Time to Prepare for the Construction RecoveryJim Haughey, RCD Chief Economist

May 5, 2010

2 0 1 0 C O N S T R U C T I O N F O R E C A S T W H I T E P A P E R S E R I E S

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Contractors and their suppliers should be shifting their focus now from coping with a declining market to planning for an expanding market. Most construction market companies will have to deal with unpaid debts from the long recession and lingering credit rating and equity participation shortfalls for another year or more. Nonetheless, they should be preparing to get a share of soon expanding bid opportunities as soon as they are able to arrange for more capital or credit.

Unmistakable signals are now appearing that the economic recovery is sustainable and that it will soon lead to increasing demand for building space and facility capacity. This has already happened in many housing markets and for some types of nonresidential projects in a small but growing number of regional markets. With space and facility completions continuing to slow, the space and capacity surpluses that prevent new project starts will soon be ebbing. Market by market, project type by project type, this turnabout will gradually happen over the next year.

How quickly construction activity begins to expand depends on how long it takes to absorb the existing space and capacity surplus. In turn, this depends on the current size of the surplus and the timing and pace of increasing demand. Uniquely in this business cycle, the lag between economic recovery and construction recovery also depends on how quickly access to credit returns to normal.

The economic recovery is sustainable

GDP has now expanded for three consecutive quarters at average pace of 3.8%, assuming a 3.5% increase in the first quarter of 2010. Concerns about a double dip recession are now seldom heard. Instead the discussion has shifted to how quickly the recovery will proceed. GDP growth in the first three quarters was about the half the pace of previous deep recessions. And the pace of recovery will slow, as always after the initial surge. GDP growth is forecast to average about 2.5% for the balance of 2010 and through 2011.

The relatively slow recovery is typical after a “financial crisis” recession. This is due to lingering problems replacing capital lost in defaulted loans, damaged balance sheets, more cautious use of financial leverage and lenders’ aversion to risk.

However, the economic recovery is sustainable even if the growth rate is relatively low compared to historical norms. Sustainability is measured by the trends in the most cyclical sectors of the economy: business investment, inventory investment and consumer durables consumption. All of these sectors are now rising strongly enough to pull up the more stable sectors of the economy after them. A recession has never occurred when the three most cyclical sectors of the economy are expanding.

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Cyclical economic sectors now expanding Last Last 4 Quarter Quarters Consumer Durables annual % change 3.2 7.3 Inventory annualized change, $ billions 15 -80 Business Equipment Investment annual % change 5.6 7.6 Source: US Dept of Commerce

Sustainability is also assured by the federal commitment to aggressive monetary and fiscal policy as well as the ongoing exogenous surge is US exports to an expanding international economy. Fiscal policy is extraordinary expansionary with federal deficit jumping about 1 $ Trillion. Concern about the deficit will limit further federal spending increases. The huge jump in the deficit is a serious threat to economic growth several years ahead but the near term impact in unambiguously expansionary. Similarly, monetary policy remains expansionary nine months after the recession was over. This is longer than usual. The Federal Reserve Board has committed to hold down interest rates for at least six more months. Interest rates have risen slightly recently with more gains ahead later this year. However, interest rates will remain low enough that they will exert only marginal restraint on economic recovery this year.

The latest economic reports have shown a clear pickup in the pace of economic growth. This includes consumer spending, exports, factory orders, sales and production, housing starts, and the Index of Leading Economic Indicators. Only confidence has yet to show sustained improvement although it has rebounded from the winter dip caused in part by unseasonably poor weather.

Economic recovery is accelerating March 10 vs. Feb 10 % ChangesHousing Starts 1.6 Retail Sales 1.6 Exports 0.3 Manufacturing Production 0.9 Manufacturing Orders 0.5 Index of Leading Economic Indicators 1.4 Employment (000’s) 162,000

Source: Federal Reserve Board and US Dept. of Commerce

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The across the board improvement in the economy in March is partly due to a rebound from unseasonably poor weather earlier in the winter as well as the beginning of huge number of Census 2010 hires. But accounting for both of these impacts, the long decline in employment ended in March. Within a few months this will have a very positive impact on both consumer and business confidence. Rising confidence will accelerate the absorption of surplus building spaced and facility capacity. The number of households (occupied housing units) declined during the recession as unemployed workers doubled up in rental units or moved back with their parents. The improved labor market will prompt the creation of more households in the next few months.

The lingering credit problems from the past recession are now having only a marginal negative impact on economic growth; but the constraint is predominately in the construction market. Many contractors and their suppliers always have damaged finances and restricted credit access at this point in the business cycle. It is the extra damage and restriction stemming from the 2008 credit collapse that will extend the usual lag between economic recovery and construction recovery in 2010.

