FMI's Nonresidential Construction Forecast
Consumer Spending, Retail Building and Green Leads Impact the Constructions Market
By Phil Warner

Retail construction, which is included in the broader category of commercial construction, may be the canary in the coal mine for nonresidential building construction as we test the economic waters in the new year.

However, even as the year-end figures for holiday shopping are showing signs of slower growth than in 2006, most large retailers continue to have significant expansion plans for new stores in 2008. Although there are increasing signs of scaling back or closing underperforming stores, not all of those events are signs of a slowing national economy. Commercial construction responds to consumer tastes and budgets much faster than construction markets like education, healthcare, manufacturing, roads and infrastructure. Therefore, companies in the construction industry that serve the commercial construction markets might need to be a little more flexible in their strategies in the near future.

The economy has not yet reached the point of a technical recession — two quarters of negative GDP growth, high unemployment and other factors used by the National Bureau of Economic Research to determine if there has been a recession. However, most of those indicators look backward. There are some regions that would already argue that they are in a recession. Despite the doom and gloom felt and perceived in the residential sector, most of the nonresidential side of the construction industry continues to be growing, even if at a slower pace than the last few years.

On the national scale, a new report developed by FMI tracks changes in nonresidential construction. The FMI Nonresidential Construction Index (NRCI) is indicating that construction executives are forecasting significant slowing in the commercial construction markets for the balance of 2008. The NRCI measures the expectations of construction company executives across the country. While the NRCI is indicating some slowing in other sectors as well, namely lodging and office buildings, the index is relatively neutral as to nonresidential construction for the coming year.

With sectors like healthcare and education construction still showing positive signs of growth, the NRCI panelists are reporting that there is significant momentum in the backlogs of contractors serving the commercial segment. Strong fundamental growth will carry commercial construction activity at a positive pace into 2008. Nevertheless, as they say in corporate press releases, these “forward-looking statements” are subject to change, and retail construction is a segment to watch as we move into 2008.

The commercial construction market includes buildings and structures used by retail, wholesale and selected service industries, including the automotive and food and beverage industries. According to FMI’s Construction Outlook, Fourth Quarter 2007 Report by FMI construction economist Heather Jones, the commercial market, which has experienced positive annual growth since 2004, will continue this trend through 2011. Commercial construction will make up 18 percent of the nonresidential construction total through 2011, trailing only the education market. Commercial construction put in place will increase 15.5 percent from $84.7 billion in 2008 to $98.9 billion in 2011.

In 2008, the connection will continue between the commercial construction market and residential building activity, although not as strong. The residential market is a leading indicator of future commercial construction activity with a one- to two-year lead-time. A slowdown in residential construction in 2006 (0 percent) and 2007 (-18 percent) will influence commercial activity in 2008. Expect put in place commercial construction (CPIP) to grow 8 percent in 2008, compared to its 10 percent increase in 2007. (Note: CPIP is reported in current dollars and not adjusted for inflation. CPIP also includes the value of change orders.) Positive market drivers such as decreasing vacancy rates and increasing rental prices, which are up 4 to 5 percent over 2006, should help maintain commercial construction spending.

Residential activity is just one indicator of commercial construction. Another leading indicator is the American Institute of Architects’ (AIA) Architecture Billings Index (ABI). The AIA recently reported a spike in design activity. The December 2007 ABI was 55.4 (any score above 50 indicates an increase in billings), up from the 55.3 mark in November. With an approximate 9- to 12-month lag time between architecture billings and construction spending, the ABI suggests a favorable forecast for commercial construction into early 2008.

Commercial construction is also dependent on consumer fundamentals, such as consumer spending, which fuels commercial business and rent. These factors contribute to making multi-retail (shopping centers, malls and general merchandise stores) the largest commercial segment. The U.S. Department of Commerce reports that shopping center construction spending grew at a year-over-year pace that was greater than 50 percent in every month for 2006. Partly a function of high construction costs, this increased spending also reflects the completion of many projects that were started in previous years.

Within the multi-retail segment, a shift in preferred building type has taken place. Open-air centers experienced above average growth in 2007 and have replaced construction of regional, enclosed malls. These centers, also known as lifestyle centers, typically have lower occupancy costs than regional malls, nearly $35 less per square foot. In addition, enclosed malls have suffered from declining traffic, loss of tenants and increased competition.

According to the National Retail Federation, the expansion of department and big box stores will also contribute to future commercial growth. Retail giants, such as J.C. Penney, Kohl’s and Target, plan to open a combined 3,500 stores by 2011. Although this retail category has grown steadily, it remains vulnerable to reduced demand for home building and remodeling supplies, appliances, electronics, furniture and yard and garden supplies.

Green Leads the Trends

One of the drivers of new retail construction is the need for change to keep up with consumers’ desires for new shopping experiences. Lifestyle centers, mixed use projects and green construction are all trends which chain stores are taking advantage of to stay out in front of consumers. Retail chains such as J.C. Penney, Wal-Mart and Whole Foods are increasingly committing to “green” construction, because it is good for business.

The FMI Nonresidential Construction Index survey for the first quarter of 2008 asked panelists to predict what percentage of their backlogs were currently considered green construction and what portion of the backlog would be green in one year and in five years. Currently, construction industry executives are reporting that only about 13 percent of their backlogs were made up of work considered green construction. However, they are predicting significant increases in that portion of their work. In a year, they predict that 23 percent of their projects will be green, and in five years, they expect that 38 percent of their backlog will be dedicated to sustainable or green construction.

NRCI panelists gave mixed responses to how green construction will affect trends in markets and the business of contractors. On one hand, many noted that it increased the work they need to do when estimating work. Owners want to see the price with and without green construction factors considered. Contractors report that owners are increasingly interested in building green, whether LEED certified or not, but still hesitant to pay any extra costs for green construction.

Watch the Trends

Among the other trends that the industry is watching is the move to smaller, community-based stores. In part, this is related to the lifestyle and mixed-use movements, but it is also an answer to the growing resistance across the country to locating big box superstores in communities. Whether it is a sign of an election year or a reaction to a slowing economy, the one thing that we can count on for 2008 is change. Retail construction, armed with tons of research on consumer spending habits and preferences, will strive to stay one step ahead of the consumer’s changing desires. In the near term, everyone has growing concerns for the economy, but the major retailers and the contractors that serve this market are in business for the long run. As such, strategies will need to reflect the possibilities of a downturn in the economy in order to position the business to take advantage of the next growth cycle.

If the much talked about recession becomes official in 2008, the construction industry will feel it later than most of the general economy. That lag does not mean that contractors can rest on their backlogs and wait it out. Instead, it is a good time to look at the markets and plan accordingly. When the dust clears on the current changes in the economy, there will certainly be new opportunities. Whether it is green construction, infrastructure, mixed-use construction projects or some other new trend, the need for construction services will continue to grow for as far out as we can forecast.

There are a still a few holdouts that think green construction is a fad that will pass in a few years. They are in the minority of the consensus and may find themselves scrambling in to catch up to the market. Nonetheless, their skepticism may be justified considering that green construction is a concept that is still being defined. But, it will be defined and more construction suppliers will learn to cater to this market, and a few will get out ahead of the curve and profit from what may be one of the biggest market changes in the built environment in several generations.

Philip Warner is a research consultant in FMI’s Research Services Group, based in Raleigh, N.C. He manages the FMI Nonresidential Construction Index survey. If you are an executive for a construction firm serving the nonresidential building markets and would like to become a panelist for the NRCI, please contact Phil at pwarner@fminet.com or call (919) 785-9357.