2007 Construction Forecast: Nonresidential Market to Continue Growth, Residential Downturn to Stabilize

By Craig DiLouie, Lighting Controls Association

Published January 2007

In 2006, the U.S. economy grew 3.1%. The year got off to a good start with the economy expanding at 5.6% in the first quarter. However, this dropped off to 2% in the second quarter and declined further to 1.6% in the third quarter—the first time in more than three years that the economy recorded two consecutive quarters of growth below 3%.

Over the past three years, industry analysts predicted that the residential building boom would end, offset by an increase in nonresidential and public construction. In 2006, they nailed it: Residential construction declined, primarily due to a reduction in speculative buying and a rise in short-term interest rates, while nonresidential construction enjoyed double-digit growth, primarily due to rising corporate profits and business investment. Overall, total construction was projected to increase to an annual rate of about $1.18 trillion, more than doubling from just 10 years ago.

Figure 1. Actual put-in-place construction in 2004 and 2005, and preliminary estimates for 2006, according to the U.S. Department of Commerce.

The residential construction boom, while it lasted, had lifted the entire economy, but all booms must end, and the economy lost one of its primary drivers. While many areas of the economy exhibited solid growth in 2006, the declining housing market created a drag on the entire economy. Job growth slowed, particularly in the second half of 2006, with 95,000 manufacturing jobs lost since June.

“Of this drop, 93% has been in either motor vehicles or in industries closely connected to housing, such as wood products, furniture and non-metallic minerals,” said David Huether, Chief Economist for the National Association of Manufacturers. As recently as the third quarter, manufacturing output was growing at a healthy 4.2%, nearly twice as fast as overall GDP growth. But the economic slowdown caught up to manufacturers by the fourth quarter. As of early December 2006, Huether anticipated that manufacturing growth would fall to about 2.1% in the fourth quarter based on the November Institute for Supply Management report. The report’s PMI Index, which summarizes the state of manufacturing, fell from 51.2 in October to 49.5 in November (a <50 score indicates contraction). “With the housing correction expected to continue at least through the first quarter of next year, I expect we’ll see continued job losses in construction-related manufacturing industries over the coming months,” said Huether.

The contracting residential construction market has resulted in a decline in business confidence across the construction industry, including the electrical products industry, and has negatively impacted shipments of lighting products.

Huether pointed to expansion in other manufacturing industries as an indicator that business investment and export demand continue to be growing. “Fueled by soaring profits and corporate cash flow, business investment spending has increased by 8.3% over the past four quarters,” he said.

This business investment is currently driving lighting products demand in the nonresidential market, which showed solid growth in 2006 and is projected to continue sustained growth throughout 2007.

“A downturn in housing will continue to drag the economy throughout the first half of 2007,” said Huether. The net effect will be a slowing economy in 2007. Any recession, he predicted, will be mild. “After slowing to a ‘below-potential’ pace in recent quarters, the economy will continue decelerating toward a ‘soft-landing’ in the coming year.”

The current phase of a business cycle often seeds the next phase. For example, with 30-year fixed mortgage rates holding steady and home prices falling due to the housing downturn, houses become more affordable, which may soften the downturn and help seed future expansion in the residential market, (but probably not until 2008). (The housing market is also expected to make a soft landing due to several current developments: The NAHB housing market index is no longer falling, mortgage applications are steady, and inventories, while still high, are slowly starting to ebb, according to NEMA.)

Meanwhile, nonresidential construction, while currently going strong, may experience a slowdown due to project delays resulting from high materials prices and labor costs resulting from high demand, or if the economic outlook worsens. For example, while gasoline and oil prices decreased between October 2005 and October 2006, and some materials such as plywood decreased (-23.3%), the prices of many materials increased continue to increase significantly, such as steel mill products (20.8%), gypsum products (15.5%) and cooper base scrap (58.8%), according to the U.S. Bureau of Labor Statistics, partly due to continuing heavy demand in robust foreign construction markets such as the People’s Republic of China.

“Overall construction spending dropped in the summer quarter of 2006 for the first time in four years …” according to Jim Haughey, Director of Economics for Reed Business Information, describing the construction market in an article published in November 2006. “Growth in nominal construction spending will resume at the beginning of 2007, when the housing slowdown stabilizes and work picks up on heavy job sites after projects have been scaled back or refinanced. So far, the weakness in the residential and civil sectors has not spilled over into the non-residential building market, but that will happen in a few months if the two declining markets do not rebound.”

Currently, however, all forecasts point to a robust nonresidential construction market in 2007. The American Institute of Architects (AIA) Consensus Construction Forecast Panel, made up of a number of organizations, convened mid-year 2006 and forecasted a 6.2% increase in nonresidential activity, adjusted for inflation, in 2007. According to AIA Chief Economist Kermit Baker, PhD, Hon. AIA, while describing the Forecast in June 2006: “If achieved, this would be the best two-year period for nonresidential construction activity since this market grew by about 30% in 1997-1998.”

