent per year, to four times its 1992 level. No wonder that investors and owners have finally begun to see declining occupancy rates and declining returns.

Nonbuilding structures

Highway construction, including bridges and streets, declined 1 percent in 1998, mostly as a result of interruptions in the flow of federal funds. With the greatly increased funds from TEA-21 now assured, state transportation departments can begin to plan for, and to commit to, growth. Although it will take a while for all the machinery to get in place and in motion, highway construction will be up 7 percent this year.

Construction of nonbuilding utility structures, the other major category in this group, grew by 6 percent in 1998. Continuing strength in the telecommunications industry and niche opportunities in electric power as a result of deregulation will yield 4 percent growth in 1999.

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