The most negative norm at this point in the construction cycle is the high unemployment. In December construction employment turned negative for the year in North Dakota, the final state showing construction employment growth throughout 2009. For the full year all 50 states showed lower employment than in 2008. Architectural unemployment also peaked at year’s end, with 184,600 architects employed compared to 224,500 at the employment peak in July 2008.

High unemployment remains a drag on the overall economy’s recovery, but in the design and construction industries the loss of jobs is much more severe. AIA chief economist, Dr. Kermit Baker, explains how unemployment in general becomes magnified in construction. “In the overall economy unemployment is 5.3 points higher now than the last peak, but construction is 21 points higher, and architecture is 17 points higher.”

For a consumer lead economy improving employment loosens purse strings and is generally looked to as a spark for renewed health in the commercial categories. For certain, the rapid decline in employment has wracked the sector over the past 18 months, sapping demand for retail, restaurants, hotels, and of course office and industrial buildings. Unemployment also draws down state income tax revenues, sales taxes, and increases the perception of risk for those contemplating a new house. Few analysts see a significant improvement in the general employment or construction employment picture this year, but early signs of the precursors of job growth are appearing.

“There is evidence that the job creation process has already begun,” says Ed Sullivan, Portland Cement Association chief economist. “Typically, extended work hours, overtime and temporary hiring precede job creation. November’s increase in the length of the average workweek—the first increase in 14 months—was unchanged in December at 33.2 hours. Furthermore, temporary employment continued to rise, as 47,000 positions were added in December.”

If the labor market sustains its better than expected performance from the fourth quarter, it could lead to a quicker healing of the underlying fundamentals surrounding construction, Sullivan said. “… a stronger labor market would improve the outlook for single family construction activity in 2010 and 2011 and shorten the period for an easing in lending standards.”

An economic recovery is by no means a sure thing at this juncture but with each week there are growing signs that demand is returning slowly to a broad cross section of the market. If these indicators are predicting a growth trend, the normalizing of lending has become the singular obstacle to a return in capital spending. With commercial loan defaults rising as predicted and residential property values still lagging well below the levels that accompanied the period of easy credit, lenders still face significant headwinds to profitability. And more time needs to pass before judging whether lender reluctance is simply higher risk aversion or a reflection of fears about future regulations on capital, or if the tight credit is due to banks’ needing to build capital ahead of another liquidity crisis.

Regardless of the causes, the slow thaw on credit is dragging down construction volume, even in markets where new construction demand is growing.

The other Sword of Damocles dangling over the potential recovery is the reluctant housing rebound. At year-end 2009 the supply and demand dynamics continued to point to conditions favorable to a housing rebound. The Census Department reported at total of 571,600 housing units for which building permits were issued in 2009 nationally and 530,000 units started throughout the country. These levels are roughly 40% of the number of new household formations annually. The drastically reduced new construction has produced a significant decline in inventory. Census also reported in January that the supply of houses for sale fell below 250,000 in the fourth quarter of 2009, a 37% decline from the same period in 2008.

Unfortunately other data unveiled at the beginning of 2010 underscores why so much uncertainty still haunts residential real estate.

On January 14 RealtyTrac® reported foreclosure filings - default notices, scheduled foreclosure auctions and bank repossessions - on 2,824,674 U.S. properties in 2009, a 21 percent increase in total properties from 2008 and a 120 percent increase in total properties from 2007. The company also reported that foreclosure filings were reported on 349,519 U.S. properties in December, a 14 percent jump from the previous month and a 15 percent increase from December 2008, when a similar monthly jump in foreclosure activity occurred. Despite the increase in December, foreclosure activity in the fourth quarter decreased 7 percent from the third quarter, although it was still up 18 percent from the fourth quarter of 2008.

In its year-end survey the Mortgage Bankers Association identified roughly four million homeowners who were in foreclosure or at least three months behind on payments.

According to a report released February 10 by Zillow.com, a real estate website, one in five housing markets entered a second leg of home price declines in late 2009, after showing price increases for nearly half of last year. In 29 of the 143 markets tracked by the site - including Boston, Atlanta and San Diego - prices flattened or began to decrease again in the second part of last year, after five or more months of consecutive monthly increases, according to the site's fourth quarter real-estate market report.

The report also found the percentage of single-family homes with mortgages in negative equity rose slightly, to 21.4% in the fourth quarter, compared with 21% in the third quarter. The equity situation was an improvement over the 23% with negative equity in the second quarter of 2009.

Another headache facing the housing market is the plan by the Federal Reserve to cease buying mortgage-backed securities in March. Following the collapse of the market for Fannie Mae and Freddie Mac mortgages, the Fed has been the overwhelming source of liquidity for residential mortgages. If housing debt must find a private sector market the odds are very good that higher interest rates will be necessary to offer the investors the yields that they will demand for the risk. That is of course, assuming that sufficient numbers of investors can be found. The timing of this pullout by the Fed, within 30 days of the expiration of the Homebuyer Tax Credit, only complicates the market further.

Most housing experts surprisingly see these challenges as insufficient to derail the turnaround in the housing market. Even if none of these problems turns out to be a knockout punch, however, the housing market – which always leads a total market recovery – will not be strong enough to drag the national construction market into a growth cycle by 2011.

So when can the construction industry look to see growth in contracting again? Kermit Baker thinks we can look forward to capital spending growth in 2011, and he gets that answer by looking backwards.

“I like the saying that history doesn’t always repeat but it usually rhymes,” joked Baker during a January 28 Webcast. He pointed out that the stock market generally changes two quarters ahead of the overall economy, and that employment lags that trend by another three quarters. Once employment has been positive for two or three quarters businesses will begin investing capital in physical plant again. Using the assumption that the stock market indeed bottomed in March 2009, Baker’s math puts growth in non-residential construction in the first half of 2011, a scenario that parallels closely the last recession’s playbook.

“In the last recession, stocks hit bottom in October 2001 and recovery in GDP occurred in the next quarter, but there was no job growth until the beginning of 2003,” he explains.

Another of Baker’s indicators, the AIA Architectural Billing Index (ABI), is a predictor future construction with a reliable track record. The index, which surveys AIA firms to discover whether billings are increasing or decreasing (an index of 50 is neutral), has shown improvement during the past year but appears to be stuck moving sideways below 50 for more than a quarter. The ABI has been accurate in foretelling what will happen to the trend in construction by about nine to twelve months. Comparing the current trend to that of the ABI during the last recession also seems to indicate that a rise in construction activity won’t occur before 2011.

The graph above shows the track of the ABI during the last two recessions. The ABI turned negative in mid-late 2001, just behind the start of the global recession. It wasn’t until the third year of recession, in 2003, that the ABI stayed above 50 again, and it was 2004 until contracting volumes showed year-over-year improvement. If this recessionary cycle shows a similar arc in the ABI, it will be well into 2010 before more than half the firms are seeing increased billings. Increased construction would be unlikely until mid-2011.

February’s heavy snowfall and cold hit hardest in many of the nation’s larger cities, and the weather will negatively impact first quarter results, potentially giving false signals about the direction of the recovery. Even discounting the winter storms’ effects, the smart money should be on the slow recovery gaining momentum in 2010, with the better odds of an outlying surprise coming from a negative event rather than a positive surprise.

Work-In-Process is provided by Somerset for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Ken Hedlund, Jay Feller, Steve George, Chris Mayfield or Rebecca Ogle  of our Construction & A/E Team. This document is not intended or written to be used, and cannot be used, for the purpose of avoiding tax penalties that may be imposed on the

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