2004 belongs to nonresidential

Construction spending growth will stay at 3-3.5% in 2004, but the timing and mix will be very different from last year. The growth pace will be 2-2.5% early in the year as new residential activity slows. The pace will accelerate to over 4% in the second half of the year as nonresidential growth quickens in an expanding economy and heavy construction gets a boost from new funds in the fiscal year 2005 public budgets.

Nonresidential is the most cyclical construction market, so it will receive the biggest boost during the recovery phase of an economic cycle. The impact is more than the shift from -1.5% growth in 2003 to +6.7% next year because some nonresidential sectors will not start to expand quickly until spring 2004.

Commercial sector first to rebound

Spending for commercial projects (which the U.S. Department of Commerce now defines as retail, parking, and warehouse) has been increasing strongly since February, with retailspace typically following closely behind new housing. This offsets the steep drop in spending in 2002 and keeps total 2003 spending unchanged.

Spending will continue to expand into 2005. Initially, this will be largely neighborhood space to keep up with recent housing construction. Later next year, as a reflection of a stronger economy, larger regional projects will kick in.

Some large retail projects will be built before they are justified by increased consumer shopping demand because capital exiting the depressed bond market is flowing to real estate to obtain better returns.

The warehouse sector (17% of total commercial) shrank by one-third in the last three years, but is poised to grow 4-5% in 2004. Surplus distribution capacity is being absorbed quickly as goods industries expand faster than service industries during this early recovery phase of the business cycle.

Footloose capital starts new office cycle

Office construction spending was stuck for most of 2003 at a $39-40 billion annual rate, after a two-and-a-half-year slide that resulted in a 40% decline. A pickup appears to have begun at the end of the year, but it is too soon to tell if it will be sustained. Thus far, the increase has largely been focused on renovations to accommodate recalled office workers and neighborhood offices to serve new housing developments.

A sustained recovery requires the start of major projects that will contribute to monthly spending totals for many months. With the current 16%-plus vacancy rate, developers can wait a few more months until they find a lead tenant or until they get commitments for investment capital at a low capitalization rate.

The financial environment — not space demand — will determine when enough new projects are begun to make the office construction recovery self-sustaining. This is expected to occur during the winter. Office construction spending will grow at a 7-8% annual pace early in 2004 and accelerate to over 10% by the end of the year. By midyear, rising office employment will begin to contribute to space demand as vacancy rates start falling quickly.

Finance (mostly mortgage banking), insurance, legal, real estate, and medical offices are the only sectors currently expanding employment. The two hottest sectors in the late 1990s, corporate administration and business technical and professional services, are still shrinking but will be net hirers by summer. Office employment growth will be the key driver of office construction spending in 2005 and beyond, as the footloose investment capital, which starts the recovery in 2004, returns to the equity market.

School boom takes recess

K-12 enrollment is up 0.3% this school year and post-high school enrollment is up 0.9%, but classrooms are getting more crowded. Education spending had increased at an 11% annual pace for 10 years, but is now in the middle of a mulityear pause as cities and states have had to postpone planned school projects to maintain balanced budgets.

This is the impact of the 2001 recession and the fizzled recovery in 2002 on tax receipts. While the recession was mild, the impact on tax receipts was severe because of overdependence on very cyclical, progressive income taxes and even higher tax rates on capital-gains income. The tax shortfall was aggravated by the diversion of public money to areas such as security, defense, and healthcare.

Already, a strong economic recovery and higher stock indexes are easing state and local tax liabilities. However, much of this added tax income won't be realized until the April annual tax returns. And then it will not be available for appropriation until the next fiscal year, beginning either in July or October. As a result, education construction spending will be stagnant until the fall, when it is expected to return to a 6-7% annual growth rate.

The combined impact of rapidly rising tax receipts and expanding enrollment make it likely that the market will be strong market for the next several years. It is even possible that the market could return to double-digit growth.

Manufacturing's engines rev up

Manufacturing has been the most depressed construction sector for several years, contracting nearly 70% since 1998. Current spending has declined below the replacement level in many industries. Recently, only automotive and semiconductor makers have expanded significantly.

The depressed market is attributed to the usual steep, cyclical decline during a recession and to the reduced U.S. share of world manufacturing caused by the 40% appreciation of the dollar in the late 1990s. Both of these factors no longer apply. The value of the dollar has retreated 20% in the last two years and the shift of the business cycle into the expansion phase has already begun to boost factory production.

During 2004, the dollar is expected to decline an additional 6-7% and industrial production is forecast to rise 5-6% on top of the small increases that occurred late in 2003. Factory capacity utilization is now only 75%, 6% below average. This means the initial construction recovery will be in the renovation or conversion of idle space in active buildings and then in vacant buildings.

Expect manufacturing construction spending to expand at a 10% annual pace through the summer and accelerate to 15% by the end of the year; a cautious outlook given this sector has had sustained 20% growth for several years during previous periods of above average economic growth.

Lodging market poised for growth

The restarted economic recovery is expected to reach the lodging market early in 2004. An abrupt turnabout is expected, with activity expanding at a 15% annual pace for most of the year. Total spending will increase 7.7% in 2004.

This sector responds quickly to higher occupancy and room rates and to capital gains on hotel properties. These have now been improving for six months due to the sharp early recovery pickup in travel. Resorts and modest business hotels have had the most improvement in occupancy.

Lodging construction will expand more than 10% in 2005. This is the typical cyclical pattern of strong expansion very late in the recovery cycle. It is too soon to tell how long the expansion will last. In the last economic recovery period, hotel construction spending more than doubled from 1995 to 1998.

Healthcare remains spry

The healthcare construction boom faltered a bit early in 2003 when the economy and investment environment were weaker, but it had enough momentum to post an estimated 7.9% gain. A 9.3% spending increase is expected in 2004.

This is an unusual market in that most healthcare services are either prepaid or welfare benefits, so short-term demand always exceeds supply. As a result, the quantity of services and the ensuing space need is determined by the amount of the prepaid pool and the size of the public appropriation for healthcare.

Although the healthcare market is predominantly private, the decisions that set the scale of healthcare construction require government approval. Insurance premium increases, typically over 10%, have been set for 2004 and will boost construction funds proportionately. Similar growth is likely for 2005, but there is a risk of another consumer revolt that would trim insurance premiums and construction funds.

Overbuilt multifamily declines slightly

The apartment vacancy rate is over 8% nationally and as much as double in some of the rapidly growing metro areas in the South and West. But this restraint on multifamily construction is nearly offset by a favorable financial environment for developers and the move of the economy into the business cycle phase that is typically most favorable for apartment demand.

Behaving similarly to single family, the condo market is stronger than apartment rental, with a much lower vacancy rate. As mortgage rates slowly rise, condos and single family will slow.

In all, multifamily construction spending is expected to decline only 2.2% in 2004, equivalent to a 4% decline in after inflation volume.

Investors seeking capital gains are moving to real estate from bonds, where low yields offer little hope of substantial gains. This raises the asset value of buildings and attracts even more capital.

On the demand side, the coming years promise a return to employment growth, gains in the household count, and higher immigration. In addition, the age cohort in their 20s, a key target of apartment developers, will expand 50% faster than the general population.

Construction spending overview