Residential building slump will cause a drop in construction starts for 2007

The surging U.S. construction market may have finally peaked, with starts expected to drop for the first time in 16 years.

By Bruce Buckley

Over the past several years, as the industry has continued to tally record-setting construction starts, executives have been left wondering, "How hot can this market get?"

With starts hitting an estimated $672 billion in 2006, McGraw-Hill Construction forecasts that total construction starts have finally peaked. For the first time since 1991, the industry is headed for a cool down, with starts forecast to drop 1 percent to $668 billion in 2007, according to McGraw-Hill Construction.

Single-family homes-the sector that buoyed the market in recent years-will largely be responsible for dragging total starts back down. A 5 percent decline in housing starts is predicted for 2007, as single-family home starts are expected to drop from $281 billion to $268 billion and multifamily housing starts will fall from $70 billion to $66 billion.

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Troubled Single-family Market
Single-family housing represented roughly 38 percent of total construction starts at the beginning of the decade, and by 2005 it was up to 48 percent, said Robert Murray, vice president of economic affairs at McGraw-Hill Construction. With the sector representing such a prominent portion of the total market, any drop was bound to have an effect, he said.

"A decline of that magnitude will obviously impact what we're seeing in overall level of construction activity," he added.

Although the housing market is cooling off quickly, the overall construction market will remain relatively stable, thanks to other strong building sectors, Murray said.

"Going into 2007, it's going to be the institutional building and public works sectors that will be key to keeping all-around activity at a good clip," he said.

Murray announced the 2007 construction forecast at the annual McGraw-Hill Construction Outlook in Washington, D.C. in late October.

Although a cooling in the residential market was expected, Murray said the market is experiencing a dramatic correction. In 2000, median home prices were roughly four times the median income in the U.S. In 2006, that ratio climbed to 5.2, throwing the market "out of whack," Murray said.

Faced with ebbing demand from home buyers, developers called for a retreat in housing starts in 2006. By the second quarter, single family housing was dropping faster than widely anticipated, matching a pace on par with the market downturn of the early 1990s, Murray said.

As a result, the total number of new single-family homes built dropped 15 percent in 2006, from 1.63 million units to 1.37 million units.

Retail & Hospitality Markets
As goes the housing market, so goes the retail market. New homes have historically led to construction of new retail centers. Total square footage of store construction rose 4 percent in 2005, mirroring the hot housing market.

With housing beginning to cool this year, retail starts are estimated to drop 2 percent to 300 million sq ft by the end of 2006. Big box retailers will be among those pulling back. Murray noted that Wal-Mart announced in October it would cut global expansion from 8 percent to 7 percent.

Subsequently, McGraw-Hill Construction estimates that store construction will slide an additional 7 percent to 278 million sq ft in 2007.

"Our forecast could be a touch on the optimistic side," Murray said. "It's virtually guaranteed that in 2007, you will have less retail construction."

Despite the drop in store construction, other income properties are expected to see a healthy uptick in activity. Although warehouses naturally align with retail construction, dropping vacancy rates and rising demand for updated facilities will keep warehouses trending upward. Construction starts in the sector should advance by 5 percent to 230 million sq ft, according to the forecast.

Office buildings continue to rebound since bottoming out at 144 million sq ft of starts in 2003. Vacancy rates are dropping in many parts of the country and major towers are under way in cities such as New York and Chicago. Overall, McGraw-Hill Construction estimates that office construction will advance 5 percent in 2007 to 197 million sq. ft.
"The market fundamentals are strong," Murray said. "It's conducive to more construction taking place."

Hotel construction is expected to remain on the rise in the face of encouraging occupancy rates and revenues. In 2006 the sector saw an estimated 72 million sq ft of starts, a dramatic 48 percent gain over 2005. Murray said the sector will continue to see gains in 2007, rising 4 percent to 75 million sq ft next year.

"That could be the top," he said. "At that point, with new hotels coming online, some of those industry fundamentals will begin to erode a bit in 2007."

Institutional Building
Institutional buildings remain hot going into 2007, thanks to the improved financial health of states and the passage of several large bond measures. Combined starts will rise from $98.8 billion in 2005 to $106.9 billion in 2006, advancing to an estimated $113.9 billion in 2007.

Increasing enrollments have created long-term demand for more classroom space, according to Murray, spurring a 6 percent rise in educational building starts to 243 million sq ft. Meanwhile, donations to colleges and universities hit an all-time high in 2005, which Murray credits for spurring major campus expansions.

Although the U.S. health care system should experience tremendous demand from aging Baby Boomers in the coming years, health care construction is expected to ease back in the coming year. The sector hit an all-time high of 107 million sq. ft. of starts in 2005. McGraw-Hill Construction estimates that starts leveled off at 105 million sq ft in 2006 and forecasts suggest it could drop to 97 million sq ft in 2007 - a 7 percent decline compared to 2006.

Public building construction, fueled in part by increased federal appropriations for courthouses, will experience a modest rise from 33 million sq ft in 2006 to 35 million sq ft in 2007, Murray said.

Other Sectors
McGraw-Hill Construction also forecasts increases in other institutional sectors such as religious, amusement-related and transportation terminal buildings in 2007.

With more companies looking to replace aging production facilities, manufacturing building is expected to rise 14 percent in 2007, from $10.7 billion to $12.2 billion.
Ethanol and petrochemical work will be among the major drivers of the trend, as the country seeks increased refining capacity and additional ways to reduce dependence on foreign oil, Murray said. Continued growth in the pharmaceutical and biotech industries will also lead to new manufacturing facilities in 2007.

With the federal transportation bill, SAFTEA-LU, in place, highway and bridge construction should have a reliable stream of funding going into 2007, rising 9 percent to $55.6 billion. However, Murray cautioned that real growth in highway work could be hampered by increases in materials costs.

Environmental projects should advance 2 percent in 2007 while site work will pull back by 2 percent, according to the forecast.

A spike in new coal-fired plants in 2006 helped the electric utilities sector see an estimated 65 percent jump to $11.7 billion. In light of such a boom year, the sector should settle back 20 percent in 2007 to $9.4 billion.

Overall, Murray said the combined construction market is remarkably stable heading into 2007. Although the single-family housing sector may have spoiled the party for a continuing surge in the construction market, Murray said the impact could have been worse. If single-family housing was taken out of the equation, the market would see an overall 3 percent gain in 2007. It's an example of how construction cycles in various sectors can balance construction activity as a whole.

"It's a more stable picture now," Murray said. "We're been seeing this offsetting pattern by sector that has created overall greater stability for construction… In 2008, you might see a pullback in public works and institutional building, but it might be the time then for single-family housing to once again be a source of expansion."

Question Marks for 2007

Here are some of the most frequently asked questions about this year from the state's building community: