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Toronto Boston Dallas Los Angeles Continuing signs of stable growth. Beyond Estimation Q3 Market Update SINCE 2006, VERMEULENS has been reporting on the state and direction of the construction market. Our guiding philosophy in forecasting is that the inflation targets of the Federal Reserve and Canada’s Central Bank will propel monetary policy and subsequently construction prices. This approach led to the successful forecast of a future drop in prices during the 2007 and 2008 price peaks. Previous recessions have been analyzed and have framed our positions on both the size and extent of the price dropoff we have seen in the most recent recession. Looking ahead we see a bumpy road for recovery and therefore buying opportunities for owners. As the money supply and credit growth stabilizes, rescue packages from central banks will continue or wind down as conditions permit. As financial markets recover to pre-recession levels, institutional buyers will be able to plan for construction in the near to medium term. See Vermeulens blog http://vermeulens.com/blog/ for more discussion on this and other topics. Selling prices have increased by 6.5% since the trough of the recession FOLLOWING THE GLOBAL RECESSION construction selling prices for institutional projects fell by 14% from their peak in 2008. During 2011 Vermeulens saw an average selling price increase of 3% The first three quarters of 2012 have seen an increase of 4.5%. In addition to a surge in commodity pricing the increase can be attributed to contractors’ need to claw back margins to remain in business. The end of QE2 and uncertainty at home and abroad have moderated growth. THE TABLE BELOW AND LEFT looks at several of the key economic indicators that drive construction volume and subsequently construction costs. On balance, current indicators support stable construction costs. Some signs of shortages in local markets are driving the rate of price increases above the Consumer Price Index Trendline. Due to recent monetary policy, nominal and real interest rates as well as financial and real estate assets will support an uptick in activity. Likely changes to fiscal policy will work against this. Cu rre nt Fo rec ast Indicator CPI Inflation Moderate ICI Demand Low Increasing Nom Interest Rates Low Real Interest Rates Stable Gov Spending Turning Gov Deficits Negative Financial Assets Stable Real Estate Assets Low Stable Construction Prices Turning Construction Employ Low Turning Toronto Boston Dallas Los Angeles After resetting to the CPI Trendline, 2011 and 2012 have escalated at a rate just above CPI FOR THE PAST 25 YEARS construction costs have trended toward a 3.3% annually compounded escalation rate. In 2008 construction costs reached a peak and adjusted rapidly downward then stabilized for two years. Similarly, costs peaked in 1990 and 2001. The rate of escalation seen in construction costs are indirectly tied to the goal of 2 - 3% annual inflation and the monetary policy used to achieve this goal. From 1986 to 2006, construction costs escalated approximately 15% faster than CPI due to lower inflation achieved in other sectors of the economy and the reduction in real interest rates. This environment came to an end with the financial crisis and high inflation in various sectors of the economy. Billings in decline The chart above illustrates bid prices (‘Vermeulens Project Bids’) for institutional/commercial/industrial projects relative to the Vermeulens Cost Index and the 3.3% construction trend line (1986=100) and the 2.9% CPI trend line. The balance of current factors has resulted in establishing a new lower trend line such as in the 1990’s. As inflation in other sectors of the economy—commodities for example— moderate, and real interest rates reduce, escalation in the construction sector will have room to increase at a higher rate. Architecture firm billings declined for the fourth consecutive month in July, although the pace of decline slowed slightly from the drop seen in June. The AIA’s Architecture Billings Index (ABI) score for the month rose to 48.7, indicating that fewer firms reported softening business conditions last month than during the previous month. Inquiries into new projects remained steady, although firms reported that the value of new design contracts continued to decline modestly. Firms located in the South reported an uptick in their firm billings in July, although business conditions continued to soften in the other three regions of the country. Firms located in the Northeast region reported particularly weak business conditions. http://www.aia.org/practicing/AIAB095765 Toronto Boston Dallas Los Angeles Construction volume has increased 9.4% from it’s bottom in March 2011. CONSTRUCTION VOLUME IS THE NUMBER ONE DRIVER OF CONSTRUCTION COSTS. As volumes increase and hence contractor bidding opportunities and backlogs grow, the margins included in a bid will grow. Residential volume appears to be recovering and is currently 16.4% higher than its recent bottom in July 2011. Put In Place Residential Construction is currently 40% of the value http://www.census.gov/const/www/c30index.html seen in March 2006. Existing home inventories have begun to decline and are now at 6.4 months which is well below the value of 12.5 months seen in July of 2010. Existing home inventory remained constant through Q2 2012. Construction levels are lower than what is required historically to satisfy long term household formation. During the depression and second world war residential construction ran below long term averages. As incomes supported renewed consumption