Companies Forego New Buildings for Renovations: EcoPulse

Many American businesses are choosing to save money by renovating existing buildings instead of constructing new ones, a sign that caution persists even as the economic recovery enters its fifth year.

Major alteration projects -- those costing more than $100,000 -- climbed as a share of total nonresidential construction as the recession began and haven’t yet come down, breaking from historical patterns, according to Robert Murray, vice president of economic affairs at McGraw Hill Construction.

That’s unusual for this stage of an expansion because remodeling or retrofitting historically rises during a construction downturn, then recedes as the economy picks up and investment in new construction follows, he said.

Upgrades generally are viewed by companies as a “less risky investment” than building new structures and “the still cautious environment for development is contributing to the continued high share of alteration work,” Murray said.

Updates to commercial, manufacturing and institutional structures made up 26.7 percent of total nonresidential building starts in the first eight months of 2013, little changed from the 26.3 percent average in 2010-2012 following the 18-month recession that ended in 2009, based on figures from the forecasting unit of McGraw Hill Construction of New York. That compares with 18.8 percent in the prior decade.

UN, Vegas

Alterations are forecast to grow 2 percent this year to $41.9 billion, Murray said. The $100 million restoration of the United Nations General Assembly Hall in New York and the $165 million renovation of Gansevoort Las Vegas Hotel are among projects that reached the construction stage between January and July, based on information from McGraw Hill Construction.

In a low-growth environment, many companies haven’t been able to justify adding or expanding to their facilities, said Brian Jacobsen, who helps oversee $221.2 billion as chief portfolio strategist at Wells Fargo Advantage Funds in Menomonee Falls, Wisconsin. Instead, business leaders are trying to make better use of existing structures to minimize costs, he said.

U.S. gross domestic product has expanded by an average annualized rate of about 2.2 percent each quarter since the downturn ended, compared with an average 2.8 percent in the four years preceding the recession, Commerce Department data show.

Tax Breaks

Amid sluggish demand, energy-efficient upgrades -- such as replacing lighting or heating, ventilation and air conditioning systems -- offer both cost savings and potential tax breaks for companies, Jacobsen said. These incentives have helped to buoy demand for retrofitting work in lieu of new construction, he said.

In addition, a “more rigorous environment” for obtaining financing has inhibited some companies from building new structures, Murray said.

Even with such factors helping to spur activity, it’s still surprising that the share of retrofitting work, relative to new construction, hasn’t fallen yet, said Kermit Baker, chief economist for the American Institute of Architects. While it’s encouraging that business leaders are willing to invest in their structures, the broader economic benefit is lower because new construction usually spurs greater activity than renovations, he said.

Hedging Bets

Investors can take advantage of the increase in alteration-related projects, while still hedging in case new construction starts to increase again, Jacobsen said. That’s why he favors industries that benefit from growth in both types of building activity, he said.

Lighting systems are “ripe for renovation” and companies specializing in these products offer investment opportunities, said Scotty McConnaughey, senior vice president of U.S. equities at Standard Life Investments in Boston, which oversees about $271 billion. “Executives are trying to do less with more,” making work that provides a “good return on capital” particularly attractive, she said.

Lighting expenses make up about 30 percent of total energy costs for a typical commercial building, so there are “significant” potential cost savings within 12 months to 24 months of an upgrade, she said. Acuity Brands Inc., which provides indoor and outdoor systems, is one company that will particularly benefit from increased demand, McConnaughey said.

Two Ponds

The Atlanta-based company experienced “continued growth for larger renovation projects” in the three months ended May 31, Chief Executive Officer Vernon Nagel said on a July 2 conference call. Acuity is “really learning how to fish in two ponds” -- new construction and retrofitting -- and forecasts that the lighting industry will experience “significant growth” in the next decade, driven by energy and environmental concerns, he said.

“While we expect the economic environment to continue to be challenging, we anticipate that businesses and consumers in North America will accelerate their investments as uncertainties over U.S. fiscal issues dissipate and the economy continues to improve,” Nagel said.

Even so, Wells Fargo’s Jacobsen said, tax incentives that have helped buoy renovation work could be at risk in the upcoming budget debate in Congress. “Some of the tax areas that could’ve been beneficial to businesses may be jeopardized,” he said.

Renovation’s Limitations

There also are limitations to the usefulness of renovation versus new construction, Jacobsen said. Retrofitting doesn’t always make sense if a company is expanding production and structures used in some industries, such as agriculture, aren’t as well suited to renovations as office buildings, for example, he said.

While there’s been a big pickup in the share of alteration work for some project types, such as retail and offices, others have yet to show significant increases, Murray said.

Still, if history is a precedent, the share of nonresidential construction starts that are renovation-related will decline as business leaders become more confident about investing in new facilities, Murray said.

Sentiment among chief executive officers weakened in August to the lowest level since March, as the Chief Executive magazine confidence index fell to 5.82 from 5.84 the prior month, based on an e-mail survey conducted by the magazine. The Federal Reserve noted in its Sept. 4 Beige Book survey that companies have “lowered their expectations somewhat regarding hiring and capital spending plans” since the last survey conducted in July.

Notwithstanding the “pronounced steep downturn” in building activity related to the recession, Baker of the architects institute said he’s been surprised by the sluggish recovery in new construction. Until leaders are more confident in their demand environment, the share of retrofitting relative to starts could remain elevated, he said.

“Companies are trying to get by with a little overtime or by retooling their existing facility,” he said.

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