Market Update

The broader economy is on the path to recovery, but economists have come to accept that the current recovery will be more muted than the previous ones. The nonresidential construction sector is closely linked to the overall economy. Consequently, growth expectation for the nonresidential buildings market needs to be moderated compared to the post-recession market recoveries in the past four decades.

Commercial construction drivers like manufacturing activity, consumer spending and corporate profits have fared better in recent months but without the conclusive evidence of a sustained recovery in these economic indicators, developers will find it difficult to justify spending on new construction. An uneven recovery in the residential market reinforces this status quo.

State and local governments, the primary drivers of institutional construction, continue to be plagued by budget constraints due to lower tax receipts and tight credit standards. Although state and local finances are gradually stabilizing, a quick recovery is unlikely as high unemployment rates are expected to keep tax receipts low in the medium term. Uncertainty over the funding of a range of government programs is also likely to adversely impact this segment.

Leading indicators of the nonresidential market like the Architectural Billings Index and construction starts also point towards slow recovery. The Architectural Billings Index turned positive during the fourth quarter of 2010 and first quarter of 2011 but the uptick was short-lived. In recent months, the index turned positive again but unless this is sustained through 2012, it is unlikely to translate into construction spending growth. The 12-month trailing average for nonresidential construction starts remained relatively flat for over a year now but it has stabilized at its lowest level in over 40 years.

Structural impediments like the large inventory of vacant houses, high levels of personal and federal debt, and rising energy and material costs will also restrict a rapid recovery in nonresidential construction. Further, project financing and refinancing in the commercial sector is still quite restrictive. Project delays and cancellations are down but fewer projects are getting started without full financing.

The retail segment still has a substantial number of distressed properties. The retail vacancy rate stabilized over the past year but remains high by historical standards. The regional mall vacancy rate is stagnant at its highest level in eleven years as high food and energy prices impact retail sales. Housing starts, a driver of retail construction, continues to be weaker than expected.

The office segment will continue to be impacted by an uncertain regulatory environment and high office vacancy rates. Office employment growth remains feeble as the market recovers from cyclical and structural issues. The large amount of unoccupied office space is expected to be a significant drag on new construction in the office market.

Hotel segment construction growth will be relatively modest as high unemployment levels persist and weak consumer confidence holds back leisure travel. Renovation work in the hotel segment is expected to spur growth in 2012 as hotel occupancy rates continue to rise. Financing of new hotel projects will continue to pose problems for developers.

The multifamily residential market, comprised of condominiums and rental units, has bottomed-out and is expected to grow at a rapid pace in 2012. However, securing financing for large projects will continue to be a challenge.

In the education segment, weak state and local government finances, the primary drivers of educational building construction, will continue to adversely impact school construction. Volatility in the stock market, where college and university endowments have significant investments, will affect college and university construction spending. The “American Jobs Act” proposes to invest $25 billion to modernize around 35,000 public schools across the country. This could provide some impetus to educational building construction but is unlikely to have an impact until 2013.

In the healthcare segment, escalating healthcare costs are expected to dampen investments in new healthcare facilities but market drivers like aging population and medical facilities will induce new projects in the medium term. As the economy improves, medical office building vacancy rates are expected to decline and provide further impetus to build new medical facilities.

The public building segment will be relatively weak with the impact of government stimulus funds waning. New spending in this segment will be moderated by improving but weak state treasuries and deteriorating federal funding.

Nonresidential building construction is expected to hit bottom in 2012, with the possibility of some growth in the commercial sector during the latter half of the year. Most leading indicators, however, seem to imply that the market will not experience any significant growth until 2013.