Spending on nonresidential buildings nationally increased a mere 2.2 percent last year, barely outpacing inflation in building costs. Given that we’re halfway through the seventh year of continuous growth for this notoriously cyclical industry, 2018 might have looked to be the year that the industry would enter another recession. However, when polled at the beginning of this year, the AIA Consensus Construction Forecast Panel instead saw an acceleration in activity, projecting 4.0 percent growth in 2018 and a nearly equal 3.9 percent in 2019.
At the halfway point of the year, this panel is even more optimistic. Their forecasts have been marked up to 4.7 percent growth in spending for this year and an additional 4.0 percent in 2019. If these projections materialize, by the end of next year the industry will have seen nine years of consecutive growth, and total spending on nonresidential buildings will be 5 percent greater (ignoring inflationary adjustments) than the last market peak of 2008.
Much of the optimism in the outlook is coming from the overperforming commercial sector. With numbers strong through the first half of the year, the consensus is that spending on commercial buildings will increase 6.7 percent this year (up from 4.4 percent projected as of the beginning of the year) and 3.4 percent next year (up from 2.9 percent). The industrial construction sector continues to be weak, and as such forecasts for these facilities have been downgraded a bit for this year and next. However, the panel is more optimistic about institutional building activity, with forecasts tweaked up modestly for both 2018 and 2019.
The optimism exhibited by the AIA Consensus Construction Forecast Panel is consistent with growing design workloads at architecture firms. Architecture firms saw a healthy growth in both ongoing billings and new project activity last year, and the pace of gains for both of these indicators has remained strong through the first half of 2018. As a result, architecture firms are reporting average project backlogs of 6.3 months through the first half of the year, their highest level since the design recovery began in late 2010. And the gains are across all major sector specialties, with multifamily residential, commercial/industrial, and institutional firms reporting billings growth for the first half of the year at least equal to the pace of growth that they reported for 2017.
What has gone right?
It is unusual to see business conditions improve this late in a business cycle. However, businesses are generally seeing a more accommodative regulatory environment, and have seen healthy growth in corporate profits. As a result, business confidence scores through the first half of the year are somewhat ahead of the average for last year and at their highest level since 2004, according to the Conference Board’s CEO business confidence survey.
Consumers are just as happy with how the economy has been performing. The economy is on pace to add almost 2.6 million net new payroll positions this year, exceeding the 2.2 million that were added in 2017. As a result, the national unemployment rate through the first half of the year averaged 4.0 percent, its lowest rate since 2000. With rising wages, more workers have decided to re-enter the labor force. Consumer sentiment scores for 2018 are at their highest level since 2000, according to the University of Michigan’s consumer sentiment index.
What could go wrong?
In spite of generally very favorable economic conditions nationally and solid trends in the AEC industry, there is nervousness about future conditions. At this stage of the business cycle, economists like to point out that there are generally more downside than upside risks. That translates to: the list of things that can go worse than expected is longer than the list that can go better than expected.
On the list of concerns are several that have been percolating for a while:
– a nine-year economic expansion that has run about twice as long as the typical expansion; – an aging construction labor force that has had difficulty attracting new workers; steadily rising interest rates that are projected to continue to rise over the next 18 months; and – federal immigration policies that threaten one of the most reliable sources of labor for the AEC industry.
However, three emerging economic concerns—an escalating threat of a trade war, rising inflation in building costs, and spiraling federal debt levels—are more recent additions to the list of worries over the economic outlook.
Escalating threat of a trade war. While implementing tariffs on selected US imports—particularly those that aren’t fairly traded—can help protect the economy in the long-run against unfair trade practices, in the short-run they drive up prices of products for US consumers. And the resulting retaliation by our trading partners can severely hurt US companies whose goods are targeted. Construction is particularly vulnerable to foreign retaliation to US tariffs because of its reliance on imported materials (metals, petroleum products), and because the domestic business response to foreign retaliation would be reduced investment in facilities. The potential impact of a trade war on US businesses is constantly shifting as different industries are threatened, but the overall result is increased uncertainty on the part of investors.
Rising inflation in building costs. Commercial land values have increased over 50 percent since their low for this cycle in 2011, according to a CoStar commercial land index. Construction costs, in contrast, have increased only about 30 percent from their 2010 cyclical low for this cycle. However, unlike land costs, construction costs have substantially surpassed the high point of the past cycle, and show no signs of abating. From midyear 2017 to midyear 2018, construction inputs have increased more that 8 percent according to the US Department of Labor, with steel prices up 12 percent, aluminum prices up 20 percent, and lumber and plywood prices up 18 percent.
The recently enacted tariffs on steel and aluminum are obviously responsible for part of this inflation in material prices, and the potential for further tariffs being imposed, with the ensuing retaliation measures, also play a role in driving up materials prices. However, construction labor and materials cost escalation predates the trade measures, and are likely to continue to be an issue even if the trade situation were to be resolved. Again, uncertainty is major result of this situation, with owners and developers not knowing how much a project will ultimately cost, and contractors not knowing what they will eventually pay for key materials as they are developing their proposals.
Spiraling federal debt levels. The federal debt has been rapidly growing in recent years, from $5.7 trillion in fiscal year 2000 to $20.2 trillion in fiscal year 2017. The Congressional Budget Office sees the federal debt increasing by almost this much again over the coming decade. Part of this upswing is their projection of the fiscal impact of the recently passed Tax Cuts and Jobs Act, which they estimate will cost the government $2.3 trillion in revenues, though it will be partially offset by almost $500 billion in added revenue created by economic growth from tax reform. The CBO sees baseline federal budget projections creating around a trillion-dollar-a-year deficit in the near term, up to about $1.5 trillion a year in a decade. Higher debt levels mean increased federal borrowing and therefore higher interest rates throughout the economy. There is also the likelihood that rising debt levels will lead to higher taxes or reduced federal spending (or both) in coming years, which will slow economic growth.
For the time being, smooth sailing likely
Until, or if, these risks to the economic outlook materialize, the construction industry is projected to continue on its pace of solid but unspectacular growth. The commercial categories are anticipated to continue to see growth levels tail off, offset in part by a manufacturing sector that has almost bottomed out and expected to see slow growth resume. The institutional categories look to finally surpass the commercial categories in terms of their growth rate and keep the construction sector growing until the broader economy falls into recession, which seems unlikely to occur over the next two years.
Kermit Baker, Hon. AIA, is AIA’s Chief Economist and part of the AIA Economics and Market Research Group, which provides AIA members with insights and analysis of the economic factors that shape the business of architecture.