Sorting Out the Outlook for Construction Segments and Materials

Jan. 19, 2007
Two worries have appeared on the construction scene. Will the plunge in housing activity drag down other types of construction? Will soaring materials costs choke off new investment? Recent reports have shown that while the economy as a whole is looking a little more feeble, there are still numerous hopeful signs as well.

Two worries have appeared on the construction scene. Will the plunge in housing activity drag down other types of construction? Will soaring materials costs choke off new investment? Recent reports have shown that while the economy as a whole is looking a little more feeble, there are still numerous hopeful signs as well.

The big picture
Recent reports support contradictory views about the economy. For instance, the Census Bureau reported only Jan. 4 that seasonally adjusted United States factory orders (excluding semiconductor manufacturing) climbed 0.9% in November, following a steep 4.5% drop in October. But orders other than the volatile transportation category slid for the third straight month. Earlier, the Federal Reserve reported that industrial production in manufacturing increased in November after dropping in the two preceding months. Meanwhile, the Institute for Supply Management (ISM) reported on Jan. 3 and 4 that its monthly surveys of manufacturing and non-manufacturing purchasing executives, respectively, showed a return to growth in manufacturing but slower growth in other sectors.

On Jan. 5, the Bureau of Labor Statistics reported that non-farm employment growth in December accelerated to 167,000 jobs, seasonally adjusted, the best showing in three months. BLS said, “Job gains occurred in several service-providing industries, including professional and business services, healthcare and food services.” But manufacturing continued to lose jobs.

These and other indicators suggest that the economy is still expanding but with much less uniformity than in 2005 and early 2006. No sector is sending a more mixed message than construction. Because more than half the total value of construction spending is residential, any downturn in the latter can create the impression that all construction is weakening. But recent data show ongoing strength.

Census reported on Jan. 3 that the value of construction put in place slipped 0.2%, seasonally adjusted, in November, the fifth consecutive monthly decline. But the fall was attributable entirely to private residential construction, which dropped 1.6%, the eighth straight decrease. Over the past 12 months, that category shrank 11%, while private nonresidential and public construction rose18% and 11%, respectively, leaving overall construction spending almost unchanged from November 2005.

Residential construction
The overall picture for residential construction remains bleak, primarily because of a dismal market for single-family home sales. On January 4, the National Association of Realtors reported that its index of pending home sales in November was down 11% from a year earlier. That followed reports from the week before that new and existing home sales in November were down 15% and 11%, respectively, from November 2005. Spending on new single-unit construction tumbled 20% from a year before.

Multi-unit construction looks robust, thanks to a spurt in rental construction. Spending in November was 16% higher than the year-ago month.

Spending on residential improvements is a huge but highly fragmented and hard-to-measure category. Census estimates that it was off 0.1% in the first 11 months of 2006 but up 0.6% from October to November. Because many improvements are tied to home sales, the category will stay weak in 2007.

A closer look at nonresidential
The largest non-residential category in the Census construction spending report is educational construction. At $77 billion in the first 11 months of 2006, it constituted 15% of the combined public and private non-residential total and was up 6% from the same period in 2005. The larger public piece ($64 billion year-to-date) has been supported by rising school-district and public university budgets. In 2007, these budgets will be pinched by slower growth in sales, income, and property taxes, which will affect construction spending in 2008 and beyond. But public educational construction should expand by another 6% in 2007, aided by a large volume of bond issues passed last November. Private spending, helped by capital campaigns that benefit from a rising stock market, should show slightly better growth.

Commercial construction (retail, warehouse, and farm in the Census classification) totaled $74 billion in January-November 2006, 14% of the nonresidential total and up 10% year-to-date. The largest commercial component is multi-retail (shopping centers, malls and general merchandise stores), up 34% year-to-date. This category has grown steadily through the first months of the housing collapse but dipped 0.6% in November, seasonally adjusted, and remains vulnerable to reduced demand for home building and remodeling supplies, appliances, electronics, furniture, furnishings, and yard and garden supplies. The multi-retail component is likely to shrink slightly in 2007, keeping commercial construction flat.

Highway and street construction, totaling $71 billion year-to-date, accounted for 14% of the non-residential total and was up 16%. Part of the jump came from the enactment in August 2005 of the federal highway authorization law known as SAFETEA-LU, which added more money and ended the uncertainty about when states would get it. The gain isn’t all “real,” however: perhaps half of this increase represents higher costs for asphalt, concrete, steel, and diesel fuel. In 2007, these cost increases should moderate slightly, but the growth in spending will also taper to high single digits. By 2008, the flattening of federal and state gas tax receipts caused by greater conservation and more fuel-efficient vehicles is likely to mean a halt to expanding highway spending.

Office construction in the first 11 months of 2006 totaled $50 billion, 10% of the non-residential total and up 15% from a year before. Because of the home-sales slump, fewer real estate, property and title insurance, and mortgage brokers will want office space. The slowdown in manufacturing growth will trim demand for larger office spaces to serve manufacturers and related service businesses. Thus, office construction is likely to grow at a 5% rate or less in 2007.