The most recent forecast comes from Reed Construction Data and was published in November 2006. Reed forecasted that total U.S. construction activity increased 5.2% in 2006 and will increase 5.3% in 2007 compared to 10.5% in 2005. Reed further forecasted that the value of total U.S. construction activity would increase 6.4% in 2008. Residential will decline until 2008, while nonresidential will increase 12.5% in 2007.

In this report from the Lighting Controls Association, we will examine a number of leading market indicators and research regarding what we can expect over the course of 2007. (Note: While reading this report, note that some figures expressing the value of put-in-place construction from some sources do not agree with other sources, largely due to different ways of assessing what constitutes each construction sector.)

Construction, Electrical & Lighting Industry Market Indicators

Before looking at the 2007 construction industry forecast, a number of market indicators suggest that 2007 will be another good year for nonresidential construction:

CIT Construction Industry Forecast: The construction industry’s contractor and distributor communities are “cautiously optimistic” about 2007, according to CIT Construction, which recently published its 31st annual CIT Construction Industry Forecast, based on interviews with more than 900 contractors and equipment distributors across the United States. “ The CIT Construction Industry Forecast highlights the fact that the U.S. construction industry remains cautiously optimistic about 2007," said Ron Riecks, President of CIT Construction. "While the level of optimism varied across the U.S. many respondents indicated they planned to increase their spending on new and used equipment in the coming year which portends to more activity in the industry. I interpret this as good news for CIT and the construction industry as a whole and look forward to a busy 2007.”

Most contractors still think residential construction will provide the best opportunities in the year ahead. More than two-thirds of builders and one-third of non-builders said that home and apartment construction is their best opportunity for 2007; those are the highest percentages for both groups in many years. The number of builders favoring residential construction over any other opportunity has grown from 53% to 68% in six years; the number of non-builders of like mind has doubled since 2004. For the first time since 2002, however, 20% or more of both builder and non-builder groups see commercial construction as their best bet for the year ahead, possibly a positive indicator for this lagging sector of the construction industry.

One-third (33%) of surveyed contractors said they view their overall business outlook in 2007 as “better” than 2006, while 45% view it as “equal to” 2006 and 22% view it as “worse than.” Forty-three percent (43%) of surveyed distributors said they view their overall business outlook in 2007 as “better” than 2006, while 36% view it as “equal to” and 21% view it as “worse than” 2006.

Click here to see the 2007 CIT Construction Industry Forecast (PDF)

It’s interesting to note that the most serious problem for contractors for the last two CIT Forecasts and for distributors for the last three has been the shortage of workers, specifically qualified technicians and other skilled employees.

Table 2. National optimism quotient (OQ) trend, CIT Construction Industry Forecast. Although the overall national OQ fell 16 points from last year’s 102, other signals indicate a positive outlook for the coming year, according to CIT.

Architecture Billings Index: The American Institute of Architects (AIA) reported that in November 2006, the Architecture Billings Index (ABI), an economic indicator of construction activity, declined marginally from a 58.4 score in November 2005 to a 57.5 score in November 2006. (The November 2004 ABI was 51.6, November 2003 ABI was 48.5.) The ABI also increased sharply from a score of 51.1 in October. Any score above 50 indicates that billings are going up nationally. Note that there is approximately six-month lag time between billings for architectural services and construction activity. The results suggest sustained growth in 2007 in the nonresidential sector.

“The nonresidential construction sector continues to see a high level of demand for design services,” said Baker, AIA’s Chief Economist. “Even though there has been some deceleration in growth the previous two months, an uptick in billings of this size is noteworthy in portending sustained construction activity in the months ahead.”

The Architecture Billings Index is derived from a monthly “Work-on-the-Boards” survey and produced by the AIA Economics & Market Research Group. Based on a comparison of data compiled since the survey’s inception in 1995 with figures from the Department of Commerce on Construction Put in Place, the findings amount to an economic indicator that provides an approximately 9-12 month glimpse into the future of nonresidential construction activity. The diffusion indexes contained in the full report are derived from a monthly survey sent to a panel of AIA member-owned firms. Participants are asked whether their billings increased, decreased, or stayed the same in the month that just ended. According to the proportion of respondents choosing each option, a score is generated, which represents an index value for each month.

The commercial / industrial sector recorded its best mark of the decade and while still reporting weak billings; residential architecture firms showed encouraging signs by posting the highest score in four months.
The biggest winners: Western U.S. firms, with an ABI of 60.7 compared to 58.0 for the Northeast, 51.1 for the South, and 49.5 for the Midwest ; and commercial/industrial and institutional firms, with an ABI of 62.9 and 54.6 respectively compared to 47.4 for residential firms.

“The spike in the ABI [in November] reflects reinvigorated design activity, now that national elections have concluded and future interest rate policy is clearer,” said Matthew A. Litfin, an equity research analyst with William Blair & Company. “The November ABI reading is near record levels last seen in fall 2005 and before that, in mid-1998. Looking ahead to 2007, we are predicting very strong growth in nonresidential construction activity and stabilization in residential construction activity.”

Key concerns for architectural firms in 2007 include attracting and retaining staff and coping with rising construction costs.