The problem for the construction market is that lenders are reluctant to invest in real estate so soon after being burned in the housing market and while they are now coping with a rising tide of troubled commercial mortgages, many now worth much less than their face value. This reluctance will fade very slowly over the next few years. Washington countered the shortage of credit in the housing market by directly providing most the funds for residential mortgages for a year and a half. But there is much less federal aid for the now troubled commercial mortgage market.

Reed Construction Data expects that the unique financial constraints in this construction recovery will delay recovery in the private nonresidential construction market by only a few months. Most of the impact will be a stretch out of the recovery period as lenders return very cautiously to commercial real estate.

Construction spending decline ends in a few months

Jobsite construction spending fell 8.4% in the last four months through February. This overestimates market weakness because of the substantial negative impact from unseasonably poor weather during the winter and an implausible surge in residential remodeling reported for last October, the base month. Nonetheless, there was a real decline of about 4-5%.

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Housing outlook

During that period single family housing construction spending rose only 3.7% during the lull after the expiration of the first homebuyer tax credit. Permits rose sharply to an annual rate of

543,000 in March assuring that housing starts and residential construction spending will rise at a more rapid pace in the spring and summer, probably at a 20% plus annual rate.

The recovery in single family housing faces a lot of headwinds but is expected to overcome them and be the fastest growing construction sector in 2010. While the oversupply of existing homes is a major headwind, homebuilders have reduced the inventory of new homes for sale to an extremely low level. Additional sales will require additional home starts. The additional sales will be spurred by the expansion of the job count which began in March. The recovery will take several years to get single family housing starts back to the underlying demographic trend set by population growth.

Multi family construction spending declined nearly 20% in the four months through February. It is now at less than half of the peak level reached in May 2008. March permits increased to an annual rate of 142,000; except for last December, this is the highest level in year and a half. A 20% gain in multi family construction spending is expected over the next year. This will be driven by the increase in jobs which leads to a surge in new households that rent apartments. The new renters move out from crashing on friends or their parents.

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Year/Quarter

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Data for chart (page 5)

Housing Starts (000’s)

Source: History: Census Bureau Forecast:ReedConstructionData

Commercial construction spending

Commercial construction spending fell 13% in the four months through February. The drop was 30% for hotels, 12% for office and 6.5% for retail. This decline will slow sharply during the balance of 2010 with spending turning up at yearend. Commercial project starts have trended lower in recent months with March starts very weak but little if any further decline in starts is expected in 2010.

Developers focus on the market conditions when their project is completed. Projects started this spring will be completed late in 2010 or in 2011 when commercial occupancy and rental rates have begun to rise again. This turnabout in national statistics will still leave some lagging cities with declining occupancy and rental rates. And even in cities with rising occupancy and rental rates, the expected net operating income of newly completed building will be too low to spur developers to add more space. It will still be cheaper to buy than build.

But within a year there will be more niches where it is cheaper to build than buy. A share of these buildings will start soon. In some cities this will be in the form of previously started then suspended projects being resumed with new financing. Hence, commercial building starts are not expected to drop any lower and will average higher than the weak March 2010 starts report.

Retail will recover first followed by offices which is turn will be followed by hotels. Lodging will be the last to recover because of the recent overbuilding in casino and destination hotels which dominated the hotel construction market in recent years. Construction of hotels targeted to consumer and business travelers will recover much sooner than construction of destination hotels.

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Yr./Qtr.10.1 617 10.2 660 10.3 700 10.4 733 11.1 766 11.2 806 11.3 854 11.4 910

Yr./Qtr.08.1 1059 08.2 1017 08.3 868 08.4 658 09.1 528 09.2 540 09.3 58709.4 559

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Data for chart (above)

Commercial Construction Spending $ Billions, seasonally adjusted annual rate

Source: History: Census Bureau Forecast:ReedConstructionData

Institutional construction spending

Institutional construction projects are started when their government or non-profit owners have the construction funds in hand or committed, whether by legislative appropriations, user fees, dedicated tax increases, bonding, donations or capital fund earnings. Occupancy and rental rates are not a concern since the building will be owner occupied and not leased. Access to private market credit is a minor concern for those projects that need cash before their dedicated funds are available.

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Yr./Qtr.10.1 103 10.2 101 10.3 100 10.4 100 11.1 101 11.2 103 11.3 105 11.4 108

Yr./Qtr.08.1 194 08.2 197 08.3 193 08.4 181 09.1 163 09.2 149 09.3 130 09.4 114

Year/Quarter

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Hence, institutional construction spending continued to increase through last June, nine months after the credit freeze and the onset of a deep recession. Funding for the construction work that continued or was started during that period was already in hand or committed. The recession came late to this sector. Construction spending has dropped 16% since last June. Spending has been just short of steady for the last three months with only a marginal decline forecast during spring and summer based on the recent decline in the value of institutional project starts, especially in education and healthcare.

