Residential and Commercial Construction to Pull Economy Ahead Through Sluggish Institutional Sector

August 11, 2014

The performance of the nonresidential building market has been a mixed bag so far this year. Comparing construction spending in May 2014 with levels from a year ago, several of the nonresidential commercial sectors were up, often at a double-digit pace. Spending on office buildings was up almost 19 percent, while the red-hot hotel market was up another 11 percent. Retail and other commercial facilities, as well as manufacturing facilities, grew at a more modest single-digit range.

However, these positive trends in the private commercial and industrial sectors were offset by weakness in the institutional sector. Spending on healthcare and public safety projects declined more than 10 percent over this 12-month period, while the larger education sector saw a modest 1 percent decline in spending. Spending on religious facilities also declined, leaving amusement and recreation as the only major institutional building sector to see improvement over the past year.

As a result, the AIA’s Consensus Construction Forecast panel scaled back its outlook for the year. Its current projections are for 4.9 percent growth in spending on nonresidential buildings in 2014, down from a projected growth rate of 5.8 percent at the beginning of the year. Its projections for 2015 remain unchanged at 8.0 percent growth. Prospects for the commercial and industrial sectors remain very optimistic, with the 2014 projections lowered only modestly but offset by slightly higher projected growth for 2015. However, emerging optimism for the institutional sector has faded, as the AIA panel is now projecting no gains in spending on institutional facilities this year, down from a projected 3.4 percent growth at the beginning of the year. Next year is also projected to see somewhat slower growth than was envisioned at the beginning of the year.

After rocky first quarter, the economy is improving

An unusually severe winter in many parts of the country slowed economic growth in the first quarter of the year. However, most economists were surprised by the severity of the downturn, with the GDP declining almost 3 percent on an annualized basis, the steepest quarterly downturn since the depths of the Great Recession.

The first quarter weakness likely was an aberration and doesn’t seem to reflect structural problems in the economy. Indeed, the Federal Reserve Board’s June economic projections call for much better growth in the second quarter and about 3 percent growth for the second half of year. That would bring 2014 growth in GDP above 2 percent for the year, followed by 3 percent gains in 2015. The Fed also sees the national unemployment rate falling to around 5.5 percent next year.

This outlook is favorable enough to get the Fed to consider changing course on its monetary policies. In all likelihood, the Fed will have wound down its purchases of long-term government bonds—the so-called quantitative easing it has been pursuing since the last recession—by the end of this year. By the middle of next year, it may begin looking to raise short-term Federal Funds rates from the near-zero percent level they have been at for several years.

Without that monetary stimulus, the economy will have to generate its momentum internally. For that to work, consumer spending will need to increase, businesses will need to resume capital spending, banks will need to be less restrictive in their lending practices, and state and local governments will need to resume needed public investment.

Consumer spending is greatly influenced by job growth, and recent employment reports have been encouraging. In the second quarter of last year, more than 800,000 new payroll positions were added, according to the U.S. Department of Labor, or 3.2 million at an annual rate. Job growth above 2.5 million is generally considered very favorable. With consumers sensing better economic conditions ahead, consumer confidence scores are at their highest level since before the last recession.

Getting businesses to reinvest in their facilities is very dependent on their profitability. With stock market indexes hovering near record highs, investors obviously feel that businesses are doing well financially. Corporate balance sheets are generally quite strong. After-tax corporate profits have increased around 25 percent since the beginning of 2012, according to Commerce Department figures.

Even with an improving economy, lenders have been cautious about lending into the commercial real estate sector since the Great Recession. Banks began dramatically tightening their lending standards for commercial real estate loans in 2007 and have reported only modest easing beginning in 2010. The 2014 second-quarter Federal Reserve Board survey shows some additional flexibility on loans for multifamily structures but only modest net easing for construction and land development or commercial real estate lending. However, this modest level of easing lending standards is falling well short of the strong increase in demand for commercial real estate loans, according to these same Fed surveys.

The fiscal condition of state and local governments is critical to the construction outlook for several of the institutional building categories, particularly education. State budget reserve balances (essentially rainy day funds to be accessed in case of an emergency) averaged a healthy 7.4 percent of annual budgets heading into fiscal year 2015, according to a recent survey conducted by the National Governors Association. (Reserve balances of at least 5 percent of the annual budget are considered the minimal desirable level.) However, there is a great deal of variation across states. Five states (Arkansas, Illinois, Pennsylvania, New Jersey, and New Hampshire) have rainy day funds of less than 1 percent of annual budgets, while an additional 13 states are below the 5 percent target. Still, governors of 39 states are recommending spending increases for K–12 education. States are likely to increase spending even more if revenue gains grow more than expected.

