FMI Building Outlook Bullish on 2003

July 12, 2002
The U.S. construction economy has been a pleasant surprise to many because it has proven to be resilient to rising layoffs and wavering consumer confidence

The U.S. construction economy has been a pleasant surprise to many because it has proven to be resilient to rising layoffs and wavering consumer confidence levels during the past year. Unfortunately, underlying drivers such as home affordability, office vacancy rates and industrial capacity-utilization rates are not likely to be as favorable for the remainder of the year. But look for a healthy rebound in many building sectors in 2003.

U.S. construction spending fell 0.9 percent in March due to a drop in public building as construction retreated from high levels seen over the mild winter. The value of new construction in the United States dropped to a seasonally adjusted annual rate of $874.0 billion in March from an upwardly revised level of $881.5 billion in February.

The U.S. real estate market is currently mixed, with residential construction strong and commercial construction markets remaining weak in many sectors. Spending on new residential housing units was at a seasonally adjusted annual rate of $294.5 billion in March, nearly the same as the revised February estimate of $293.3 billion. Low interest rates and steady personal incomes have resulted in record affordability for U.S. households in the winter and spring of 2002, driving sales higher. In addition, restrained levels of housing inventories have kept the market very strong and prices appreciating throughout the year.

Nonresidential building construction was at a rate of $181.9 billion in March, nearly the same as the revised February estimate of $182.5 billion. The rise in available commercial space has been exacerbated by active sublease markets and additional construction in some areas. Office rents have declined moderately compared with a year earlier. Consequently, commercial construction activity has slowed in most parts of the country.

Single-Family Construction

The residential construction forecast has been revised downward for two reasons. This winter, many residential projects were started because of exceptional building weather, and they do not reflect an underlying trend toward even greater growth for 2002. Also, mortgage rates will probably rise later in 2002, and rising oil prices will create further uncertainty in debt markets.

The residential real estate market got off to a great start in January when existing single-family home sales reached a record one-month high and also posted the largest monthly increase on record. Existing home sales jumped 16.2 percent to a seasonally adjusted annual rate of just over 6 million units, according to the National Association of Realtors.

After a strong beginning, signs of a pause have started to appear this spring. U.S. housing starts plunged 7.8 percent in March, their biggest drop in two years, according to the U.S. Department of Commerce. This followed a 2.8 percent drop in existing home sales in February and a very large drop in new home sales in January. In April, construction employment declined by 79,000, following seasonal adjustment, with the bulk (61,000) of the decrease occurring in specialty trade contractors. Job losses in construction have totaled 155,000 thus far this year, according to the U.S. Department of Labor.

Considering the recovering economy, it may come as a surprise that the second half of the year for single-family construction will likely not match recent quarters' strength. This slowing is because key factors that determine who can afford to buy a house — home price appreciation, personal incomes, and mortgage rates — point toward less affordability later in 2002.

Multifamily Construction

FMI forecasts that multifamily residential construction will slow significantly in 2002 before strongly rebounding in 2003. This sector marches to a different drummer in that it responds to the demographics of housing demand and also to the economics of commercial investment. We perceive this second component to be the source of weakness in 2002. The divergence of 2-4 unit and 5+ unit authorizations in March illustrate this weakness in that the commercialized 5+ market dropped significantly while the residential 2-4 unit market gained momentum.

The apartment industry is still battling a soft market as a result of the recession, but there are signs of improvement according to the National Multi Housing Council's latest Survey of Apartment Market Conditions (second quarter 2002). Multifamily construction will be a strong market in coming years because its two primary market demographics — young “20-somethings” and “empty nesters” — will be among the fastest growing demographic groups. After more than two decades of declining in number, the population in the traditional renting years (ages 20-29) is expected to increase 11 percent between now and 2010. In addition, the number of traditional households is in decline, now accounting for just one quarter of all households. In their place are a growing number of nontraditional households that are more likely to choose apartment living — childless couples, people who live alone, and nonfamily/nonrelated households.

Nonresidential Construction

It will likely be several years before we see rates of commercial investment like those found in the late 1990s. Commercial construction had benefited from large influxes of investment spending in previous years but seemed to be headed for a downturn as capital investment funds decreased in 2001. Surprisingly, however, commercial construction held up well in many areas over the winter despite recessionary conditions, rapidly rising vacancy rates and subleasing activity.

