National Outlook

Construction Starts Still on the Rise in 2006

New housing construction may cool this year, but the rest of the industry is staying active. With high hopes in the hotel, office, school, health-care, and public-works sectors, the construction industry is primed for another record year.

by Bruce Buckley

Soaring materials costs, rising interest rates, and a string of devastating hurricanes weren't powerful enough to derail the construction market in 2005.

The industry showed remarkable resilience last year, rising to a record $636 billion nationwide in total construction starts, according to data from McGraw-Hill Construction's economic forecasting unit, which unveiled its assessment of industry activity in 2005 - and what it expects for this year - at a conference last fall in Washington, D.C.

The $636 billion tally reflects an 8 percent increase over 2004 figures, well above the 2 percent increase that the division had forecast at the same time a year earlier.

"Much of the reason for the upgrade [to that forecast] has been the robust performance of single-family housing," Robert Murray, vice president of economic affairs at McGraw-Hill Construction, said at the conference. "In 2004 it set records and in 2005 it did the same."

It's unclear whether the industry will stay on the statistical pace, partly because single-family house construction starts may begin a pullback this year. But with the hotel, office, school, health-care facility, and public works sectors, among others, pegged for growth this year, the McGraw-Hill Construction estimate for total construction starts still calls for comparatively modest 3 percent growth this year.

"If these forecasts work out, we can certainly go by the saying, stable as she goes," Murray said.

advertisement

The industry's challenges can't be overlooked, however. Rising materials costs contributed to slower activity in the first quarter of 2005, Murray said. However, activity picked up again by midyear, which he credits in part to projects that were delayed and redesigned to help offset mounting costs.

"Looking at the broad picture, we see a sense of project deferral, but not derailment," Murray said.

Rising interest rates are causing some concern for new residential property buyers and developers looking for project funding. However, Murray added that Federal Reserve surveys show a recent easing of lending standards, which should help more projects get off the ground.

The active hurricane season had an immediate impact on materials costs, but Murray said the national effect would be short-term. Ultimately, the push to rebuild the affected Gulf Coast region - which suffered an estimated $150 billion in damage from Hurricane Katrina, according to the Congressional Budget Office - should lead to a significant increase in construction activity.

A Cool-Down for the Housing Market

After turning in another record year in 2005, the single-family homebuilding market is set to cool down, Murray said. Single-family housing advanced an estimated 3 percent to 1.6 million new units in 2005, topping the record-setting 1.55 million units of 2004.

But change is in the air. Murray credited the continued boom in large part to 30-year fixed mortgage rates staying below 6 percent for much of 2005, but he expects that rates will push up to between 6.5 percent and 7 percent this year. Home price increases are also outpacing income growth. These factors should spur a pullback in single-family house construction throughout most of the nation, resulting in a 5 percent reduction in starts for 2006, according to the McGraw-Hill Construction data.

Meanwhile, multifamily housing starts remain at a steady pace. Murray said condominiums and town houses are growing in popularity, with a particular emphasis on luxury condos developed as part of downtown redevelopment projects.

Multifamily housing has remained relatively stable since 1998 with starts topping 400,000 units annually. Murray estimated that 2005 closed out with a 2 percent increase in units started, and he forecasted an additional 1 percent increase for 2006.

Commercial Prospects Look Bright

After dropping significantly at the beginning of the decade, construction starts for new office properties generally remained even in recent years.

But early 2005 saw many office projects delayed in light of higher construction costs, Murray said. As a result, office construction starts were expected to finish last year 5 percent below 2004 levels.

Now, demand is improving in the office market, with office-based employment holding at historically strong levels and vacancy rates dropping, Murray said.

"There will be some response as vacancy rates drop back and rents increase," he added.

That response should translate into a 9 percent increase in office construction for 2006, according to the McGraw-Hill Construction data.

Improved market fundamentals are also driving increased activity in the hotel sector. Since bottoming out in 2002, the market has been increasing, with construction starts up 5 percent in 2004 and another 7 percent in 2005.

And the future looks even brighter. Occupancy rates and revenue per available room (RevPAR) are both on the rise, Murray said. Major new hotels are slated to begin construction this year in Las Vegas, Baltimore, Phoenix, New York, and Los Angeles. As a result, hotel construction starts are expected to increase 17 percent to 58 million sq. ft. this year.

The commercial warehouse sector will also see increased activity. Although major retailers may pull back in the retail market, Murray said he sees increased plans by those companies to build regional warehouse facilities. After a 3 percent drop in warehouse starts in 2005, the forecast calls for a 6 percent increase this year.

