Construction: A Little Less Solid

-- Homebuilding will slow a tad but still reach a near record

-- On the commercial side, vacancy rates will rise and new projects will stall

Once sizzling hot, the residential-construction market shows signs of cooling off in 2003. Builders everywhere are relearning caution. Wilson Construction LLC typically has at least four reservations to build posh, multimillion-dollar custom houses in the resort haven of Sun Valley, Idaho. This year, it has two. And in Chicago, LR Development Co. is building 294 luxury condos downtown, some with jaw-dropping views of Lake Michigan. But rather than fetching $1.5 million, as they might have a couple of years ago, only a few of the units will top $1 million this year. "It's time to set expectations a little bit lower," says LR President Thomas O. Weeks.

Not too much lower, though. The outlook for homebuilders in 2003 remains strong--just not as stellar as in 2002. Last year, housing starts hit a record 1.69 million, a 6% jump over 2001, according to the National Association of Home Builders (NAHB). Construction "put-in-place" reached $336 billion, according to the Commerce Dept., another record. The pace was fueled by irresistible interest rates: The 30-year fixed mortgage rate dropped from 8.1% in 2000 to less than 6% in December.

Things will come back to earth this year. The NAHB expects 1.63 million units to be built in 2003, the second best ever, but still off 3.5% from last year's all-time high.

Will this modest pullback hurt? Residential construction was, after all, a big boon to the economy. New construction pumped hundreds of billions into the gross domestic product, and a huge wave of refinancings contributed $100 billion. The refis gave consumers the money to remodel homes, pay off loans, and buy retail products. David F. Seiders, the NAHB's chief economist, estimates that rates will climb to 6.5% by yearend, though. With that rise, refis could add less than $75 billion to GDP this year, he says. "Don't look to housing to be a major growth engine," Seiders warns.

A bigger hammer has fallen on commercial construction. In 2001, the peak year for office-building, developers completed 68 million square feet of new space in the 20 biggest U.S. markets, according to Torto Wheaton Research. Last year brought 42 million square feet, and the forecast for 2003 is just 22 million. Most other nonresidential building sectors, including warehouses, hotels, and retailing, will continue to shrink some more in 2003, forecasts McGraw-Hill Construction, which like BusinessWeek is a unit of the McGraw-Hill Cos. The exceptions: Developers are still busy putting up more hospitals, clinics, and schools.

That plunge has doused other suppliers and industries. Outlays on all nonresidential structures have dipped a record 20.9% over the past year, spreading pain across many other sectors. Steelmaker Nucor Corp. (NUE ) and office-furniture producer Steelcase Inc. (SCS ) complain that the downturn is cutting into earnings. All told, estimates Richard Berner, chief U.S. economist for Morgan Stanley, the construction industry's contraction has sliced 0.7% off GDP in a year. And going forward, "it's going to be a cold 9 to 12 months," warns Kenneth D. Simonson, chief economist for the Associated General Contractors of America.

Construction industry financiers present a mixed picture. Large, financially stable builders such as Denver-based MDC Holdings Inc. (MDC ) and Pennsylvania's Toll Brothers Inc. (TOL ) had no problems raising hundreds of millions of dollars from debt offerings last fall. So clearly, "the window has opened a bit," says Robert Curran of Fitch Ratings. On the other hand, apartment vacancies are rising--from 8% in 2000 to a projected 8.8% this year--as renters look to buy. That will make it difficult for multi-dwelling builders to land financing, explains Sung Won Sohn, chief economist at Wells Fargo & Co. (WFC )

Make no mistake: Homebuilding of all sorts remains the construction industry's saving grace. Housing jobs have held construction-industry employment steady at 6.5 million. Builders are adjusting to the demands of a more value-oriented customer, making more modest houses even if they have to spend more money. Rather than invest $3 million to $4 million to build a handful of $1.5 million houses in Silicon Valley, Pulte Homes is investing $7 million to build a mix of $300,000 to $400,000 lofts and townhomes in San Jose. Similarly, Dallas-based Centex Homes (CTX ) is boosting the number of entry-level homes it will build in cities such as Atlanta and Indianapolis. "The high end is not an area you want to be playing in at the moment," says Centex CEO Andrew J. Hannigan. Yet even without the high end, housing's hot run won't be put on ice.

By Roger O. Crockett with Michael Arndt in Chicago

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