Despite challenges in 2013, positive signs are ahead

The United States economy faced many challenges in 2013. It seemed the economy was under attack on several fronts. Despite numerous impediments, the economy continued to grow and is poised for an improved 2014 and 2015.

On the domestic side, there was fiscal drag from reduced government spending, including the sequestration (the across the board cuts to much of federal spending). The end of the two-year Social Security tax holiday restored an additional 2 percent tax on wages and salaries. Meanwhile, state and local governments were practicing austerity, with many cutting spending and laying off employees in an effort to avoid a deficit.

There was the political gridlock in Washington that prevented much from being accomplished. Failure to provide funding for federal government operations resulted in the partial shutdown of the government and the furlough of many government employees that stretched from October 1 through October 16. The shutdown ended with the passage of a continuing resolution (CR) that extended the 2012 fiscal budget through January 15 and left the sequester in place.

The CR also provided a short-term fix for another issue facing the government and the economy:  the threat that federal debt would hit the debt ceiling and prevent the Treasury from borrowing funds to meet government outlays. This threat would have forced the Treasury to delay paying various federal obligations, such as Social Security and Medicare, federal payrolls, payments to contractors, tax refunds, and debt payments (a technical default of U.S. government debt). Payments would have been made only to the extent that receipts from taxes and other fees flowed into the Treasury. The CR included a provision that raised the debt ceiling to a level that should not become effective until early February.

On the foreign side, much of Europe was in or fell into recession in 2013, reducing demand for U.S. exports to that part of the world. There was also the threat of sovereign debt default by one or more European countries, one or more countries leaving or being forced out of the Eurozone, and one or more countries abandoning or being forced to abandon the euro. The risk of these possible events rose and fell throughout the year adding to uncertainty for the business community. That uncertainty acted as a drag on investment and hiring.

There were positive forces at work as well. The most notable was the revival of the housing market. Multifamily construction was the first to revive, with a ramp up in 2010. Although multifamily starts stumbled in the fourth quarter of 2010, they soon revived in 2011 and continued growing into early 2013. There was a pullback on ventures in the second and third quarters of 2013, while the market absorbed the influx of new space as builders completed projects. In spite of the influx, vacancy rates fell and rents rose. Thus, the outlook for additional multifamily projects remains bright.

The single-family housing market struggled more. Single-family construction began to turn up in 2009 and into 2010 on the back of various tax breaks for home purchases. With the expiration of the tax incentives in the spring of 2010, the market faltered and did not truly begin to revive until the latter part of 2011. Since then, single-family construction has been increasing, albeit from a low level. In spite of this less than spectacular growth, housing stopped being a drag on the economy and returned to its traditional role as one of the engines that helps the propel the economy forward following a recession.

Rising home prices have moved some underwater mortgages above water, encouraging more homeowners to make their mortgage payments. Rising housing prices give potential homebuyers more confidence in making a purchase and motivate lenders to extend loans to homebuilders and homebuyers. Also, foreclosure rates have fallen and the shadow inventory of foreclosed homes held off the market for future sale has been greatly reduced.

As housing revived, nonresidential building construction also began to show some life, turning up in early 2011. Confusion and concern over what was happening in Washington, the threat and eventual reality of a government shutdown, and the risk of a federal government debt default due to the debt ceiling all held down investment in nonresidential buildings, slowing activity in the second half of 2013.

Washington is showing signs of becoming somewhat more functional. The first great test is rapidly approaching with the expiration of the CR as of midnight January 15. Passage of a budget for this fiscal year or a good agreement that promises such a budget within a relatively short time would be an excellent sign. A new CR would be less desirable, but still a positive sign. Another partial shutdown of the federal government would be a bad sign, and all bets would be off. Tied into these negotiations is the need to raise the federal debt ceiling.

State and local government receipts have been growing again. Combined with previous austerity budgets, most of these entities are entering 2014 with real fiscal strength (with the notable exception of the Detroits of the country) that will allow them to restore some of their spending. Renewed fiscal strength will mean pay increases for police, fire, and teachers as well as hiring/rehiring within these areas.

State and local governments are no longer waiting for the federal government to provide funds for infrastructure. They are looking for and finding creative ways to fund these much-needed projects. Clearly, federal funding for infrastructure repair, maintenance, and improvement would be best, but only limited federal funding for these sorts of projects is expected to occur in 2014.

With residential construction headed higher, employment increasing (albeit, still at a slower than desirable pace), Washington becoming somewhat more functional, state and local governments on stronger fiscal footing, and increasing spending, expect to see a somewhat stronger economy, particularly once we are beyond the first quarter of 2014.

The better-performing economy will mean that the Federal Reserve will begin to taper its purchases of new long-term assets (currently $85 billion per month) possibly as early as March — leading to higher long-term interest rates. The rise in rates will occur amidst a healthier economy and, as a result, the increase will not act as much of a drag on economic activity. The reduction in asset purchases and the eventual sale of many of the Fed’s accumulated assets will be a long, drawn out process, extended over many quarters.

Based on this forecast for the economy, here is Reed’s outlook for some important construction sectors.

Lodging

Lodging construction ramped up strongly in 2012 and 2013, as many companies addressed a long period of deferred maintenance for their properties. As the business climate improved, companies began to increase travel budgets that previously had been reduced as part of austerity measures in the face of falling demand. Leisure travel has increased as employment has improved and as households have felt more secure in their various job situations. Lodging construction should continue to expand at a somewhat slower, but still robust rate in 2014.

