Economists Appear Cautiously Optimistic About 2005 Market

Economists Appear Cautiously Optimistic About 2005 Market

Industry analysis performed in 2003 predicted 2004 would be a flat year for construction, putting the construction industry on a slow road to recovery. However, in its 2005 Construction Outlook, McGraw-Hill Construction says 2004 will actually end the year with a 9% increase in new construction starts and reach $577 billion the biggest gain in total construction since the late '90s (Fig. 1 below).

Industry analysis performed in 2003 predicted 2004 would be a flat year for construction, putting the construction industry on a slow road to recovery. However, in its 2005 Construction Outlook, McGraw-Hill Construction says 2004 will actually end the year with a 9% increase in new construction starts and reach $577 billion — the biggest gain in total construction since the late '90s (Fig. 1). So in retrospect, the slow road to recovery didn't turn out to be quite so slow after all. What caused the results to exceed projections? The single greatest influence was the fact that long-term interest rates and inventories stayed low enough to keep the raging residential housing market hot, despite economists' predictions that it would cool off.

As 2004 comes to a close, the question on everyone's minds is, “What will 2005 bring?” Projections vary from a 2% increase predicted by McGraw-Hill Construction to the U.S. Department of Commerce's 6% estimate — with several more falling in between. (For more 2005 predictions on construction put-in-place, see Table 1 and Table 2) Because economists must base their projections on many unknowns and rely on historical data and trends to make educated guesses, in a way they're really hedging their bets as to what tomorrow will bring — and most tend to stay on the conservative side.

Based on the fact that last year's percentage increases far exceeded expectations, it's hard to know exactly what to expect for 2005. However, most economic analysts agree that the overall construction market is on an upswing, and the driving force behind that growth is shifting.

The residential housing market has carried the load for the majority of the construction industry during the recession and beyond, and public projects have struggled to keep up. But that may be changing. Once interest rates rise, economists predict the homebuilding market will finally slow down; however, they believe the non-residential market will step in to take its place.

“I expect housing to taper off the way I'd expected it to in 2004,” says Ken Simonson, chief economist for the Associated General Contractors of America, Washington, D.C. “I think 2005 will be better for private non-residential work and start to get better for public construction. Public sector finances are getting better at the state level, so I think the legislatures will start appropriating more money.”

In Simonson's Dec. 2, 2004, report he suggests the silver lining for 2005 may be tucked inside storm clouds. For example, he says real gross domestic product has grown at a steady pace (between 3% and 5%) for four straight quarters and should produce a repeat performance in the final quarter of 2004. This is a great lead-in to 2005. “I believe the case is slightly stronger for an economy that will thrive, rather than dive, in 2005,” Simonson says. “But the results will vary significantly among sectors, and even within some.”

The consensus among experts at Reed Construction Data's North American Construction Forecast Conference in October was that 2005 will bring the beginning of an economic recovery that will gain momentum through 2007, despite impending interest rate hikes and continued sluggish job growth during 2004. The group forecasted that the next two years would not only provide an increasingly stronger economy, but will also usher in a positive upward swing for the industrial, public, and other non-residential construction markets.

Ed Sullivan, chief economist of the Portland Cement Association (PCA), feels strong growth in non-residential construction, moderate growth in public construction, and slowing residential construction will equate to about a 3% increase in the real value of total construction in 2005. Sullivan believes that a strong economy will fuel non-residential construction while increasing interest rates will begin to slow down residential construction. He also believes industrial construction will experience a strong increase by the summer of 2005, and despite higher office vacancy rates across the country, office construction will improve.

Randy Giggard, manager of research services at FMI, Raleigh, N.C., thinks 2005 will bring with it many of the same risks as 2004, including confusion over oil prices, the Iraq situation, job creation, and unstable consumer confidence. However, he expects oil prices to fall and consumer confidence to improve gradually in 2005. The only wild card, he says, is the Federal Reserve policy and expectations that it will steadily raise interest rates.

So although most experts agree 2005 has the potential to be a good year for construction, the key will be to know where to look for the work. That's why this year we've taken a different approach and broken down the construction market into 12 sub-categories to give you a better idea of which sectors are hot and which ones aren't.


