Commercial Construction Slows in Second Quarter

August 17, 2010
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Owing to a strong beginning, real U.S. gross domestic product is projected to grow an annualized 3.8% in the second quarter of 2010, up from 2.7% in the first quarter. However, growth in the latter half of 2010 should moderate to around 2.5%, as housing activity slows with the expiration of the homebuyers' tax credit, the inventory cycle loses its force, and boost from the fiscal stimulus fades. The weaker economic outlook fuels a vicious circle for private consumption and employment; consumers will spend more readily once they have more confidence about conditions in the labor market, but businesses will be hesitant to hire until the economy starts growing faster-which will require accelerated consumer spending.

What does this mean for nonresidential investment? For capital equipment, the news is positive, as businesses are flush with cash and opting to address replacement needs neglected during the recession. For nonresidential structures, the story is quite different, and the outlook remains poor, particularly in the commercial segment. According to IHS Global Insight's June U.S. Construction Briefing, real spending on commercial construction put-in-place fell 41.1% year-over-year during the first quarter of 2010, and the segment will continue its downward trend through the first half of 2011. In addition to dimmer outlooks for key economic indicators, spending on commercial construction is facing severe headwinds from rising vacancy rates, lack of demand for commercial leases, and illiquidity in the credit market.

Accounting for about 36% of total commercial construction spending in 2010, office is the largest piece of the commercial segment. Unfortunately, the outlook for office construction remains quite grim. Office vacancy rates climbed to 17.4% nationally in 2010Q2, as 1.8 million square feet of occupied office space across the nation was lost. The abundance of vacant space will be a great detriment to the office market, and as such, IHS Global Insight expects office construction to suffer a more protracted downturn compared to other commercial segments. Year-over-year, declines in real put-in-place spending on office construction will last through 2011 and into early 2012.

Further adding downward pressure to the office construction market is the employment report for June, which was published after the release of IHS Global Insight's latest U.S. construction forecast. The disappointing June report showed that monthly payrolls contracted for the first time in 2010; additionally, there were decreases in hours worked and hourly wage. The unemployment rate also fell from 9.7% to 9.5% but only because the labor force fell more than payrolls. As a result, June monthly data suggest that employment growth will not be as strong as anticipated. Since the office segment is closely tied to employment and business hiring, the outlook for office construction spending will likely be revised downward as employment and the general economy grow at a more muted pace.

Another major component of commercial construction, retail, is expected to fare better than office construction. Nonetheless, similar to the office segment, retail construction will also be hampered by the continued accumulation of vacant retail space in the second quarter, when the retail vacancy rate rose to 17.4%. Positive outlooks for housing, consumer spending, employment, and business spending earlier this year had bolstered confidence that retail construction would resume growth before other commercial segments. However, new June data has brought down growth expectations for many of the retail sector's key supports. The aforementioned employment report will dampen consumer confidence, which will in turn yield decelerated consumer spending. As spending tapers, businesses will be cautious of new investments in either physical or human capital.

Lodging construction tumbled 29.7% in 2009, and the most recent forecast for 2010 calls for an even steeper drop of 52.4%. These declines stem from lack of demand from both business and personal travelers; recovery in lodging construction will depend on how quickly private consumption resumes and how soon business and consumer confidence is restored. Given the weaker economy, the turnaround may be further away that previously thought.

Each segment of commercial construction is waiting for sustained strong economic growth to lift it from the doldrums. However, with the housing market slowing following the expiration of the homebuyers' tax credit, the inventory cycle losing momentum, and the stimulus boost fading, overall economic growth will downshift in the second half of 2010. Employment growth will slow, dragging down consumer confidence, consumer spending, and consequently, business confidence and spending. The rebound in commercial construction will resemble a slow and steady hike, rather than a quick liftoff.

For more information, contact IHS Consulting, phone (781) 301-9157; fax (781) 301-9409; or visit www.ihsglobalinsight.com.

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