National Outlook

One of the quirks of a major shift in the direction of the economy is that a little bit of news can influence sentiment in a short period of time. So it’s a bit dangerous to make too much of the raft of good economic news that greeted the start of the second quarter. With that caveat in place, the data and economic surveys, coupled with upbeat earnings reports from the stock market are showing the first signs of a sustained recovery.

Some of the news was good enough to embolden a minority of economists to start talking about a ‘V’ recovery instead of a double-dip ‘W-shaped’ recession.

Among the highlights of the data was a surprising rise in consumer spending during the first quarter, with the 3.5% rate of growth the highest in almost three years. March inflation was virtually flat from February and the core consumer price index was up only 1.7% in the previous twelve months, the smallest rate of inflation since early 2004. China reported stronger than expected growth in the first quarter at 11.9%, signaling better prospects that a global recovery was in higher gear. The Federal Reserve’s Beige Book of economic anecdotes showed that businesses here in the U. S. were reporting ‘somewhat faster’ rates of recovery than expected, even while indicating that loan volume and credit quality continued to decline. And in the bad news is better than worse news category, the NAHB reported on April 15 that its monthly builders’ index had risen four points in March, from 15 to 19.

The most encouraging report from the first quarter was the first significant growth in jobs during March. After mid-April revisions the Labor Department showed a gain of 220,000 jobs in March, approximately 150,000 of which were private sector created. March also marked the third straight month of job gains and the fourth month in the last five. Improving business conditions and consumer spending are only sustainable if steady progress is made in reclaiming the more than eight million jobs lost during the recession.

PNC chief economist Stu Hoffman and AGC’s Ken Simonson spoke of the economy in a forum held at the Master Builders’ Association headquarters. Hoffman laid out six steps to recovery and pointed to the improved employment situation as a critical transition step.

“The fiscal stimulus was necessary to head off the financial crisis and to restart the economy, but it’s tinder not fire wood,” he said. “For a recovery to begin there must be a handoff from the public sector to the private sector for job growth.” Hoffman sees the employment data as consistent with the trend at this stage in a typical recession cycle. “In the first quarter, the job creation followed the trend of permanent hiring following several months of growth in temporary and part time jobs.”

Hoffman laid out his ‘recipe’ for continued progress, with a recovery in the housing market, an across the board global recovery, further availability of credit and continued confidence from consumers and business as the key ingredients. He also called out six speed bumps in the road to recovery: job growth that is too slow to enhance demand; high oil prices that inhibit consumption; commercial real estate problems; budget problems at the state and local level; increases in taxes plus the sunset of the Bush tax cuts in 2011; and the sovereign debt problems, here and abroad.

For the construction industry the most threatening of these speed bumps are the depressed commercial real estate values and the interrelated stressed credit markets. Among those reporting stronger than expected first quarter earnings were banks and financial institutions. Most of this good news was built on the reduction in overhead and the artificially high spreads for lenders. With overnight borrowing rates near zero, even historically low mortgage rates are still yielding margins of 400 basis points. What isn’t readily known from the earnings reports is how much of their loan portfolios are being carried at levels that approach reality, especially with the prospects for a commercial real estate recovery nonexistent until at least 2011.

There is a certain ‘High Noon’ feel to the commercial real estate market as summer approaches and more lenders edge closer to facing down the value of their asset portfolios. Many banks are continuing to extend short-term loans, hoping that the market will recover enough to get the asset value more in line with the original appraisal (a slim hope at best) or that the borrower’s overall condition will continue to improve enough the he or she will be able to contribute more equity to the refinance arrangement. Either strategy will be undone if regulation requires that financial institutions recognize current market value and reset their reserves accordingly.

“I think that if every bank in the country had to recognize the true market value of its commercial real estate portfolio, twenty five percent of the regional banks would be illiquid,” says Jack Kopnisky, partner in SJB Escrow, a Boston-based private equity investment fund. “Balance sheets are still stressed at a lot of banks. The worst are A D & C [acquisition, development and construction] portfolios because the rate of absorption is slow and uncertain.”

This dilemma – slow lot takedowns freezing ADC lending and shrinking portfolio values prohibiting commercial lending – will keep the mother’s milk of construction financing from flowing freely for privately-funded new residential or non-residential development through at least the end of 2010.

An optimistic scenario for lenders with shaky portfolios is based on the fact that the 40% to 50% decline in value that occurred in 2009 was driven by a lack of buyers. The current phase of decline is rooted in the recession’s fallout, with higher vacancies and tenants getting lease rate concessions that are damaging the internal return of the property. Assuming that economic conditions are on the mend, improvement in the performance of the properties will follow later this year and in 2011. The final piece of that optimistic puzzle would follow, as investors with cash begin to come back into the market, sensing a bottom to the decline and hunting bargains. This is how the last two commercial real estate bubbles re-inflated.

Prospects for a sustained recovery have not surfaced in the numbers just yet. The lag in national construction data reporting means that full first quarter results aren’t available yet from many sources, and those that are have been showing different trends.

The U. S. Commerce department reported on April 1 that total construction spending had fallen 1.3% in February, following a 1.4% decline in January. It’s likely that follow up adjustments will move the February number down once the full effect of the major snowstorms is evaluated. On an annual basis Commerce shows the construction level at $843 billion, down more than 20% from the 2008 levels.

Private publisher McGraw-Hill Construction reported a 5% rise in construction in February, to a seasonally adjusted $440.9 billion. McGraw-Hill’s data showed a 19% jump in non-building construction, a 5% increase in residential building and a 7% decline in non-residential contracting. “The pattern shown during February is what’s expected for 2010 as a whole – more public works construction, improved activity for residential building, but further weakness for nonresidential building,” stated Robert A. Murray, vice president of economic affairs for McGraw-Hill Construction.

Reports from Reed Construction Data showed nonresidential construction starts in March starts 4.5% higher than in March 2009. For the first quarter as a whole, starts rose 8.6% from the same period of 2009. Commercial starts fell 16% and industrial dropped 9.4% but institutional starts climbed 11.5% and civil projects grew 28%.As the quarter closed Reed reaffirmed its overall forecast of an 8.1% drop for U. S. construction in 2010, with a 7.4% increase forecast for 2011. “The total value of starts is expected to be steady to slightly down in the next few months and then begin to rise slowly later in the year,” Reed’s chief economist Jim Haughey said.

Within that national forecast Reed sees an increase of 4.4% in residential new construction and remodeling, but a drastic 20.5% decline in non-residential in 2010. The company also differs slightly with McGraw-Hill in the non-building construction market analysis, reflecting the decline in stimulus spending with a 1.6% drop in contracting in that category.

Regardless of the potential for recovery in the bigger economy during the rest of 2010, there is little to suggest that any of the better conditions will impact the construction industry this year. Infrastructure construction will see some lingering benefits of ARRA but the uptick will be offset by the dire situation in state coffers. Residential construction is a good bet to see significant growth in terms of a percentage of 2009 volumes but the level is still depressed by historical standards. And non-residential construction will be off significantly because of the drag of commercial real estate.

The upside of the current status is that improving conditions suggest that a national real estate recovery is in the works for 2011.