Recession Claims Its Next Victim: Commercial Construction
February 19, 2008
By Richard Berner | New York
Recession is about to claim its next victim: Commercial construction. A downturn in such activity would represent a significant turnaround from last year’s boom: Although nonresidential or structures investment accounted for only 3.4% of (nominal) GDP, the 16% jump in real outlays contributed half a point to overall real GDP growth over the four quarters of 2007. Such a gain — the sharpest 4-quarter rise since 1984 — is unsustainable, and we think this economic asset is about to turn into a liability. Tighter financial conditions, uncertain tenancy, rents, and property values all will contribute to a downturn in office, retail and warehouse activity. Soaring construction costs are also a negative. Weakness is already showing: Nonresidential construction starts tumbled 13% from a year ago in January, according to Reed Construction Data.
Despite these hurdles, we think that the contraction in outlays will be shallow by historical comparison. The key factor limiting the downturn in traditional commercial construction is that the overall growth in supply for much of this expansion has been modest by historical standards. The “capital discipline” theme that governed corporate spending in this expansion partly extended to construction as well. For example, commercial construction excluding healthcare facilities rose by only 3.9% annualized over the past five years. But discipline seems to have faded over the past year, when construction accelerated in virtually all categories, and with the slowdown in business activity, vacancy rates have begun to rise. There are clear pockets of excess in financial services office building and in retail and lodging. A slowdown in office employment and shakeouts in retail and wholesale activity may pressure rents just as lenders and investors tighten credit availability and raise its price. However, mining, power, and healthcare construction may buck the trend. Because nonresidential construction includes a broad variety of structures, it’s important to distinguish among them to assess vulnerability. In my view, the commercial, lodging, manufacturing, and amusement areas, comprising 45% of total nonresidential outlays, are the most vulnerable to the forces described above. Commercial building proper — including offices, facilities for retailers, restaurants and warehouses — accounted for 28.8% of private nonresidential outlays last year, and hotels, amusements, and manufacturing consumed 7.6%, 2.4% and 6.1% of outlays, respectively. Two other categories were much bigger than these last three, and look much less vulnerable: Spending on power generation and communications structures represented 12.2%, while mining and exploration accounted for fully one-quarter of the total. Slower growth is likely; annualized gains in those two infrastructure components of 16.6% and 17.9% over the past two years are unsustainable. But given the needs, downturns seem unlikely. Religious, educational and farm spending made up the remainder. The tightening in financial conditions for commercial real estate is manifest both in reduced availability and in higher cost of credit. Regarding availability, according to the Fed’s January Senior Loan Officer Opinion Survey of 56 domestic banks and 23 foreign-owned banking institutions, some 80% of domestic banks reported tightening their lending standards on commercial real estate loans over the past three months— the highest since the Fed introduced this question in 1990. Most banks in the latest survey said that they had required higher debt service coverage ratios and lower loan-to-value ratios on commercial real estate loans in 2007, and nearly half reduced the maximum loan sizes that they were willing to grant over the past twelve months. Further stark evidence of the evaporation of credit availability comes from the securitization market: Until last week, no commercial mortgage-backed securities (CMBS) had been issued so far this year —the longest such dry spell since October 1990. Indeed, the CMBS market has been under intense pressure so far this year. Spreads for the highest-quality names at the top of the capital structure (AAA super senior securities) have widened by 100 bp or more to 225-240 bp over Libor just in the past month. The buyers’ strike in the CMBS market is understandable: Investors are afraid that a recession will trigger soaring delinquencies and defaults. Several years of rising property values convinced issuers to add leverage to their operations, and encouraged the rating agencies to maintain or boost ratings based on property values rather than the ability of cash flows to cover debt service. As a result, investors see CMBS as much more vulnerable to losses than in the past. Beyond the tightening in financial conditions, the fundamental outlook is darkening for commercial construction. Tenancy, rents and property values all face a highly uncertain economic and financial backdrop. Office employment growth has decelerated over the past two years from 2.6% to 1.8%, and further declines seem likely. Retailing is clearly under pressure as consumers trim spending gains. And some large hotel chains are lowering their expectations for revenue per available room (REVPAR) this year. On the supply side, real outlays for office construction rose at an 18.6% annual rate over the past two years. In the fourth quarter alone, more than 19 million square feet of new office space came on the market according to Reis, Inc., the most since the fourth quarter of 2000. In 2008 Reis expects about 75 million square feet of new office space to come online in the 79 markets it tracks, up from 53 million square feet finished in 2007. Real construction spending for multi-merchandise shopping and lodging increased 10.3% and 53.7%, respectively, over the past 8 quarters. The emerging imbalance between supply and demand is beginning to show up in rising vacancy rates. The national office vacancy rate rose to 12.6% in the fourth quarter — the first increase in four years. Some markets are still strong. Effective rents in Boston jumped 4.9% in the fourth quarter, and in New York City, they rose by 3.9%. But vacancy rates jumped by 1.9 percentage points in San Bernardino/Riverside, California; 1.7 pp in Orange County, Calif. and Fort Lauderdale; and 1.6 pp in Las Vegas. Smaller increases were evident in Salt Lake City, Tacoma, Austin, Hartford, Phoenix and the Maryland suburbs of Washington. Vacancy rates don’t yet reflect sublease space coming available as mortgage lenders go out of business. They will soon. As if those imbalances weren’t enough, construction costs are soaring. True, the overall price index for nonresidential construction in the National Income and Product Accounts rose by just 5.1% last year following two years of double-digit gains. This deceleration may not last, as steel and copper prices are rising again. Domestic mills are hiking steel quotes, reflecting supply problems, increased exports, and limited imports. Copper futures jumped to $3.62 per pound last week, 20% higher than a month ago. The International Copper Study Group reports that global copper consumption rose 7.2% in the first 10 months of last year. Severe snowstorms in China might have disrupted copper production there. Rising energy costs, especially for diesel fuel, are also contributing to the surge in overall construction costs. Such price hikes are driving up costs and hurting builders’ budgets, and thus will be another hurdle to construction activity this year. For investors in the CMBS market, the battering in values over the past two months must seem reminiscent of the subprime meltdown. CMBS spreads are now pricing in significant weakness in real estate fundamentals bordering on a record-setting collapse. We disagree with this outlook. Defaults will rise over the next two years, especially where leverage is excessive, but they aren’t likely to be as severe as in 1990. Thus, we think that the CMBS market is oversold, especially at the top of the capital structure. According to Ahsim Khan of Morgan Stanley’s CMBS trading unit, based on historical loss severities, virtually every loan in AAA super senior CMBS would have to default for the securities to default That seems highly unlikely. Downside risks predominate for construction activity, reflecting the tightening in financial conditions. The uncertain economic and financial backdrop may mean that lenders will tighten further. But while the credit cycle is only beginning, and buyers should be selective, investors may look back on this episode as a reasonable buying opportunity in the highest-quality securities. That’s especially the case as the market forces discipline on developers by cutting new construction and thus supply.
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