The Construction Industry and the Economy

July 31 2008

By Dale Belman, Ph.D.

You don’t need an economist, a soothsayer or a Magic 8 Ball to tell you that the current economic downturn will affect the U.S. construction industry. The real questions are which markets will be most affected and how long will the current market conditions last?

In order to fully answer these questions, we need to examine the market forces at work that created this predicament. Problems in the mortgage market, a downturn in housing sales and the increase in foreclosure have had an immediate effect on residential construction. But market forces like the credit crunch – and the Federal Reserve’s response to a tightening of available capital – are landing a few punches to the construction economy. Not far behind are high oil prices, consumer and business demand for more energy capacity and devaluation of the dollar. Each blow will be felt throughout the construction industry.

Opportunities Ahead

Before you reach for Tums or your favorite antacid, organized contractors do have opportunities ahead. First remember that, in time, markets will adjust to these events and growth will return to all parts of the construction industry. But second, market opportunities could well be expanding in core city areas and close-in suburbs. To be ready for the good news, let’s start examining the simplest piece of our current market woes: residential. In essence, the low interest rates of the last five years, and the “innovative” financing methods of the mortgage industry, have created tremendous over-building. The availability of old and new housing for sale is running far ahead of demand. Projects that were begun prior to the downturn, and were too far along to stop, are now competing with houses brought onto the

Banks Assets De-Valued

The credit crunch, or the emerging reluctance of banks to provide loans, poses problems for all of the construction industry. The housing boom was facilitated by lax lending rules and regulation, profit seeking from everyone from home buyers to major commercial banks, and lenders’ appetite for financial instruments with high yields. With the collapse of housing values, a significant proportion of bank and non-bank financial firms are holding assets, such as mortgage-backed securities, with declining value. Some assets may not be saleable, and have no value, until the mortgage and foreclosure situation stabilizes. Many financial institutions have fewer assets with which they can back loans and have begun to ration credit based on loan quality. Being reasonably certain of having a loan pay back is more important than realizing a high interest rate. The problems of residential and light commercial cause lenders to worry about the credit worthiness of construction firms, even those with solid finances. A significant number of construction projects are at risk of cancellation even after work has begun. Because of this increasing risk, banks and other lenders may view even firms with full work schedules, especially ex-urb retail in some areas, as poor risks. Risk-averse lenders respond by limiting access to or cutting off credit entirely. Lenders are requiring more evidence that firms will be able to repay a loan or keep up payments on a line of credit. Again, tightened lending will take several years to shake out and credit limits will not loosen until then.

Fewer Top Quality Projects

A slowing of commercial construction among banks and financial firms also means fewer top quality projects for bidding. These institutions, so prosperous over the last two decades, built many new – and expensive – facilities. Growth in their workforce increases the need for space, and growth in their bottom line created a need for glamour and size. But with the credit crunch, this growth is over for some time and will contribute to the decline of the commercial construction sector. The brightest spot in the construction market is industrial and utility work. Even with a severe downturn, the high fuel prices and the need for additional electric capacity will create ongoing demand for industrial and utility construction. The financial stability of firms in these sectors will support continued construction, as the sector should see large returns from increased refinery capacity and added utility construction. The industrial sector, moribund for the last five years, may see considerable new investment as a falling dollar makes investing in U.S. capacity more attractive for foreign firms, particularly those in Europe. Given that the decline in the dollar is likely permanent, and that oil prices may only fall back to $80 to $90 per barrel if that, this sector may grow steadily for the next decade.

Public Works–Uncertain

Finally, public works is the least certain of any area of the construction economy. The short-term prospect is one of tight state and local budgets and reductions in expenditures. This is likely to be countered by increased federal spending on roads, schools and other public works by the next administration. The increase will be driven by both long-term needs and a desire to jump-start the economy in ways more effective than a tax reduction.

Inflation Slows Recovery

Recovery will be made harder by inflation. Inflation, particularly of construction materials and fuel, has been rising because of higher global demand, particularly from China. Demand-driven inflation has been magnified by the efforts of the Federal Reserve’s pumping money into the financial system to stave off a lock up of credit. Allowing both banks and other financial firms to borrow from the Fed using risky mortgage-backed securities as collateral prevented very serious credit problems. But the practice feeds inflation by causing the value of U.S. currency to decline relative to other currencies. A declining U.S. dollar further raises the price of imported construction materials and fuel. These price increases challenge the construction industry, which must raise prices in the face of weakening demand. As mentioned, the one bright side of currency devaluation is the spurring of the industrial market.

Conclusion

It’s going to be a tough several years for much of the construction economy, particularly for residential and sectors driven by residential construction. Even in these sectors, fortunes will vary by region and where firms work. The decline of the ex-urban areas associated with high fuel prices will be balanced, in part, by expansion of urban and suburban growth near city centers. The need to reduce the time and cost associated with commuting will drive populations into city centers, indicating long-term growth in these areas. Given that many organized contractors are located within core urban and suburban regions, these companies should look to expanding their work in these areas to take advantage of this prospective growth.

Dale Belman is a professor at Michigan State University’s School of Labor and Industrial Relations & Economics Department, and director of economic research for CPWR – The Center for Construction Research and Training.

The Center for Construction Research & Training (www.cpwr.com). CPWR is a nonprofit organization created by the Building and Construction Trades Department, AFL-CIO. Since the inception of research initiatives in 1990, CPWR has become an international leader in applied research, training, and service to the construction industry. It is based in Silver Spring, Md.