Single-family housing. While the housing market is expected to cool down in 2005, the pace of construction should remain at near-record levels. Speaking at the NAHB Construction Forecast Conference in October, David Seiders, chief economist and senior staff vice president at the National Association of Home Builders (NAHB), Washington, D.C., expects single- and multi-family housing starts to slow down in 2005 to a combined total of 1.853 million units. Due to the unexpected resilience of the housing market, Seiders has had to revise his projections over the past several years. For example, the actual construction totals in 2004 were 13.82% higher than what he forecasted last year. Similarly, he's raised his 2005 total construction prediction by 11.76% since last year's conference.

NAHB expects fixed mortgage rates to increase from 5.9% this year to 6.5% next year before passing the 7% mark in 2006. Based in part on this rate increase, NAHB is calling for single-family housing starts in 2005 to decline 4.4%, followed by another 3.5% decline in 2006 (Fig. 2 above). Glenn Mueller, Ph.D., a professor at Johns Hopkins University's Real Estate Department and a real estate investment strategist for Baltimore-based Legg Mason, says it's important to remember that a 6.5% mortgage rate is considered the “tripping rate,” or the point at which enough pressure on home affordability results in significant declines in single-family construction activity.

The run-up in residential construction over recent years has been phenomenal, notes Giggard, who continues to be surprised by this sector's endurance. “It's interesting because if you look back, economists have been predicting this market would cool off, and it just keeps going,” he says. “Again, we're predicting a slowdown, although the total construction value is still up 6%.”

According to McGraw Hill's 2005 Construction Outlook, there's been more to the residential market's phenomenal run than the low cost of financing. Demand has been boosted by the attractiveness of housing as an investment, especially when compared to the sluggish performance of the stock market. In addition, the increase in demand for second-home construction has increased due to the number of baby boomers approaching retirement age.

Multi-family housing. As the job market improves, so will the multi-family and real estate markets, Mueller predicts. According to his latest projections, he expects multi-family vacancies to drop below 7% by mid-2005, producing 2% to 4% rental growth. New employment growth forecasts show increases from 1.2% in 2004 to as high as 1.8% in 2005, which translates into good news for the apartment business. As more young people get jobs, they'll leave home and move into places of their own. He expects new construction starts to fall over the next year, slowing the unreasonably high new supply of the past two years. These two factors, says Mueller, will combine to produce positive absorption and declining vacancy forecasts.

According to the 2005 Construction Outlook from McGraw-Hill, while rents have remained flat recently, the sharp rise in housing prices in specific markets will allow them to increase. Multi-family housing in 2004 will slip back to 435,000 units, which is only a 2% decline from the previous year (Fig. 3). In 2005, McGraw-Hill expects multi-family housing to rebound 2% to 445,000 units. The report also suggests that this sector continues to be supported by the emphasis on downtown redevelopment in a number of cities across the country.

Another interesting footnote in this category relates to demographics. The number of 18- to 24-year-olds is expected to increase by 3.2 million in the current decade, as the children of baby boomers move out on their own. This should bring a surge for apartment demand.

Home improvement. If interest rates continue to rise as expected, new home purchases will inevitably taper off, leaving room for home renovation projects to pick up steam. The value of residential improvements has increased more than 35% since 1999, and a report from FMI Corp. predicts this trend will continue. FMI's Forecast for 2005 report found that the market reached $134 billion in 2003 and is expected to exceed $147 billion this year (about a 10% increase). The report predicts that figure could increase another 7% by the end of 2005.

The size and health of the remodeling segment of the housing market was also discussed at the NAHB Construction Forecast (Fig. 4). Industry observers expressed frustration with the lack of reliable sales numbers in this important segment of the housing industry, but a few are available. The U.S. Census Department predicts a 12% increase in the housing renovation market next year and estimates that annual residential-remodeling expenditures will be $177 billion. However, a new study by the Joint Center for Housing Studies at Harvard University puts this number significantly higher at $225 billion. Kermit Baker, senior research fellow at the program, is developing a leading economic indicator based on a survey with more than 50,000 households that he believes will more reliably forecast the size of the remodeling market.

