Over the Top

2007 Construction Outlook:
Has Market Reached Its Peak?

by Bruce Buckley

Over the past several years, as the industry has continued to tally record-setting construction starts, executives have been left wondering, "How hot can this market get?"

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With starts hitting an estimated $672 billion in 2006, McGraw-Hill Construction forecasts that total construction starts have finally peaked. For the first time since 1991, the industry is headed for a cool down with starts forecast to drop 1 percent to $668 billion in 2007, according to McGraw-Hill Construction.

Single family homes - the sector that buoyed the market in recent years - will largely be responsible for dragging total starts back down. A 5 percent decline in housing starts is predicted for 2007, as single family home starts are expected to drop from $281 billion to $268 billion and multifamily housing starts will fall from $70 billion to $66 billion.

Robert Murray, vice president of economic affairs at McGraw-Hill Construction, said single family housing represented roughly 38 percent of total construction starts at the beginning of the decade and by 2005 it was up to 48 percent. With the sector becoming such a prominent portion of the total market, any drop was bound to have an effect, he said.

"A decline of that magnitude will obviously impact what we're seeing in overall level of construction activity," he said.

Although the housing market is cooling off quickly, the market will remain relatively stable thanks to other strong building sectors, Murray said.

"Going into 2007, it's going to be the institutional building and public works sectors that will be key to keeping all-around activity at a good clip," he said.
Murray announced the 2007 forecast at the annual McGraw-Hill Construction Outlook in Washington, D.C., Oct. 27.

Although a cooling the residential market was expected, Murray said the market is experiencing a dramatic correction. In 2000, median home prices were roughly 4 times the median income in the U.S. In 2006, that ratio climbed to 5.2, throwing the market "out of whack," Murray said.

Faced with ebbing demand from homebuyers, developers called for a retreat in housing starts in 2006. By the second quarter, single family housing was dropping faster than widely anticipated, matching a pace on par with the market downturn of the early 1990s, Murray said.

As a result, the total number of single family homes dropped 15 percent in 2006, from 1.63 million units to 1.37 million units.

As goes the housing market, so goes the retail market. New homes have historically led to construction of new retail centers. Total square footage of store construction rose 4 percent in 2005, mirroring the hot housing market.

With housing begin to cool this year, retail starts are estimated to drop 2 percent to 300 million sq. ft. by the end of 2006. Big box retailers will be among those pulling back. Murray noted that Wal-Mart announced in October it would cut global expansion from 8 percent to 7 percent.

Subsequently, McGraw-Hill Construction estimated that store construction will slide an additional 7 percent to 278 million sq. ft. in 2007.

"Our forecast could be a touch on the optimistic side," Murray said. "It's virtually guaranteed that in 2007 you will have less retail construction."

Despite the drop in store construction, other income properties are expected to see a healthy uptick in activity. Although warehouses naturally align with retail construction, dropping vacancy rates and rising demand for updated facilities will keep warehouses trending upward. Construction starts in the sector should advance by 5 percent to 230 million sq. ft., according to the forecast.

Office buildings continue to rebound since bottoming out at 144 million sq. ft. of starts in 2003. Vacancy rates are dropping in many parts of the country and major towers are underway in cities such as New York and Chicago. Overall, McGraw-Hill Construction estimated that office construction will advance 5 percent in 2007 to 197 million sq. ft.

"The market fundamentals are strong," Murray said. "It's conducive to more construction taking place."

Hotel construction is expected to remain on the rise in the face of encouraging occupancy rates and revenues. In 2006, the sector saw an estimated 72 million sq. ft. of starts, a dramatic 48 percent gain over 2005. Murray said the sector will continue to see gains in 2007, rising 4 percent to 75 million sq. ft. next year.

"That could be the top," he said. "At that point, with new hotels coming online, some of those industry fundamental will begin to erode a bit in 2007."
Institutional buildings remain hot going into 2007, thanks to the improved financial health of states and the passage of several large bond measures.

