Maybe Next Year: Economy Improves, But Won’t Help Construction Yet

As the country headed out of 2009, the Federal Reserve Banks reported that market conditions for commercial real estate and construction had weakened in nearly all 12 of the Federal Reserve's districts "with rising vacancy rates, downward pressure on rents, and little, if any, new development." The various regional banks were not given to optimism. The Boston bank described the outlook for commercial real estate there as "bleak."

The Dallas bank said construction there was at "historically low levels," and Kansas City characterized commercial real estate and construction as "distressed." The St. Louis Fed called the commercial real estate market in November "weak," and noted that lending had declined and credit standards had tightened as industrial and office vacancy rates had risen. The Fed added that the outlook for office space was actually worse than the vacancy rate might suggest, because of the large amount of space available through subleases.

Seth Leadbeater, CEO of the St. Louis region of Commerce Bank, an $18 billion regional bank headquartered in Kansas City, said his bank had more money to lend than a year earlier. "We're being consistent in our lending practices," he said, and added that development activity was slow, because "developers are being cautious right now. If the economy gets better, credit will follow."

"Liquidity is not the challenge. A lot of banks, including us, have plenty of money to lend," said Ronald Barnes, chairman of
Midwest BankCentre, a $1 billion local bank with two-thirds of its portfolio in commercial and residential real estate. "The greater challenge is finding viable projects to lend to," he said. Barnes said that Midwest BankCentre has not changed its underwriting principles. "We still value projects in terms of the real equity in the project, pre-leasing, and correct economic assumptions in terms of valuation," he said. It is just that in today's market valuing a project correctly is difficult to do.

The chief challenge is that commercial real estate values are still falling. Barnes explained: "We are in the earlier stages of a general commercial real estate market correction, which will play out throughout 2010 with further recognition of valuation declines. The real challenge is underwriting in the contexts of rising cap rates, rising vacancy rates, and falling rental rates. None of those are going in
the right direction to maximize value.

"There was a bubble in commercial real estate like there was one in housing. The market has to reset at a lower valuation level that is more in line with long-term trends before things come back. I look for movement forward in 2011," he said. Regional and local banks such as Commerce and Midwest BankCentre, however, represent only a small portion of the financial market. James Bullard, president and CEO of the Federal Reserve Bank of St. Louis, said that the 20 largest national financial institutions control 80 percent of the nation's financial assets. Bullard spoke at Commerce Bank's annual economic breakfast in November. And the large banks, according to the St. Louis Fed, were still tightening credit standards for commercial real estate loans near the end of the year.

The issue for banks - and for developers and contractors - is demand. Bullard said economic activity began picking up in the third quarter of 2009 and consumer spending was recovering, but Joel Prakken, CEO of Macroeconomic Advisers, LLC, said the recovery "was well below historic norms following a deep recession." Prakken spoke at the sixth annual Midwest BankCentre Economic Forecast. Prakken predicted that unemployment would stay high - above nine percent - throughout 2010 and not fall below eight percent until near the end of 2011. High unemployment presages weak demand for many types of private, nonresidential space.

Private Options Dwindle, Public Options Take Up the Slack

Robert Murray, vice president of economic affairs for McGraw-Hill Construction, predicted that weak demand for space will continue to hamper the commercial and industrial building markets in 2010, but any further decreases will be mild compared to what those markets saw in 2009. Even though private, nonresidential construction markets will continue to retreat, Murray predicted an 11 percent increase in total construction nationwide, due largely to a rebounding housing market and stimulus funding for highways, environmental Murray said the value of construction on commercial buildings will fall another four percent in 2010, something that looks almost like recovery after the precipitous 43 percent drop in commercial building construction in 2009. The value of construction in the manufacturing sector will fall 14 percent, due to slack demand for more space. And the value of work on institutional buildings, which tumbled 23 percent in 2009, will stabilize, advancing just one percent on the strength of military projects and energy efficiency upgrades to federal buildings.
"Given the weak outlook for private sector construction, any near-term turn in overall construction activity will be dictated by public construction," said Edward Sullivan, chief economist for the Portland Cement
Association. Sullivan predicted that cement consumption would increase a modest five percent nationally in 2010 on the strength of stimulus spending on public construction. He said cement consumption fell 26.6 percent in 2009 from already weak 2008 levels. Cement consumption peaked in 2006.

Despite positive projections by Murray and Sullivan, even the highway sector is by no means healthy, said Ken Simonson, chief economist for the Associated General Contractors of America (AGC).

"It is impossible to overstate how dire the outlook is for [2010]," he said. Describing the results of a survey of highway and transit builders by the Transportation Construction Council, of which the AGC is a member, Simonson said, "75 percent of firms anticipate declining spending, over 76 percent expect state departments of transportation to put out less work to bid; two-thirds of firms laid-off people this year and 87 percent say they don't have enough work booked to avoid laying off more non-seasonal workers. Only five percent of firms plan to add employees," he said.

The problem, Simonson said, is that there is nothing coming after the stimulus money "except depleted state and local coffers." With tax collections falling in 44 states, and bigger budget shortfalls expected next year, state departments of transportation are cutting funding and some states, such as Illinois, are looking at raiding state highway funds to cover deficits elsewhere, he said.

"The real value of pavement work has been declining every year since 2005, said Alison Premo Black, economist and vice president of policy for the American Road and Transportation Builders Association. "Without the federal investment of stimulus funds, we would have seen the bottom drop out of the transportation construction market. In spite of stimulus funds, the long-term trend in transportation construction is down, so there is no reason for contractors to make new investments that would stimulate other parts of the economy," she said.

Green Building
One part of the construction economy is booming, however: green building. New buildings, however, account for less than 2.5 percent of the U.S. building market each year, said Harvey Bernstein, vice president of global thought leadership and business development at McGraw-Hill Construction. So the real action, he said, is in retrofits and renovations. Green building retrofits and renovations currently accounts for five-to-nine percent of the value of the retrofit and renovation market, but it is growing rapidly, Bernstein said.
McGraw-Hill projected that by 2014, or in less than five years, green building retrofits and renovations would account for 20-30 percent of the money spent on building renovations and retrofits. By 2025, half of all retrofits and renovations could be "green."
Bernstein said the projected demand for green retrofits in 2014 comprises, "a $10-15 billion market opportunity in major projects alone, and it will significantly contribute to the expansion of green products and services, which will have a long-term impact on our future economy."

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