Although the totals vary markedly among the various sources, it's a sure bet this market segment is worth keeping an eye on.


Retail/Commercial. As recently as the year 2000, private sector commercial work made up about half of the Norwalk, Conn.-based EMCOR Group's construction backlog. Today, it accounts for about 20%. “Although that speaks to the diversity and flexibility of our firm, it also means we have a lot of improving to do in rebuilding our commercial portfolio that was really decimated by the recession and shortage of private sector capital spending that went along with it,” says Frank MacInnis, the company's chairman and CEO. “We'll really be concentrating on commercial construction and redevelopment in the next couple of years, but all in all 2005 looks like an improving year over 2004.”

Based on the research out there, it looks like MacInnis and EMCOR may get their wish. Mueller of Johns Hopkins maintains that retail is the only property type in the expansion phase that's doing well in occupancy and rental growth in 2004. “Commercial construction is hottest in most of the Florida markets as there is lots of job growth there,” he says. “We don't watch individual markets' construction rates alone, but look at the balance of demand versus new supply. Southern California has the best occupancy levels on average for the five major commercial property types.”

Mueller says retail was the sector least affected by the recession. Low interest rates and refinancing opportunities have given consumers more disposable income. He predicts the retail occupancy rate, which typically averages about 86%, will stay flat through 2004 and grow 3% to 4% in 2005 (Fig. 5).

More specifically, Simonson of AGC believes retail construction will be more evenly distributed among malls and specialty stores as opposed to big-box and discount chains. This may also feed into the growing popularity of mixed-use centers, which many developers are using to blend commerce and culture to revamp many U.S. city's downtown areas.

Lodging. The future is now for a few segments of the non-residential construction market, namely the hospitality industry. “The hotel industry seems to be coming on strong in 2005,” Simonson says. “We are expecting 2004 to wind up being a record year for air travel. We've seen a significant increase in both occupancy rates and average rates per room. So the hotel chains are certainly seeing more business and leisure travelers. With the steep decline of the value of the dollar, the U.S. has become a cheap place for foreigners to come and visit and shop, so I expect more business travelers to be coming from abroad.”

The hotel industry bottomed out after 9/11, but is showing signs of recovery, Mueller explained in his presentation to the crowd at Reed Construction Data's North American Construction Forecast Conference. However, he didn't predict that occupancy rates would climb above the average rate of 65% until 2007.

Against the backdrop of a healthier economy and improved demand for travel, 2004 is turning out to be a stronger year for lodging, McGraw-Hill Construction reports in its 2005 Construction Outlook. For example, hotel occupancies improved to 60.5% in the first half of 2004, which is an increase of 4% from the same time last year. The report goes on to say that contracting for hotels is expected to climb 13% to 53 million square feet.

“This market obviously took a big hit after 9/11, but the rates at which the rooms are being filled [now] are much higher,” Giggard says. “The other interesting thing in lodging is that through the business downturn owners found ways to be much more efficient, so they were actually making money with much lower occupancy rates.”

Education. According to figures from the National Center for Education Statistics, enrollments for K-8 peaked in 2002 at 38.8 million students, will decline modestly through 2005, and then grow to a projected 40.6 million students by 2013. In the next decade, higher education enrollments are expected to increase from 16.7 million in 2003 to 18.2 million by 2013.

Although this category is down at present, McGraw-Hill Construction notes there are signs that fiscal conditions are improving. It cites the most recent Fiscal Survey of the States, which reveals that 39 states reported their fiscal 2004 revenues would meet or exceed budgets. That's why it's predicting education will experience a modest upturn in 2005, rising 3% to 223 million square feet. Some of this construction may also give way to the somewhat new trend of public-private building partnerships in the education sector.

Studies conducted by the National Education Association reveal that billions of dollars are needed for school modernization across the country. And when you consider that enrollment in U.S. schools is supposed to peak in the next two years, according to a report from FMI, this situation potentially sets the stage for educational construction, and therefore more electrical work (Fig. 6), in the short term. Of course, the keyword is “potential” because all public projects depend on the approval of local budgets.