Combined starts will rise from $98.8 billion in 2005 to $106.9 billion in 2006, advancing to an estimated $113.9 billion in 2007.

Rising enrollments have created long-term demand for classroom space, according to Murray, spurring a 6 percent rise in educational building starts to 243 million sq. ft. Meanwhile, donations to colleges and universities hit an all-time high in 2005, which Murray credits for spurring major campus expansions.

Although the U.S. health care system should experience tremendous demand from aging Baby Boomers in the coming years, health care construction is expected to ease back in the coming year. The sector hit an all-time high of 107 million sq. ft. of starts in 2005. McGraw-Hill Construction estimates that starts leveled at 105 million sq. ft. in 2006 and forecasts suggest it could drop to 97 million sq. ft. in 2007 - a 7 percent decline compared to 2006.
Public building construction, fueled in part by increased federal appropriations for courthouses, will experience a modest rise from 33 million sq. ft. in 2006 to 35 million sq. ft. in 2007, Murray said.

McGraw-Hill Construction also forecasted increases other institutional sectors, such as religious, amusement-related and transportation terminal buildings in 2007.

With more companies looking to replace aging production facilities, manufacturing building is expected to rise 14 percent in 2007 from $10.7 billion to $12.2 billion. Ethanol and petrochemical work will be among the major drivers of the trend, as the country seeks increased refining capacity and additional ways to reduce dependence on foreign oil, Murray said.

Continued growth in the pharmaceutical and biotech industries will also lead to new manufacturing facilities in 2007.

With the federal transportation bill, SAFTEA-LU, in place, highway and bridge construction should have a reliable stream of funding going into 2007, rising 9 percent to $55.6 billion. However, Murray cautioned that real growth in highway work could be hampered by rises in materials costs.

Environmental projects should advance 2 percent in 2007 while site work pulls back by 2 percent, according to the forecast.

A spike in new coal-fired plants in 2006 helped the electrical utilities sector see an estimated 65 percent jump to $11.7 billion. In light of such a boom year, the sector should settle back 20 percent in 2007 to $9.4 billion.

Overall, Murray says the combined construction market is remarkably stable heading into 2007. Although the single family housing sector may have spoiled the party for the surging construction market, Murray said the impact could have been worse. If single family housing was taken out of the equation, the market would see an overall 3 percent gain in 2007. It's an example of how construction cycles in various sectors can keep construction activity level as a whole.

"It's a more stable picture now," he said. "We're been seeing this offsetting pattern by sector that has created overall greater stability for construction… In 2008, you might see a pullback in public works and institutional building, but it might be the time then for single family housing to once again be a source of expansion."

Southwest Region Activity to Drop Slightly

McGraw-Hill Construction Dodge forecasts an eight percent decline in overall construction activity in the Arizona, New Mexico and Nevada region for 2007.

While the feverish pace of growth in the construction sectors may not continue into 2007, the forecasts from McGraw-Hill Construction are more optimistic than some other recent economist's predictions, according to Cliff Brewis, senior director of editorial for McGraw-Hill Construction. In an analysis of construction projects in planning or awarded to contractors, McGraw-Hill forecasts an eight percent drop in construction activity for 2007 in the three-state region.

In Arizona, total construction activity is forecasted to be almost even with 2006, continuing the state's high level of activity over the past five years. While public works and institutional projects are expected to drop by up to 10 percent in 2007, other categories such as commercial and even residential construction should break even.

Nevada should see a drop in overall activity of eight percent, according to the report. The value of public works projects is expected to rise 31 percent in 2007, while commercial, industrial and institutional construction starts will drop by around 10 percent.

New Mexico is more difficult to forecast, since one or two large-scale projects can skew the numbers, according to Brewis. Activity in education and medical construction should be on the rise in 2007, while multi-family residential and public works activity will slow.

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