1999 construction-industry outlook: ups and downfalls

The U.S. economy has down-shifted, but it is moving ahead nicely. Nonfarm jobs increased by 2.2 million in 1998; 300,000 of those jobs were added after the summer upset in the stock market. Year-end unemployment was an impressively low 4.7%, and consumer prices were up only 2%.The stock market became more stable as the year ended, regained its lost ground before Thanksgiving, and closed the year near

The U.S. economy has down-shifted, but it is moving ahead nicely. Nonfarm jobs increased by 2.2 million in 1998; 300,000 of those jobs were added after the summer upset in the stock market. Year-end unemployment was an impressively low 4.7%, and consumer prices were up only 2%.

The stock market became more stable as the year ended, regained its lost ground before Thanksgiving, and closed the year near the midsummer highs. U.S. factories began to turn more slowly in 1998 because major parts of the world are in very difficult economic times and less of our potential output is being bought. U.S. producers are being squeezed as desperate overseas producers try to stimulate sales with bargain prices.

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

Residential construction Single-family construction surprised nearly everyone by growing 11% 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% in 1999. 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% 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% 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 1980s and early 1990s and are, in general, avoiding the temptation to overbuild. Construction in this category will be down 1% in 1999.

Residential improvements grew 6% in 1998. Driving forces behind home improvements are many and complex, but two major ones are, "Let's fix up this house we just bought, so it will be like we really want it," and, "Let's fix up this house and sell it, so we can buy one we really want." In either case, housing starts and sales of existing homes are major determinants of home improvements. Furthermore, last year's sales of existing homes add to the correlation, too, reflecting fix-up of newly acquired homes. Because 1998's strong home sales will still buoy 1999 home improvements, that category will not decline as much as starts or this year's sales; residential improvements will drop 1% in 1999.

Commercial/industrial construction Construction of public safety, administration and other buildings will be the star (in terms of growth rates) of 1999 nonresidential construction, growing 8% from the 1998 level, which was, in turn, 7% 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 included in this catchall category are transportation terminals (air and rail) and roofed sports stadiums.

Privately owned office and professional building construction rose 14% in 1998. Vacancy rates, continuing the decline that began in 1992, now stand at 9.2% nationwide. That is the lowest level since the survey series was begun in the mid-1980s. Commercial Realtor CB Richard Ellis (CBRE) reports that, in the most recent quarter surveyed, 51% of the new space brought to market was already leased. This is about 15 points above the sky's-the-limit days of the late eighties, but already 10 points down from a year ago.

Investors must exert prudence and restraint to avoid a replay of the eighties. Of the 57 geographic areas surveyed by CBRE, only seven 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 in 1999 and office construction will grow at 5%. Although 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% 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 positive growth in 1999. Hospitals will decline, as in 1998, reflecting the lack of resolution that still surrounds our healthcare 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% in 1998. This was surprising on two counts: first because it was a big drop from the 14% growth shown in 1997, and second, because the privately owned sector showed a 12% growth while the publicly owned sector fizzled, with only a 1% growth. This overoptimistic forecast resulted 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 in 1999, to a growth of only 2%.

Construction of stores and other mercantile facilities declined 6% in 1998, the first decline in this category since 1991. The frenzy of building big boxes and category killer megastores 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% in 1999, although, as mentioned in a preceding paragraph, store improvements will show growth.

Industrial building construction dropped 6% in 1998-an improvement over the 12% 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.

The industrial vacancy rate, as reported by CBRE, rose to 8.6% in the latest quarter, from 8.1% a year ago. Vacancy rates in the 46 metropolitan areas covered in CBRE's survey range from Baltimore's 22.3% to Oklahoma City's 2.6%. Twenty-six areas showed increases over the previous year. The top four gainers, all east of the Mississippi, were Jacksonville, Baltimore, Nashville, and Wilmington. The four with the biggest drops in vacancy rates were Miami; Portland, Ore.; Orlando; and Stamford, Conn. 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% in 1999.

Hotel construction, which grew 3% in 1998, will show the largest decline of the major construction categories. It will drop 11% in 1999, the first drop since 1992. Over the seven-year span from 1992 through 1998, this category averaged growth of 22% per year, to four times its 1992 level. No wonder investors and owners have finally begun to see declining occupancy rates and declining returns.

Contractor self-defense Remember the cliche about generals preparing to fight the previous war? That's what comes to mind when some pundit says a really severe economic shakeup can't happen now because we've fixed all the problems that wreaked havoc in the 1920s, or the 1960s, or the 1980s. A little voice then says, "yes, but what new traps have we built since then?" It wasn't so much the near-failure of Long-Term Capital Management, or the fact that at the urging of he Federal Reserve itself, major financial institutions were willing to risk $3.6 billion to slow its demise, fearing worldwide financial carnage. The scary thing was another financial institution also required a multi-billion-dollar bailout a few weeks later. How many of those, for how many different reasons, are just over the horizon? And, how many can we rescue before we're out of life preservers?

The point here is there are some really serious things that could go wrong. They are not likely to happen. The U.S. economy will probably downshift again but keep moving ahead. We don't really know what's out there in the darkness, and a very prudent, cautious, aggressiveness is the proper stance for now. Contractors should plan with extra care, and stick to their plans. Avoid panicking into abandoning your plan. The economic climate will be chilly, but, like your mother told you, take along extra protection and avoid exposure.

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