New Jersey is one state taking matters into its own hands. With the passage of the New Jersey Educational Facilities Construction and Financing Act in 2000, the state will allocate $8.6 billion to the public school system for construction and renovation over the next decade. The New Jersey School Construction Corp. is expected to award $2 billion in contracts in 2005.

For 2004, the McGraw-Hill 2005 Construction Outlook estimates that the entire educational building category will be down 10% to 217 million square feet — the lowest volume since it hit 203 million square feet in 1998. It should be noted, though, that it's still more than 20% above the average for the '90s.

Health-care. As baby boomers move toward retirement age, the need for more health-care facilities and expanding existing ones continues to drive this market segment. Based on several industry forecasts, experts expect the health-care market to enjoy a slow-to-moderate rise in 2005. The U.S. Dept. of Commerce is expecting 8% and McGraw-Hill Construction is projecting an increase of 3% to reach 94 million square feet, while others are calling for more modest bumps of less than 2%. Nevertheless, hospitals across the country continue to plan for major expansion and renovation projects to compensate for technological advance, a growing population, increased use, and aging facilities (Fig. 7).

As the need for health-care increases, hospitals are looking for creative ways to upgrade. Rather than funding expansion projects, some are teaming up with developers to pay for construction costs. In this arrangement, developers pay for construction of the new building and the hospital signs a long-term lease. Such a partnership allows hospitals to provide new products and services to their patients without tying up cash in the construction of new surgery centers, medical office buildings, or wellness centers.

“Health-care is a very important business for us,” MacInnis says. “This is not just because all of us are getting older and are going to need more sophisticated medical and clinical facilities, but also because these facilities are so systems-rich. Therefore, they are so significant from the standpoint of the electrical contractor and electrical systems manager.”

Manufacturing/Industrial. Of all the non-residential market segments economists track, manufacturing/industrial is one to watch next year. Not only has this category performed extremely poorly in recent years, but future forecasts for growth are extremely widespread, ranging from 10% to more than 50%.

FMI is staying on the conservative side, showing growth of 13% for 2005. “A lot of lower tech industry jobs have gone overseas and probably won't come back,” Giggard says. “But at the same time the higher tech industries, such as pharmaceuticals and electronics, are continuing to grow. The manufacturing segment was so decimated over the last couple of years, and there hasn't been much investment. We think some of that is going to come around, and companies that have realized productivity gains are going to have to start expanding and updating.”

Sullivan of the PCA predicts industrial construction will experience a strong increase by the summer of 2005, possibly enjoying a leap in industrial work of 53% next year (Fig. 8).

After a five-year decline, construction of manufacturing buildings is finally on an upward track. According to Mueller's projections, demand for industrial space will improve by 2.5% in 2005 while new stock is only expected to rise 1%. New industrial starts are expected to decline over the next year, allowing rents to grow 1% to 3%. McGraw-Hill Construction says the manufacturing building category will increase 10% to 80 million square feet in 2005, fueled by an increase in automotive-related projects followed by pharmaceutical and biotech projects. To put this growth into perspective, it's important to note that the 2005 level is less than half of the 1997 peak of 191 million square feet.

Office. According to the McGraw-Hill 2005 Construction Outlook, office and warehouse construction is poised to see its first gains in four years in 2005. The report calls for a 10% increase from 2004 in square-footage to 170-million square feet and a 12% increase from 2004 in contract value to $22.9 billion (Fig. 9).

In his presentation to Reed Construction Data's North American Construction Forecast, Mueller cited Orange County, Calif., as the area that's experiencing the best office market rental growth, with additional markets in Southern California and Florida showing flat or slightly positive rental growth — unlike the rest of the nation where office market rental is suffering.

Once the exclusive domain of industrial facilities and manufacturing plants, urban areas with a surplus of abandoned or underutilized spaces are catching the eye of many developers who are renovating these structures into high-rent condos and offices.