Electroindustry Business Confidence Index: Confidence in current North American business conditions deteriorated throughout 2006,as measured by the National Electrical Manufacturers Association (NEMA) Electroindustry Business Confidence Index (EBCI), which is based on a monthly survey of senior managers at NEMA companies representing more than 80% of the electrical industry. The measure of confidence decreased overall by about 46% from January’s 55.2 points to December’s 30.0 points, peaking at 68.5 points in February but declining over the rest of the year. Confidence deteriorated significantly in December at 30.0 points from November’s 39.6 points. A score of 50.0 points or higher indicates industry growth.

On the plus side, the EBCI for future North American conditions, a measure of executives’ expectations for conditions six months head, increased about 15 points in December 2006 to a 48.0 score, its highest level since April.

Study participants attributed the December decline to the continuing decline in the residential construction sector and typical end-of-year slowdown in incoming orders. According to NEMA: “While the housing market is unlikely to provide much support to electrical equipment manufacturers in the near future, the other key end-markets of the electroindustry—nonresidential construction, manufacturing and utilities—are expected to see further growth in 2007. Indeed, the future conditions EBCI for North America climbed in December to its highest since slipping below 50 points last spring, a hopeful sign that the recent retrenchment in business conditions may be shallow and of short duration.”

Figure 2. NEMA Electroindustry Business Confidence Index, reflecting electrical industry confidence in current conditions, 2005-2006.

NEMALighting Systems Index: Looking at the lighting segment, NEMA tracks the industry’s health using a metric called the Lighting Systems Index (LSI), a composite measure of NEMA member companies’ U.S. shipments of lighting products such as lamps, ballasts, fixtures and emergency lighting and exit signs. Product shipments data are drawn from statistical surveys conducted regularly by NEMA and are adjusted for inflation and regularly recurring seasonal fluctuations.

The LSI dipped 0.6% in the third quarter of 2006 and further declined 2.3% in the second quarter after increasing 7.2% during the first quarter. In the third quarter, domestic shipments of emergency lighting, fixtures and large and miniature lamps all posted increases, while fluorescent ballasts experienced a decline before adjustment for typical seasonal variations. Despite the gains registered in four of the five underlying component categories, the LSI declined because shipments failed to increase at a rate that is typically expected for this time of year.

“The flagging residential market is likely the major source behind the recent weakening in overall demand for lighting equipment,” said Brian Lego, Director, Economic Analysis for NEMA. “Numerous indicators, such as the 20% decline in starts of new single-family homes since the beginning of 2006, and flat or falling prices in many once-hot markets, show the U.S. housing market continues to struggle. While this segment will likely remain a source of weakness for lighting equipment demand going forward, conditions may be beginning to stabilize.”

On the other end of the spectrum, commercial-, industrial- and outdoor-use lighting equipment should continue to see demand increases due to an improving nonresidential construction sector, said Lego. “Business investment in structures, excluding mining-related activities, has increased at a double-digit pace for four consecutive quarters,” he said, “and additional growth in nonresidential construction activity is likely in part because firms have seen space requirements climb amid steady growth in payrolls and output and because nearly three years of unprecedented growth in profits have left businesses the wherewithal to invest in new commercial or industrial space.”

Figure 3. NEMA Lighting Systems Index, based on product shipments for NEMA member companies that manufacture lighting products.

2006 Construction Forecast

In previous years, the Lighting Controls Association roundup included detailed portrayal of the AIA Consensus Forecast. Because that Forecast was developed in mid-2006, we will focus on the most recent forecast—from Reed Construction Data, published in November 2006.

Reed forecasted that total U.S. construction activity—including new residential, residential improvements (remodeling, renovation and replacement work), nonresidential building and non-building (heavy engineering)—increased 5.2% in 2006 and will increase 5.3% in 2007 compared to 10.5% in 2005. Reed further forecasted that the value of total U.S. construction activity will increase by 6.4% in 2008.

The residential new construction market, after increasing 15.1% in 2005, was forecasted to have declined 0.9% in 2006 and forecasted to decline by 4% in 2007. Reed forecasted a rebound in 2008 with a 2.8% rate of growth. The residential improvements market, after increasing 9.3% in 2005, was forecasted to have declined 2.4% in 2006 but will rebound with a growth rate of 8.5% in 2007 and 8.2% in 2008.

The nonresidential building market, after increasing 7.5% in 2005, was forecasted to have increased 13.9% in 2006 and forecasted to increase by 12.5% in 2007. Reed expects a slowdown in 2008, however, with a more modest 7.3% rate of growth in this sector.

Table 3. U.S. total construction spending (billions of U.S. current dollars). Actuals: U.S. Department of Commerce. Forecasts and table: Reed Construction Data. NOTE: % change is year vs. previous year.

“Nonresidential construction is now 18% higher than a year ago,” Haughey of Reed wrote in November 2006. “The year-over-year gain will slow, but will stay in the double-digit range. Rental and occupancy rates, building assets values, public tax receipts and the investment income of non-profit entities are all very strong, but unlikely to get much stronger. The pipeline of new projects is full, with the year-to-date value of starts up 15% for commercial buildings and 21% for institutional buildings, compared to the same period in 2005.”

For more information about the Reed forecast, including detailed tables, click here.

RETURN TO KEY ISSUES