Office/Corporate

Demand for office space has been under attack for several years. According to a 2013 Corenet Global survey, the average space per office worker was roughly 225 square feet in 2010. In 2013, two thirds of companies responding to the survey indicated that the average space per office worker was 150 square feet or less.

The shrinkage in average square footage per worker is due to a number of factors. Less space is needed for storage of records and reference materials as many of these items have migrated to digital storage. Space needs have been greatly reduced as equipment such as the fax machine, copier, and large printers have been eliminated, shrunk in size (think of the personal printer that now sits on many office workers’ desks), or greatly reduced in numbers. Telecommuting has allowed companies to maintain their workforce while also reducing the amount of company supplied space.

At the same time, as the economy grows, companies need to expand their workforce, increasing the need for office space even if the space per worker is lower than in the past. Even as more companies are embracing telecommuting, businesses (especially in high tech areas) are recognizing the value of bringing people together on a daily basis (i.e., in an office setting) allowing for random interaction that sparks collaboration and new ideas.

Although some older buildings can be retrofitted to accommodate current technology and to be more “green” (i.e., be more energy efficient and reduce water usage), sometimes that is too costly and building new space makes sense. Also, as the population moves, there is need for new space to be closer to the desired pool of labor.

Thus, after a difficult 2013, expect the office construction market to show solid, if unspectacular gains in 2014.

Commercial

Commercial construction, which is mainly driven by construction for retail purposes, including warehouses — generally representing about 85 to 90 percent of private, commercial construction spending — began to increase in 2012 and continued to grow in 2013. Much of the 2012 activity, and to some extent the 2013 activity, was the result of reviving earlier projects that had been shelved as a result of the recession and its aftermath. As these projects are completed, new projects will be closely tied to the strength of the housing market.

The Internet may have dramatically changed the landscape for brick and mortar stores in some categories (most notably for books and electronics), but the inroads for other sectors is limited or nonexistent. The Internet will chip away at the need for clothing and shoe outlets, but brick and mortar stores will continue to account for the vast majority of their sales. Grocery stores, restaurants, and various services (e.g., hair care) may use the Internet to promote themselves, but will not be supplanted by Internet alternatives. Larger retailers (e.g., Walmart, Target, Nordstrom) have successfully carved out niches in the market while also adopting the Internet as another sales tool and distribution channel.

The outlook for commercial construction is fairly positive. 2014 promises to be another year of growth. The health of the housing market will determine the overall health of this sector.

Health Care

Health Care construction barely held its own in 2011 and 2012 and fell in 2013. Uncertainty surrounding the Affordable Care Act (sometimes referred to as Obamacare) kept many health care providers on the sideline. The legality of the act has been settled. The massive foul ups surrounding the online portal for the health care exchanges have created new uncertainty for health care providers.

The law cannot be repealed before 2017. Repeal would require a Republican majority in congress, including a filibuster-proof majority in the Senate and a Republican president. Even under those circumstances, repeal would not be a certainty. By then, a majority of Americans may well have come to depend on many of the benefits of the law (covering dependent children until age 26, no exclusion for a pre-existing condition) and repeal would not be politically practical.

The Affordable Care Act will have the effect of increasing demand for medical services and changing the distribution of the type of demand. One hope is it will reduce demand for emergency room care and increase use of preventive care. The need for new health care facilities in new locations will increase. The competition between large institutions (hospitals) and various groups of medical practitioners (mainly groups of doctors) will create pressure to build new facilities — a condition that will be further bolstered by continued advances in medical equipment.

Look for health care construction activity to improve significantly over the course of 2014.

Education

There has been a bifurcation in construction activity for educational facilities. Construction of private educational facilities fell off dramatically in 2009 and 2010, as the recession and the drop in the stock market took their toll on charitable contributions and the value of the portfolios of educational entities. The recovery from the recession and the rebound in the stock market has meant a resurgence in both contributions and the market value of portfolios. Expansion plans that had been put on hold were revived and new projects are being contemplated.

Meanwhile, given the hard economic times, support for new taxes and bond issues for public education was nowhere to be found. Projects that had already received voter approval proceeded, but few new projects were put forth or approved. That “anti new tax/anti new bond” issues sentiment still prevails. We expect that sentiment to recede over the next few years as the economy improves and parents begin to complain about crowded and/or deteriorating classrooms. Rising house prices are also slowly helping to refill depleted coffers as property tax receipts move higher with the higher home values.

Although private education construction spending looks bright, given that public education construction spending accounts for roughly 80 percent of all education construction spending, the outlook in the near term for total education construction spending is not favorable. The best that can be said is that most of the reductions in public education construction spending are now behind us. In 2014, total education construction spending will be essentially flat.

Residential Construction/Multifamily

Multifamily construction activity has rebounded much more strongly than single-family construction activity. Although still below what the country needs on a long-term basis, the pace of multifamily construction is much closer to that level than is single-family activity. Demand for multifamily rental properties is strong. Vacancy rates continue to fall, rents continue to rise, and financing for multifamily projects remains relatively plentiful. Nonetheless, there remains enough caution in the market that the risk of overbuilding is low. The prospect of higher interest rates in the coming months does not seem to be a deterrent to multifamily construction projects.

Dr. Bernard M. Markstein is U.S. Chief Economist for Reed Construction Data, provides economic analysis and forecasts of commercial construction activity as well as tracking developments in building materials prices. Dr. Markstein received a Bachelor of Arts Degree in Economics from Brown University and a Doctorate in Economics from Yale University. Among his professional activities, Dr. Markstein serves as the Chair of the National Association for Business Economics (NABE) Real Estate/Construction Roundtable and is past Chair for the NABE Financial Roundtable.