Although the office sector has already begun to turn around, it continues to recover more slowly than expected, Mueller notes. He admits every time he runs a new forecast, the numbers are slightly lower than anticipated. Simonson agrees. He predicts it’s going to be late in 2005 before this category sees any kind of sustained upturn.

FMI is looking for a 10% growth spurt in the office market for 2005. “It’s an interesting segment because vacancy rates are still relevantly high—in the 17% range—but they vary a lot with downtown areas having a lower rate than suburban areas,” Giggard says. “We’re seeing a lot of companies choosing to do client refit work—taking buildings and turning them into what they want or going to areas and building corporate centers to suit their specific needs.”

According to Mueller’s latest projections, he expects office demand to grow at 2.5% from 2004 to 2005. However, office starts are projected to be down 25% year-over-year, creating a stock increase of about 1%, which translates into a vacancy decline of just more than 1% by the end of 2005, leaving the national average vacancy at about 16.5%.

Despite higher office vacancy rates across the country, office construction will remain on a steady upswing starting in 2005 and lasting through 2007.

Water and sewer. EMCOR’s MacInnis is watching water and wastewater work closely. “We think water, and especially wastewater treatment projects, are going to be extremely important across the country for the foreseeable future,” he says.

According to McGraw-Hill Construction’s 2005 Construction Outlook, 2004 will post strong growth from water supply system and sewer work, as a backlog of jobs reaches the construction start stage. In 2003, the report reveals that water supply projects dropped 13%; however, the decline has reversed in 2004 with this segment jumping 17% to $10 billion, thanks to several large projects in the West.

Sewer construction rose 1% in 2003, and a 7% increase is expected for 2004. Part of this hike is attributable to a $191 million sewer tunnel project in Atlanta. But analysts aren’t too optimistic just yet. Because the Bush Administration has proposed reducing federal contribution to state clean water revolving funds for 2005 from $1.35 billion to $850 million, more concrete projections will have to wait until Congress weighs in on this issue.

Power. Competition in wholesale electricity markets and an increased demand for power have lessened the reliability of the nation’s electric grid. However, investment in new power plants and transmission and distribution lines is still minimal, at best.

New construction starts for electric utilities continue to retreat. In its 2005 Construction Outlook, McGraw-Hill Construction reports that last year’s 29% decline brought construction down to $8.9 billion—well below 2001’s all-time high of $24.3 billion. In 2004, it predicts a similar reduction, with construction estimated to fall 32% to $6 billion.

The report indicates that capacity utilization rates for power plants reached 96% in 2000 but fell to 89% by 2002. The large increase in generating capacity drove rates down to an average of 84% in 2003, followed by a slight improvement to 85% in the first nine months of 2004. Accordingly, electric utility starts will continue to decline through at least 2005, with next year’s starts expected to drop 8% to $5.5 billion.

On the other hand, while power plant construction has fallen dramatically, McGraw-Hill Construction reports that transmission line work has picked up significantly. For example, power line work jumped 112% in 2004, which accounted for 7% of electric utility starts in 2003. In the first three quarters of 2004, this market has seen another 67% increase.

In the power business, MacInnis points out that the problem lies not just in the high cost of energy but in the uncertainty and variability of that cost. However, he does call attention to a bright spot in this declining market segment. “The cost of owning or operating a facility used to be relatively static, and now it’s one of the most unpredictable factors,” he says. “I think the proliferation of systems and of management services that help owners or end-users of facilities to know what their costs are going to be will be in great demand.”

Final thoughts. As the country leaves memories of the recession behind and gears up for better times, electrical professionals will be waiting and watching to see what 2005 will bring for the construction market. And if the fiscal events of the last few years have taught electrical industry professionals anything, it’s that you can never take the state of the economy too lightly. Nearly half of EC&M’s Top 50 electrical contractors report that the health of their bottom line weighs heavily on their minds.

However, most admit all that worrying may be unnecessary. The vast majority (86%) agrees with economists’ predictions and expects the market to improve next year, while merely 3% foresee a decline. So if you put stock in economic experts’ predictions and the expectations of some of the most successful electrical contractors in the business, 2005 should turn out to be a pretty good year for most in the electrical industry.

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