Market volatility, nonresidential construction

This week's market volatility will have a downline impact on construction markets. According to Reed Construction Data Chief Economist Jim Haughey, a drop in commercial construction activity is coming, initially from the abrupt loss of access to credit and higher credit cost and then later, when credit markets stabilize, from the feedback on space demand from reduced spending in the economy. Together the two impacts will reduce expected profits from new construction and make buying rather than building a better option for real estate developers in an increasing number of markets.

The commercial mortgage backed bond market is virtually shut down because the usual bond buyers are conserving their scarce capital and demanding large premiums for what they now believe are more risky assets than they previously thought. Similarly construction financing from banks has been reduced to about half of previous levels. Funding is still available from insurance companies and other non-bank investors but at significantly higher rates than only a few months ago.

This situation will persist until banks have more capital more trust that their borrowers are solvent enough to repay them. The fixes are gradually being put in place. This includes the Treasury plan to buy and hence establish a price for depreciated mortgage bonds, continued cash injections from the FRB and other central banks and regulatory changes that end the requirements for financial firms to value some of their assets at temporarily distressed prices.

It is not yet clear how long this will take or whether enough resources have been committed to this task. Our forecasts assume that the dimensions of the problem are known and the credit problem is easing by the end of October.

How large the negative feedback from a slowing economy on construction spending will be is also unknown yet. Our only comparable experience is the post 9/11 period. The shock to the economy impacted everyone. Caution lead to deep cuts in spending over a few weeks. Then it became clear that the immediate threat had passed. There was a burst of make up spending and then a resumption of normal spending trends which, at that time, was very slow growth.

We assume the same pattern of shock, caution and slow recovery for the current shock to consumers’ retirement savings.

Other macroeconomic and construction forecasts are gradually being updated to Septembers’ credit crunch.

Converted to real, inflation, adjusted dollars, The Reed Construction Data forecast projects a 1.0 percent drop in nonresidential, including facilities, construction spending in 2009 and a 2.0 percent decline in 2010. The pace of decline will be much higher later this year and early in 2009. Spending will be rising at the end of 2010. Absent the credit crunch growth would have been marginally positive over the two years. Economy.com, a widely followed forecast has a generally similar outlook with slightly less drop late this year but 3 percent more next year. Wachovia bank projects a 12 percent fall in 2009 and a further 14 percent drop in 2010. The banks’ GDP forecast is about 1 percent below Reed Construction Data and Economy.com so they see some unique problems in the construction market, especially credit access for commercial developers.

Drops as large as projected by Wachovia bank have occurred before when a severe recession in the general economy occurred when the real estate market was overbuilt. Obviously, there will be surplus space in the next two years but we do not believe there was significant surplus space a few months ago. Reed works with closely on construction data and forecasts with Property & Portfolio Research, a Boston commercial real estate advisor. Their updated forecast is pessimistic for commercial rents, occupancy rates and building asset values but pessimistic enough to cause major cancellations of work underway or set to start soon. Your comment?