2006 National Outlook: Stable as She Goes

Construction starts remain on record pace

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 McGraw-Hill Construction forecasts.

The forecast was announced Oct. 20 at the Construction Outlook 2006 Executive Conference in Washington, D.C.

The tally was an 8 percent increase over 2004 figures, well above the 2 percent increase forecast for 2005 at last year's Outlook conference.

"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."

Still, analysts remain cautious about the industry's ability to keep building steam. McGraw-Hill Construction predicted that single-family home construction starts will begin a pullback in 2006. Meanwhile, sectors such as hotels, offices, schools, health-care facilities and public works should see growth this year. As a result, total construction starts would see comparatively modest 3 percent growth in 2006, according to McGraw-Hill Construction estimates.

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

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 as new homebuyers enter the market and developers look 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 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 - would lead to a significant increase in construction activity.

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Housing Cool-down

After turning in another record year, the single-family home market is set to cool down, Murray said. Single-family housing advanced an estimated 3 percent to 1.6 million new units in 2005. That increase tops the record-setting 1.552 million units in 2004.

New home sales, existing home sales and home renovation work hit record levels in 2004, and Murray added that initial estimates indicate the pace remained high in 2005.

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 in 2006. Home price increases are also outpacing income growth.

These factors should spur a pullback in single-family home construction throughout most of the nation, resulting in a 5 percent reduction in starts for 2006, according to McGraw-Hill Construction forecasts. The south-central United States is the only region that should see growth in single-family homes, which would be primarily driven by posthurricane rebuilding efforts.

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

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

Income Projects Cash In

Income properties continue to rebound from the doldrums of 2001 and 2002. The sector saw 3 percent growth in 2005 and is forecast to see another 3 percent increase in 2006, according to McGraw-Hill Construction.

Office properties are expected to see a healthy uptick in 2006. Like many income sectors, it dropped significantly at the beginning of the decade but has generally leveled off in recent years. However, in early 2005 many office properties were delayed in light of higher construction costs, Murray said.

As a result, office construction starts are expected to finish 2005 at 5 percent below 2004 levels.

But demand is improving in the office market. Statistics show that office employment is holding at historically healthy levels while vacancy rates are 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 McGraw-Hill Construction forecasts.

Improving market fundamentals are also driving increased activity in the hotel sector. Since bottoming out in 2002, the market has been gradually increasing. Construction starts rose 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. In 2006, major new hotels are slated to begin construction 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. in 2006.

The stores and shopping centers market could sound the one sour note for income properties in 2006. After three years of positive gains, McGraw-Hill Construction forecasted a dip in activity for 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 since retail construction is based largely on housing demand, the coming decline in housing should have an impact on new retail development. After a 1 percent increase in 2005, McGraw-Hill Construction estimated a 5 percent decrease in starts to 283 million sq. ft.

Meanwhile, commercial warehouses will 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, McGraw-Hill Construction forecasted a 6 percent increase for 2006.

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.

Manufacturing buildings are expected to get a much needed boost in 2006. Construction 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, McGraw-Hill Construction forecasted the sector will rise 9 percent to 82 million sq. ft. in 2006.

Murray said that new pharmaceutical and biotech projects will contribute to rising starts.

Institutional Increases

Prospects are also looking up in the institutional building market. With institutional building activity tied heavily to tax revenues, the expanding economy in 2004 and 2005 bodes well for the sector in the near future, Murray said. Governments are also well-positioned to approve more work.

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

Demand for institutions is also being created by rising student enrollments and the growing elderly population. As a result, McGraw-Hill Construction forecasted that total institutional building will increase 4 percent to 520 million sq. ft. in 2006.

The educational building market is set for comeback after heavy declines starting in 2001. The market leveled at 1 percent growth to 212 million sq. ft. in 2005 with strong gains in primary junior high schools and laboratories, while community colleges, museums and vocational schools declined.

Market fundamentals bode well for future development in the sector. School enrollments are on the rise to create demand, and the improved fiscal conditions of state governments help make more funding available 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 should spark a 6 percent increase in educational building starts in 2006, according to McGraw-Hill Construction.

The health-care buildings sector set a record pace in 2005 and should see further advances in 2006. McGraw-Hill Construction statistics 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 in 2004.

Demand for new health-care facilities remains high, particularly as the baby boomer generation heads into retirement, Murray said. McGraw-Hill Construction forecasted a 2 percent increase in health-care building starts in 2006, setting a new record of 107 million sq. ft.

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

Public buildings mark the lone slump among institutional buildings, forecasted to see a 3 percent drop in 2006. Murray credited the decline to cutbacks in federal courthouse projects.

Public Work Boom

Public works projects have experienced positive growth in recent years and prospects are even better for 2006. Increased starts in transportation and environmental projects will be the biggest contributors, boosting activity by 7 percent this year, according to McGraw-Hill Construction.

After nearly two years of uncertainty, the Bush administration and Congress finally agreed on a new $286.5 billion federal transportation bill, SAFETEA-LU, in 2005. Although critics say the bill falls short of demand, Murray said that it eliminates the uncertainty that held up several projects around the nation.

McGraw-Hill Construction forecasted that the value of highway and bridge starts will see a 12 percent increase in 2006.

Environmental public works projects continue to show strong growth. After a 7 percent growth in 2004, the sector tallied a 15 percent increase in 2005, according to McGraw-Hill Construction estimates. Contracts for water lines, tunnels, pipes and treatment plants are among the biggest boons in recent years.

Sewer and wastewater projects also ended on an up note in 2005, rising by 13 percent compared to 2004.

Public works will continue to pick up in 2006, particularly in light of hurricane damage in the Gulf States. McGraw-Hill Construction estimated that the sector will end up 3 percent above 2005 at $31.8 billion in construction starts.

With the notable exception of single-family homes, 2006 is shaping up to be another boom year for the construction industry. Murray added that while the industry has been shown to go through up and down cycles in the past, the industry has remained on an upward trend for nearly 15 years despite market challenges.

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