Surprising Slowdown in Nonresidential Building: EcoPulse
Private nonresidential construction is losing steam in the U.S., a sign that commercial real estate may be a drag on the economy as business leaders are reluctant to make large property investments.
Spending on lodging, office, commercial and manufacturing buildings grew 5.6 percent in April to about $11 billion from a year ago on a nonseasonally-adjusted basis, the slowest pace in almost two years, data from the Census Bureau show.
Four years into the economic expansion, “we’d expect to see more lasting signs of strength,” said Kermit Baker, chief economist for the American Institute of Architects. “That hasn’t happened yet.”
Normally, this type of construction exhibits “late-cycle” growth because the design and building process may take several years, so business leaders need to be confident that a durable recovery is well under way before undertaking a project, Baker said. Activity has been “unusually volatile” since the 18-month recession ended in June 2009, with “only brief flashes of growth,” he said.
Investment in nonresidential projects historically is “about on par” with spending on homebuilding, and further weakness would be troubling, said Brian Jacobsen, who helps oversee $221.2 billion as chief portfolio strategist at Wells Fargo Advantage Funds in Menomonee Falls, Wisconsin.
“Everybody seems to be hitching their wagons to the revival of the homebuilding industry to revive the economy, but let’s not forget nonresidential construction because it’s also very important,” he said.
Investment in private nonresidential structures subtracted 0.11 percentage point from gross domestic product in the first quarter, while homebuilding added 0.3 percentage point, according to Commerce Department figures.
The weakness may persist, judging by the Architecture Billings Index, a monthly survey of U.S. based architecture firms that serves as a “good, solid leading indicator” of nonresidential construction nine to 12 months down the road, Baker said. The commercial and industrial component of this index fell to 49.2 in April, the lowest level in seven months, according to figures from the Washington-based association. May figures are scheduled to be released tomorrow.
That confirms other data, such as vacancy rates, pointing to a slowdown in construction this year, said Jacobsen. The billings index has averaged 50.3 during the past 12 months and if several consecutive readings were below 50 -- a sign of contraction -- it would point to a “longer-lasting slowdown,” he said.
The U.S. office vacancy rate was 17 percent in the first quarter after a quarterly average of 17.4 percent in 2011-2012, according to Reis Inc., a New York property-research company. Net absorptions for metro-area offices -- the change between space leased and vacated -- rose to almost 4.1 million square feet in the first quarter, from 3.3 million the prior quarter, Reis data show.
The absorption rate has averaged about 4.3 million square feet since 2011, showing commercial real estate has been stuck in a “slow and steady state,” said Ryan Severino, senior economist at Reis. Further declines in office vacancies -- a bellwether for commercial real estate -- hinge on improvements in the absorption rate, which “probably won’t accelerate much” in the next two to three quarters, he said.
Excess capacity of commercial, industrial and office space has yet to be fully absorbed and is stalling the construction recovery in these industries, said Russell Price, senior economist at Ameriprise Financial Inc. in Detroit.
“The market needs to become a little tighter before we see increasing demand for floor space,” Price said. Limited credit is also “part of the headwind” that’s holding back the industry, he said.
That’s pinching architectural firms, as projects have been delayed, scaled back or canceled because clients haven’t been able to secure financing, Baker said, citing the association’s survey. “This has been a very uneven recovery with more stops and starts in the design process.”
Given the cost of large projects, the “sluggish” recovery in nonresidential construction is largely a “confidence issue,” said Stephen Volkmann, a New York-based analyst at Jefferies Group LLC. That’s holding back some companies that make or supply construction equipment, such as United Rentals Inc., Oshkosh Corp. and Eaton Corp., he said.
For Dublin-based Eaton, which makes equipment such as excavators and loaders, some smaller commercial projects that historically happen earlier in the economic cycle haven’t “come back,” Chief Executive Officer Alexander Cutler said at a May 21 conference. As housing starts improve, buildings such as a new McDonald’s or a shopping center usually follow suit, he said, and that “hasn’t occurred yet.”
Further weakness in construction spending could cause shares of companies reliant on nonresidential work to lag behind the market in the short term, Jacobsen said. Still, they are “fairly diversified” -- with exposure to many end-markets and types of customers -- and amid further improvements, this industry “could represent a longer term buying opportunity.”
Amid “a fair amount of pent-up demand” in commercial construction, there’s still good reason to have a “positive bias” on this industry, said Volkmann, who maintains a buy recommendation on Oshkosh, Wisconsin-based Oshkosh and a hold on Eaton. “Animal spirits will be unleashed at some point and we’ll have better growth.”
Oshkosh, a commercial-truck manufacturer, expects “improvement in nonresidential construction activity in the coming years,” which would “bolster demand” for its products, Chief Executive Officer Charles Szews said on an April 30 conference call.
Similarly, the Federal Reserve noted progress in its June 5 Beige Book business survey, which found that commercial real estate and construction “expanded at a modest to moderate pace in most districts,” with contacts in New York even reporting “robust” activity.
There’s been a “lot of choppiness” in construction spending during the past three years, consistent with the broader economy, Price said. He forecasts that private nonresidential construction spending will expand 1 percent in 2013, following a 17.6 percent gain last year that “wasn’t sustainable.” In addition, the billings index probably will exhibit “sustained improvements” later this year, he said.
“A measured pace of expansion over the long-term is the best for the economy,” Price said.
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