Vacancy rates in warehouse facilities have also been declining, dropping to 10.2 percent in mid-2005. Murray said there is a need for updated facilities to handle improved inventory management practices.

Construction starts on manufacturing buildings are expected to finally jump this year. Starts in the sector plummeted from 200 million sq. ft. in 1997 to nearly 60 million sq. ft. in 2002. Since then, the sector has experienced fluctuation, and after a down 2005, the sector is pegged to rise 9 percent, to 82 million sq. ft., this year.

The stores and shopping centers market could sound the one sour note for commercial construction this year. After three years of positive gains, the McGraw-Hill Construction data forecasts a dip in activity this year.

Major retailers have fueled much of the recent activity, including Wal-Mart, Home Depot, Lowe's, Target, and Kohl's, but Murray said the boom won't last.

"If you look at the retail statistics for the first half of [2005], 45 percent are related to major retailers, but we're beginning to get a sense of pullback from them," he said.

Murray added that because retail construction is related closely to housing demand, the expected decline in housing starts should dampen new retail development. After a 1 percent increase last year, the forecasting team sees a 5 percent decrease in starts down to 283 million sq. ft.

New Demand in Institutional Sector Prospects

in the institutional market, with building activity tied heavily to tax revenues, are also strong. The expanding economy in 2004 and 2005 and the healthier status of state and municipal government budgets bode well for the sector in the near future, Murray said.

"The fiscal position of state and local governments has bottomed out, and we're seeing the effects in 2005 and 2006," Murray added.

Rising student enrollments and the growing elderly population are also pushing demand for new institutional construction. The McGraw-Hill Construction forecast expects that total institutional building will increase 4 percent to 520 million sq. ft. this year.

The educational building segment is set for a comeback after heavy declines that started in 2001. The market leveled at 1 percent growth to 212 million sq. ft. in 2005, with strong gains in starts of primary and junior high schools and laboratories offset by declines in community colleges, museums, and vocational schools.

Market fundamentals bode well for future development in the sector, with rising school enrollments creating demand and the improved fiscal conditions of state governments likely freeing up more funds for school construction, Murray said. The improving economy has also boosted college endowments, which can be tapped for construction projects, he added. Those positive signs are behind the forecasting division's estimate of a 6 percent increase in educational building starts this year.

The health-care buildings sector set a record pace last year and should see further advances in 2006. The McGraw-Hill Construction data estimated that 2005 closed out with a record 105 million sq. ft. of starts - a 12 percent increase over 2004. In the first eight months of 2005, 41 hospital projects broke ground, compared with 24 projects during the same period a year earlier.

Demand for new health-care facilities remains high, particularly as the baby >> boomer generation heads into retirement, Murray said. The economic unit has projected a 2 percent increase in health-care building starts this year, which would set a new record of 107 million sq. ft. in starts.

Other institutional sectors appear mostly positive in 2006. Religious buildings would bounce back from last year with a 3 percent increase in starts in 2006. Amusement and recreational buildings would rebound with a 7 percent increase over 2005.

Public facilities mark the lone projected slump among institutional buildings, forecasted to see a 3 percent drop this year, with Murray crediting the decline to cutbacks in federal courthouse projects.

Boom in Public Works Expected Public

works projects are expected to continue on their strong recent pace. Increased starts in transportation and environmental projects are slated to be the biggest contributors, boosting activity by 7 percent this year, according to the McGraw-Hill Construction projections.

After nearly two years of wrangling, the Bush Administration and Congress finally agreed last year on a new $286.5 billion federal transportation bill, dubbed SAFETEA-LU. Although critics say the bill falls short of the country's needs, Murray said that it eliminates uncertainty that held up projects around the nation. That new landscape also fuels the forecast for the value of highway and bridge project starts to rise by 12 percent in 2006.

The environmental public works sector remains active. After 7 percent growth in 2004, the sector was expected to increase by 15 percent last year, according to the McGraw-Hill Construction estimates. New contracts for water lines, tunnels, pipes, and treatment plants led the way in recent years. Sewer and wastewater projects also ended on an up note in 2005, rising 13 percent over 2004.

Construction starts in public works overall are expected to continue their rise this year, particularly in light of hurricane damage to the Gulf Coast region. The McGraw-Hill Construction estimates call for the sector to end up 3 percent higher this year at $31.8 billion in construction starts.

With the notable exception of single-family housing, 2006 is shaping up to be another boom year for the construction industry. Murray added that while the industry runs through up and down cycles, it has remained on an upward trend for nearly 15 years through all of the market challenges.

"For 2006, the resilience of this industry will allow for another year for expansion," he said.

National Econimic Forcast (Source: McGraw-Hill Construction)