Optimistic Outlook

Total construction starts expected to rise in 2005 despite cooling housing market.

By Bruce Buckley

On the heels of another strong year in construction, the construction industry is expected to see continued improvement in 2005 thanks to an improving commercial market.

The construction industry enjoyed another year of tremendous growth in 2004, and prospects continue to look up heading into 2005, according to McGraw-Hill Construction forecasts.

Total construction rose 9 percent to $576.7 billion in 2004, fueled by the sustained strength of the single-family home market. Although McGraw-Hill Construction predicts the housing market will cool in 2005, other sectors are expected to gain strength and boost total construction nationwide by 2 percent to $585.5 billion.

"The stable construction cycle continues," said Robert Murray, vice president of economic affairs at McGraw-Hill Construction. "In current dollars, total construction continues to see growth, while avoiding decline. In constant dollars, the 2004 level is within 1 percent of the 1999 peak."

Murray announced the forecast in October at McGraw-Hill's Outlook 2005 Executive Conference in Washington, D.C.

Last year's surge in construction is credited to a 14 percent jump in the single-family home sector, which reached $276.6 billion nationwide. Single-family home construction tallied an estimated 1,530,000 units in 2004, which tops the previous record of 1,434,000 units set in 1978.

Low mortgage rates remain a primary reason for the dramatic increases in recent years, but change is in the wind. Interest rates rose gradually last year and analysts expect that trend to continue through 2005. As a result, McGraw-Hill predicts that rising rates will slow single-family housing starts, dropping 3 percent to $267.6 billion by the end of 2005.

Even if single-family housing backs off its current pace, several other sectors are expected to make up the difference. Income properties felt the ill effects of the weak economy in 2001 and 2002, but Murray said today's improving economy is turning things around.

The economy expanded about 4 percent in 2004 and is predicted to grow about 3.5 percent in 2005, he said. As a result, income property starts rose 11 percent to $110 billion in 2004 and they are expected to rise another 9 percent to $119.7 billion in 2005.

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"The corner has definitely been turned in the commercial building sector," Murray added.

The office market also appears to be pulling out of its nosedive, according to McGraw-Hill estimates. Office construction peaked at 298,000,000 sq. ft. in 2000 and plummeted 52 percent by 2003.

As the economy is warming back up and office employment is on the rise, vacancy rates are beginning to dip, Murray said. In addition, several companies have invested in large projects recently, such as new corporate headquarters. By the end of 2004, office construction was expected to rise 8 percent to 155,000,000 sq. ft. and Murray predicted that it will increase by another 10 percent to 170,000,000 sq. ft. in 2005.

"Most of the top 10 metro areas for office building have seen increases in 2004," Murray said. "The bottom was reached in 2002, and now we are starting to see the correction."

With an improving economy, hotel construction is also reaping the benefits. Although financials in much of the hotel market remain weak, Murray said they are improving and investors are looking to catch the upturn. Hotel construction rose a modest 4 percent to 47,000,000 sq. ft. in 2004, but McGraw-Hill predicts a 13 percent boost in 2005 to 53,000,000 sq. ft.

"When you get a sense of how investors are looking at this market, you see that it is becoming increasingly positive," Murray said.

Like several other commercial sectors, warehouses appear to be on the rebound. Warehouse construction hit 304,000,000 sq. ft. in 2000 and dove 40 percent over the next three years, falling to 184,000,000 sq. ft. in 2003. But, vacancy rates dropped in 2004 and large retailers, such as Wal-Mart, Home Depot, Lowe's and IKEA, have started new warehouse projects, Murray said.

Construction rose 5 percent to 193,000,000 sq. ft. in 2004 and is expected to rise 14 percent to 220,000,000 sq. ft. in 2005.

"We see warehouse construction on the upturn in 2005 and probably continuing through 2006," Murray said.

Although the economy continues to show strength, store construction is expected to slow down in light of a weakening housing market, Murray added. As new communities sprouted up around the country in recent years, stores and shopping centers followed. With McGraw-Hill predicting a slowdown in single-family home construction, stores are expected to feel the effects. Store construction rose 3 percent to 290,000,000 sq. ft. in 2004, but the sector is expected to drop 3 percent in 2005 to 282,000,000 sq. ft.

Despite the rollback, Murray said the competitive retail market continues to keep store construction going at a healthy pace, particularly among the major retailers.

"The Wal-Mart juggernaut will still be present in 2005," he said.

Multifamily housing construction remains at a steady pace heading into the year. Murray said demographics and urban development are keeping things moving. Construction starts dipped 2 percent to 435,000 units in 2004 and starts are expected to recover with a 2 percent gain to 445,000 units in 2005. The push for downtown redevelopment in many cities is sparking new construction around the country.

Meanwhile, Murray said investors recognize that the echo generation of the baby-boom generation is moving into its 20s while increasing numbers of empty nesters are also demanding apartments.

"Apartments remain a favorite property type among investors," he said.

The institutional building sector, which has remained relatively flat in recent years, is expected to see a 7 percent increase to $97.4 billion in 2005. School construction is looking to make a comeback in 2005 after years of decline nationwide. Funding has been the biggest drag on the market in recent years, but as tax revenues improve and student enrollment continues to rise in many parts of the country, construction starts will improve this year, Murray said.

Construction starts in institutional building dropped 10 percent to 217,000,000 sq. ft. in 2004, but McGraw-Hill predicts it will increase by 3 percent to 223,000,000 sq. ft. in 2005.

"Our sense is that the worst of the dampening has taken place," Murray said.

Health-care facilities have been in a mild retreat since 2002 but will see a slight increase in 2005, according to McGraw-Hill Construction estimates. The sector saw a 5 percent decline in 2003 and dropped another 1 percent in 2004, ending up at 91,000,000 sq. ft. By the end of 2005, health-care facility starts should increase 3 percent to 94,000,000 sq. ft., which Murray credited largely to aging baby boomers.

Manufacturing plant construction is expected to accelerate its steady increases in 2005. Businesses are increasing their level of investment in light of the healthier pace of economic growth, Murray said. After increasing by 4 percent to 73,000,000 sq. ft. in 2004, manufacturing buildings are predicted to increase 10 percent to 80,000,000 sq. ft. in 2005.

Public works project, after dropping in recent years, appear to be on the rebound. Fiscal appropriations passed in January 2004 were more supportive than expected, Murray said.

The federal-aid highway program was up 4 percent, mass transit increased 1 percent and EPA water infrastructure was up 3 percent. Total public works rose 4 percent to $85.9 billion in 2004 and is predicted to rise another 2 percent to $87.4 billion in 2005.

Highway and bridge construction, which dropped 5 percent in 2004, could get a 5 percent boost next year if Congress passes the new transportation bill, Murray said.

Meanwhile, electric utilities are expected to continue to decline, but at a more gradual pace. After a spike of activity that peaked in 2001, construction dropped 26 percent in 2003 and another 32 percent in 2004. McGraw-Hill predicts it will drop by a more modest 8 percent to $5.5 billion in 2005.

Overall, several factors could significantly affect every sector analyzed by McGraw-Hill, Murray said. Rising construction costs, particularly steel prices, severely hampered many projects in 2004. If those costs continue to rise, more projects could end up being shelved, Murray added.

Meanwhile, if gasoline prices continue to rise, it could affect the rebound in consumer spending.

The greatest unknown remains in single-family home construction. McGraw-Hill predicts that rising mortgage rates will slow new starts and drag total construction. However, if the sector remains hot, Murray said the industry could see another big year.

"This really all hinges on what happens with single-family housing," he added.