The decline in institutional construction spending will turn out to be only one-third as deep as the decline in commercial construction spending. The institutional market is always steadier because of its funding sources and its use as a means to stimulate spending and jobs during a recession. The February 2009 stimulus plan appropriated over $50 billion for the construction or renovation of public and institutional buildings. Most of this has yet to be spent. The stimulus funds will dampen the recession for institutional buildings.

The recent decline and the lack of any improvement in the next six months are due primarily to the collapse of state and local government tax receipts over the last five quarters. This includes an estimate by the Rockefeller Institute of Government that receipts fell further in the first quarter of 2010. This is the steepest drop in tax receipts in more than 50 years. It is causing cutbacks in public construction, especially K-12 education and public safety facilities that will persist through 2011 and possibly beyond.

K-12 education has the most risk for further declines since it is heavily dependent on property tax receipts which continued to expand well into 2009 because they are based on much earlier property value assessments. Higher education has and will continue to fare better because construction funds come heavily from tuition receipts which have continued to expand and from capital funds, now expanding rapidly again.

Healthcare construction spending has fallen 20% since the peak level last June but the decline has been very small in the last three months with no further decline expected. Hospital building programs, especially at university hospitals, were cautiously cut or delayed early in the recession. The caution was the result of concern about the cost and availability of short term commercial borrowing, the usual concern about profit margins at for profit hospital chains and uncertainty about the outcome of the Washington healthcare reform debate – specifically the so called “public option”. None of these issues are any longer as concerning.

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Data for chart (above)

Institutional Construction Spending $ Billions, seasonally adjusted annual rate

Source: History: Census Bureau Forecast:ReedConstructionData

Heavy construction spending

Heavy construction spending weathered the recession better than building construction spending. Heavy spending rose through last September and has dropped less than 7% since then through February with only minor further declines expected for the rest of 2010. The

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Yr./Qtr.10.1 167 10.2 167 10.3 167 10.4 171 11.1 175 11.2 180 11.3 185 11.4 192

Yr./Qtr.8.1 188 8.2 194 8.3 195 8.4 195 9.1 195 9.2 198 9.3 189 9.4 174

Year/Quarter

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heavy market received a substantial boost from the “shovel ready” portion of the stimulus plan. That boost is now ebbing with little likelihood of additional federal highway stimulus money. Instead, the failure of Congress to replace the failed federal highway funding system assures that highway construction spending will not keep up with project cost increases until at least late in 2010.

The large power construction market, mostly electricity generation, but also oil& gas surface facilities and pipelines began to decline last October after more than doubling in the previous three years. This is a very cyclical sector that is expected to decline more than 20% in the next two years. The decline would be larger without the energy stimulus funds and mandates for alternative energy sources. Several large pipelines are set to start soon for ethanol, Canadian natural gas and US natural gas from recently developed shale formation in the Northeast and Rocky Mountains.

Construction spending in the balance of the heavy construction sector is unchanged from a year ago although water has weakened significantly due to the sharp cut back in site development. Construction spending for transportation and communications facilities and water, sewer and conservation projects are all expected to be slightly higher a year ahead although probably not enough to fully cover higher project costs.

The spending drivers will be delayed spending of stimulus funds, a rebound in pace with the rest of the economy in demand for new transportation and communications facilities and a pick up in site work and the need for new water/sewer lines with the recovery in housing and, to a lesser extent, the initial recovery in nonresidential buildings.

Note that the site work and utility expansion comes very early for a building project and that building starts will expand quicker and sooner than building construction spending.

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Data for chart (page 10)

Heavy Construction Spending ($ Billions, seasonally adjusted annual rate)

Source: History: Census Bureau Forecast:ReedConstructionData

Construction suppliers

Many suppliers involved at the design stage will see the earliest signs of recovery. However a large number of projects have already passed through this stage and then were halted. So a more than usual share of the design work for projects that will start in the next year has already been done. The American Institute of Architects (AIA) tracking of design activity suggests that the current work level is just short of stable. Similarly, employment data for architecture and engineering employers suggests that several years of layoffs may soon be ending.

Construction equipment manufacturers have had increasing sales for nearly a year but it was all export business. Domestic purchases continued to decline until March when equipment orders, sales and apparent domestic purchases all rose significantly. Strengthening sale prices on used equipment sold by equipment rental houses has been reported recently by Rouse Assets Services.

The construction materials market shrank about 20% over three years but then recorded a reasonably up tick in March with gains reported for orders, production, sales and sales through retailers. The one month surge may not be sustainable but a progressive recovery of this market is expected to begin about mid-year.

Yr./Qtr.10.1 269 10.2 269 10.3 269 10.5 271 11.1 273 11.2 275 11.3 276 11.4 280

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Yr./Qtr.8.1 264 8.2 268 8.3 271 8.4 270 9.1 262 9.2 276 9.3 282 9.4 275

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