Healthcare construction totaled $38 billion so far in 2006, 7% of the total and up 14% year-to-date. Most of the growth has come from private hospitals, up 25% so far. That growth should continue in 2007, as hospitals race to update old facilities to accommodate new technology and build new structures closer to new population centers.

Power and manufacturing construction, at $37 billion and $34 billion year-to-date, each account for about 7% of total nonresidential and have risen 10% and 21%, respectively. For the next several years, there will be rapidly rising expenditures on conventional and alternative fuels and sources of power, including environmental and energy-enhancing retrofits to coal power plants and refineries, further expansion of ethanol, biodiesel, and wind facilities, investments related to natural gas development and distribution, and experimental facilities. New power plants and transmission lines will start in 2007. Selected other categories of manufacturing, such as cement plants, will also grow, but overall, manufacturing construction will drop back to single-digit growth at most.

Construction of transportation facilities amounted to $27 billion in January-November 2006, 5% of the total and up 10% from a year ago. About one-third of the total has been airport construction, with the remainder scattered among ports, truck terminals and other facilities. The category has benefited from surging demand from passengers and freight. Growth should continue at a high single-digit rate in 2007.

Amusement and recreation construction, totaling $21 billion year-to-date, or 4% of the total, is up 22% from the same time in 2005. Spending represents a variety of public and private projects, nearly all of which have risen. Stadium construction will be hot in 2007 but total activity is hard to predict.

Lodging construction, $18 billion in January-November 2006, equaled 4% of all nonresidential and was the fastest-growing piece, up 52%. Spending has been propelled by renovation and expansion of hotels and resorts, buoyed by strongly rising occupancy and room rates for the past two years. By late 2007, the growth should taper off but the total for 2007 should be up another 10-15% from 2006.

Construction of sewage and waste disposal facilities has amounted to $18 billion so far in 2006, 3% of the total and up 19% from the first 11 months of 2005. The category reflects rising state and local revenues and housing construction. Conversely, spending on these facilities will slow to single-digit growth in 2007 and perhaps turn down in 2008, following the slowdown in revenue growth and downturn in housing.

Materials costs
The producer price index (PPI) for materials and components for construction fell in October and November for the first time since Hurricane Katrina struck, thanks to falling fuel prices and lower demand for materials used in residential construction, such as lumber, oriented strand board (OSB) and gypsum products. Nevertheless, the latest 12-month change was 5%, while the consumer price index rose 2%.

Aside from wood products and diesel fuel, most construction inputs still had hefty year-over-year increases. For instance, from November 2005 to November 2006 there were double-digit increases in the PPI for copper and brass mill shapes, up 54%; asphalt paving mixtures and blocks, 28%; aluminum mill shapes, 14%; steel mill products, 12%; and gypsum products, 11%.

Unfortunately, diesel and natural gas prices stopped falling from October to mid-December and are now close to, or above, year-ago levels. Although materials that are extensively used in homebuilding, notably gypsum and copper products, should fall sharply in price as new housing starts keep sinking, most other construction materials costs are not likely to drop.

Two factors make construction materials costs susceptible to steeper increases than the overall rate of inflation. First, construction requires generally fixed quantities of materials, unlike industries that can substitute cheaper materials or can design products to be smaller or lighter than their predecessors. Many materials used in construction are also in demand from other sectors, both in the U.S. and in fast-growing economies, like those of China, India, and elsewhere in Asia. Yet supplies of some materials expand only slowly. An example is copper, where all of the major mines have been subject to labor unrest or political turmoil. As a result, prices jump.

Second, materials must be physically delivered, using a transportation network that is often stretched to its limits. Transport costs are high and bottlenecks frequent. In addition, fuel price spikes add to transport costs as well as the direct costs of operating equipment. As a result, construction materials costs may show a year-over-year increase of as little as 2-4% for the next few months, matching the overall inflation rate as measured by the consumer price index. But a year from now, construction materials are likely to resume their recent 6-8% cost increases, with higher spikes possible.

Nonresidential construction appears to be in good shape to build upon the momentum of the last year. Hospital, lodging and energy-related construction remain the best bets. Expanding public works budgets, thanks to record volumes of bond approvals last month, also will help contractors. But the economy is slowing, and non-residential construction growth in 2007 is more likely to be in the 8-10% range than at the current 14% year-to-date level. Multi-unit residential construction will benefit from growth in rental construction, which should roughly offset a drop in condo construction. But an 8-10% further decline in new single-family residential construction, and a small downturn in residential improvements, will keep total construction spending from showing any growth.

For the next few months, materials cost increases will not be as severe as they were in most of 2006. But contractors are constrained to use generally fixed quantities of materials for which there is worldwide or economy-wide demand and often slow-growing supply, and they must pay to have the materials physically delivered, using congested transport modes. These facts make it likely that materials cost increases will usually outpace the 2-4% annual rate of increase in the CPI or overall PPI.