Shifting Economic Sands Challenge Construction Spending

As banks continue to curtail the availability of financing, a slowdown in commercial real estate construction spending appears inevitable. After gaining an average of 2% per month for the first seven months of the year, total spending in nonresidential construction was up a mere 0.2% in July, according to a Census Bureau report. And according to the August figures released by the government, nonresidential construction spending contracted 0.1% in August, compared to July.

Sam Chandan, chief economist for New York-based research firm Reis, sees the slowdown in construction spending growth as an imminent consequence of softening demand for space; tighter credit for acquisition, development and construction project finance; and persistent construction cost inflation.

While projects currently under construction are being completed, a larger number of planned and proposed projects are being pulled from the pipeline, according to Reis. “Speculative projects with lower preleasing levels constitute the bulk of delayed and cancelled projects,” Chandan says.

Ken Simonson, chief economist of the Associated General Contractors of America, also is beginning to see “a significant weakening” in construction activity in some commercial property sectors. For instance, construction spending on retail projects declined 0.6% in August.

“These figures do not take into account the much higher material costs this year, so a 3% gain [for the first seven months of the year] probably represents a drop in square footage or number of projects. I would say that retail is in decline,” according to Simonson.

Lodging construction was down 0.1% in July from the previous month. And office construction is up only 2.1% from June levels.

“Now that we’ve gotten eight months of declining employment in the country, it will be harder to justify new office construction. There is so much shadow space available in companies that have downsized,” Simonson points out. Unemployment was up to 6.1% in August, its highest level since 2003.

In the multifamily sector, spending activity gained 0.2% in July, after being down 11% for the first seven months of the year. In response to the ongoing economic uncertainty, Newland Communities, a San Diego-based company involved in land development on residential communities that also incorporate office and retail components, has put a number of projects on hold. Newland plans and creates the lots for the communities, getting them through the entitlement process and building the infrastructure, and then sells the lots to developers.

The company has delayed construction activity on about 20 projects that would have generated hundreds of millions of dollars of construction spending activity, according to Derek Thomas, chief investment officer of Newland. The delayed projects are predominantly located in California, Arizona and Florida -- all states that have been in the eye of the housing market decline. There has also been some slowdown in the Carolinas and in major Texas cities.

One positive impact of a decline in construction activity is that even a slight rebound in demand in 2010 to 2011 will have a significant impact on vacancy rates for all sorts of commercial real estate properties since very little new product will be completing during those years, according to Boston-based Portfolio & Property Research.

Joshua Scoville, director of strategic research with PPR, says that the decline in construction spending has been more muted in this cycle because the peak of the construction cycle was much lower than the peak in the last cycle.

Associated General Contractors’ Simonson doesn’t see any quick up tick in construction spending activity going forward. He expects that 2009 and 2010 will be very bad for office construction activity because of the excess space freed up in companies that are laying off workers.

Retail spending activity has a chance of recovering in 2010. And he expects lodging construction activity, which tends to have fairly long cycles, to continue to be in decline through 2010.

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