This winter construction probably has been the result of excellent weather conditions in many areas that enabled projects to start earlier in the year than they normally would. A summer drop-off in commercial construction is expected to follow this period of unseasonable building conditions. Unlike commercial and industrial construction, public-sector construction should continue to grow with the expanding role of federal government.

U.S. businesses invested a record $1.172 trillion in capital investment in 2000, a 12 percent increase from $1.047 trillion in 1999, according to a report released by the Census Bureau. In hindsight, this spending appears to be a classic overinvestment boom. Like all booms, it was driven by excessive optimism about the “New Economy,” as evidenced by massive capital investments into the telecommunications, computer, and utilities industries. Then, as the economy began to slow in the second half of 2000, firms reevaluated their assumptions and abruptly revised down capital investment plans.


Although times are slowly improving for some of the major users of office space, office construction will feel the effects of falling vacancy rates and sublease activity in many markets before recovering in late 2003 or 2004. The U.S. commercial office sector deteriorated very rapidly in 2001, and commercial real estate lenders will experience rising delinquencies in 2002 as office vacancy rates appear likely to increase further. In addition, projects that were planned in better times are being completed early and will put additional space onto the market, adding to the millions of square feet of sublet office space already there.

Nationwide, the office vacancy rate increased by over 5 percent during 2001, and rents declined by nearly 10 percent, according to the Federal Deposit Insurance Corp.


Even though the manufacturing sector appears to finally be recovering from its deep two-year recession, overinvestment during the 1990s and current low factory utilization rates will prevent much new construction until 2003. Manufacturing activity rose in March 2002 to its highest level since February 2000 to meet the strongest demand for goods in more than eight years, according to the Institute for Supply Management's (ISM) closely watched Purchasing Managers Index. Also favorable are the recent results of a National Association of Manufacturers survey of its members regarding their capital investment plans. The results of the survey suggest that overall capital spending will rise by about 5 percent during this year.

While about half of ISM's survey respondents expect investments in structures to rise up to 5 percent next year, almost 40 percent expect investment to be negative. Data from the Commerce Department confirms that better times for manufacturers may not equal new capital expenditures because so much was invested in the 1990s, especially in the high-tech sector. Overall, manufacturers spent $215 billion on capital goods in 2000, up 9 percent from 1999. The information sector spent $164 billion on capital expenditures — up nearly 34 percent, following a 1999 increase of 27 percent. The semiconductor industry alone posted an increase of 60 percent over 1999.

Spending on new manufacturing facilities plunged in 2001, helping to limit the overhang felt in 2002. According to the real estate firm, Cushman and Wakefield, the year-end industrial vacancy rate was 8.1 percent, up from 6 percent a year earlier. Most of what was built was warehousing/distribution space, with very little new manufacturing space added in 2001.

Hospitals and Health Care

For 2002, FMI forecasts slightly lower health care construction activity. The reason is that approximately three-quarters of health care construction is private and will experience growth limitations similar to other commercial structure types.

However, FMI forecasts a growing need for health care construction as the population grows and ages. According to the American Hospital Association, “With an aging population and the baby boomers entering years of higher incidence of disease, the demand for health care services and the need [to] provide care are increasing significantly.” In 1950, 12 percent of Americans were over the age of 60. The Labor Department projects that number to increase to 25 percent of Americans by 2030. As a result of this steady increase in older Americans, the Labor Department projects that an additional 3.1 million new health workers will be needed by 2010.


Coming off the worst downturn of any segment of the economy, it may take several years before substantial increases in construction spending are needed by the telecommunications industry. Telecommunications was the biggest job-cutting industry in April. Its 38,176 job cuts announced during the month were 75 percent higher than the 21,831 announced in March, representing 34 percent of the April job-cut total. This industry has announced 120,698, or 22 percent, of all job cuts in 2002, according to the outplacement firm, Challenger, Gray and Christmas.

Telecommunications construction will be further suppressed by very large capital overhangs from previous years. In 2000, the telecommunications industry spent $78 billion on new structural capital, up 31 percent over 1999. Wireless carriers, at $25 billion, were up 77 percent.
Reprinted with permission from FMI's Construction Outlook: Second Quarter 2002 Report, FMI Corp., 919-787-8400