Construction spending expected to improve

Compared to their outlook at the beginning of the year, the AIA Consensus Construction Forecast panel lowered its 2014 outlook for nonresidential building activity very modestly, but left the 2015 forecast largely unchanged. Commercial buildings are expected to see healthy gains during the remainder of 2014 and continue into 2015, while the institutional market is not expected to begin a full-fledged recovery until next year.

Residential outlook solid

Housing starts nationally are expected to total between 1.0 and 1.1 million this year and should represent a 10 to 15 percent increase over 2013 levels. However, this is not only well below the over two million housing starts at the peak of the last upturn in 2005, but also well below the 1.5 million annual average housing starts seen over the last five years of the 1990s, when the market was seeing more traditional levels of demand.

Single-family starts are expected to approach 700,000 this year. While up from their low point of 430,000 in 2011, they still are only slightly more than half of their late-1990s annual average of 1.2 million. Multifamily construction is expected to be in the range of 350,000 to 400,000 this year. That figure is well above its 2009 low of 110,000 and also above its late 1990s average of 325,000. The ABI residential index (which is heavily weighted toward the multifamily market because of architects’ heavy involvement) averaged 56.7 during the second quarter of this year, and was above 50 for every month since the fourth quarter of 2011. As such, expectations remain very positive for residential activity, at least through 2015.

Commercial sectors continue recovery

To date, the commercial property recovery has been very uneven. After a modest downturn in 2011, spending on commercial facilities increased over 8 percent in 2012 and another 6 percent last year. However, given the magnitude of the downturn, these two single-digit annual gains were quite disappointing, and month-to-month growth figures were unusually volatile.

The commercial/industrial ABI index averaged a solid 52.5 over the second quarter of this year. The Construction Consensus Forecast panel sees a strong year this year for the commercial sector, with 9.9 percent growth in construction spending, followed by another year in excess of 11 percent. Both the office and hotel markets are projected to see combined 2014 and 2015 growth rates exceed 25 percent. Retail construction held up better during the downturn, and as such is seeing a more modest recovery at present.

Institutional market poised to recover but remains stalled

Institutional building activity normally lags the commercial market by several months. However, it’s been two and a half years since the commercial market recovery began, and the institutional numbers are still disappointing. The rebound expected to occur in the first half of the year has now been pushed back to the second half of the year at best, but will more likely wait until next year.

After some encouraging numbers in the institutional ABI sector in late 2012 through August 2013, the institutional scores dropped below 50 again, and remained there through this past May. The June reading was barely above 50, and hopefully will remain there in the coming months. Given the normal six-to-nine–month lead of the institutional ABI over institutional construction spending, the expectation is that market conditions will not improve significantly this year. The forecast panel is expecting no growth in spending this year before a modest recovery next year. The education sector may be closest to recovery at present, given the improvement in the fiscal situation at most state and local governments. However, the strongest upturn next year is expected to be for healthcare facilities, as healthcare providers get a better sense of underlying demand generated by the Affordable Care Act.

Wildcards abound

Overall, the AIA Consensus Construction Forecast panel has a reasonably positive outlook for the industry over the next 18 months. But possible downside risks remain, including access to credit and construction financing. Real estate remains an uncertain sector in the economy, and it wouldn’t take too much to scare off lenders even more. Also, corporate profitability has been very strong, driving up equity and stock prices in most sectors of the economy. However, many investors remain nervous that stocks are overvalued and that they may retreat quickly with signs of weaker profitability in the coming months. Finally, international tensions are unusually high, with concerns that these events may disrupt energy markets or generally have a negative effect on the domestic economy.

But uncertainly doesn’t always mean bad news, and there are several upside risks that could buoy the economy beyond current projections. Rising home prices should help improve the financial situation of many local governments that rely on property taxes to fund their expenditures. Also, the upcoming Congressional elections should help point to a more certain direction for government and reduce the uncertainty that has paralyzed businesses. Finally, continued growth in domestic energy production will elevate employment numbers and consumer spending trends, as well as make domestic manufacturing activities more profitable.

By Kermit Baker, Hon. AIA, AIA Chief Economist
Reproduced with permission of The American Institute of Architects, 1735 New York Avenue, NW, Washington, DC 20006.