after the war residential volumes boomed. Using this as a model, employment and income growth will need to re-establish themselves before a real recovery occurs in this sector. Although it can mostly be attributed to several large scale projects, Non-Residential construction has increased 14% from its bottom. Along with cues from the continued increases in the AIA Billings Index, the NonResidential sector may have stabilized. Infrastructure spending peaked in August 2009 and fell by 12% to its bottom in Feb 2010. Infrastructure spending has rebounded since by 4.2%. New fiscal policy will be an important driver in this sector. Capital markets continue to moderate demand in the construction market. Stable commodity prices will help to allow low interest rates to stimulate construction demand. THE NYSE (black line) IS A STRONG PREDICTOR (Vs index green line) of construction costs. The reason for the correlation is that improving equity markets provide capital and investment spending. Markets have moved ‘sideways’ for much of the last two years. This is due to uncertainty with debt levels, default concerns and minimal growth in the jobs market. If markets return to growth this will lead to increased construction volume and consequently support for construction prices. COMMODITY PRICES are an indicator but not necessarily a predictor of construction prices. The era of stagflation (rising prices and low growth) that has prevailed for the last 10 years may be reaching an end. The energy sector is particularly important as it underlies all economic activity. Technical advances and peak oil will continue to do a dance for some time until significant “unconventional” supplies and efficiency reductions to demand come on stream. In North America, natural gas is in surplus and local crude oil is also in surplus, trading at a significant discount to West Texas benchmark rates. Toronto Boston Dallas Los Angeles Construction employment at lowest level in 16 years There will be enough labor capacity to support noninflationary growth for some time. Attrition in the labor force will bring an end to wage reductions. CONSTRUCTION EMPLOYMENT PEAKED (,000’s) understandably at the same time as construction put in place (March 2006). However, the sharp downward decline in employment did not occur until approximately 12 months later. From the peak, construction employment has fallen by 29% or by 2.3M workers. With such substantial layoffs the remaining workers are generally the most experienced and productive resulting in improved productivity and consequently lower costs to suppliers. Improved productivity has offset annual labor wage increases. As we move back towards increased construction volume there is substantial capacity for the market to grow without labor shortages. However, the non-inflationary level of employment will reset to a lower amount as workers will leave the construction labor market. CAPACITY UTILIZATION RATE (Chart Left) is calculated by taking the ratio of current construction employment to the peak construction employment and allowing for a sustainable rate of growth. Generally, a utilization rate of greater than 85% will begin to put upward pressure on construction labor costs. As you can see from the chart on the left, the majority of U.S. states are well below their peak levels of employment. However, it is important to note that several states are entering the “warm” zones which may begin to put upward pressure on labor rates. CONSTRUCTION UNEMPLOYMENT (bottom chart) in the US has been on its seasonal downward swing during the summer months. Fall will turn this trend around to increased rates. Expect the labor force to continue to shrink. This should bring unemployment into the 1015% band in the next 12 to 24 months. Unemployment seasonally fluctuating between 5% - 10% will tend to put upward pressure on labor costs (20042007). A range of 15% - 25% will put downward pressure on labor rates (20082011). A range of 10% - 15% is considered stable. Most regions are still in the downward pressure range however as seen with unemployment rates and the labor utilization charts we have been moving to the intermediate zone. Toronto Boston Dallas Los Angeles Strong confidence leads to increases in contractor margins. The CICI survey shows that respondents are a little less confident. However, private-sector markets once again were considered the most active. Applying the CICI rating formula, the power sector was up three points, to 69, tying it with petroleum (up one point) and multi-unit residential (also up one point) as the strongest markets as perceived by the survey respondents. The hospital/health-care market also is seen as being strong, but it fell in the third quarter by three points, to a CICI rating of 65. The only other market showing significant gains was the environmental/hazardous-waste sector, which rose three points, to 58.Several sectors were seen as falling from the previous quarter. The biggest decline was in the industrial and manufacturing sector, which fell six points, to 56, as corporate owners hold off launching projects pending the election. Buildings sectors also fell or were flat. The commercial-office (CICI 46 rating), hotels-and-hospitality (50) and higher-education (53) sectors all were down three points. Survey respondents continue to believe project financing has stabilized; until it becomes more readily available, the recovery will be slow. Mcgraw Hill/ENR Survey Discretionary spending at the federal level will be reProspects for fiscal 2013 appropriations strained for the fore- are not encouraging. President Obama seeable future launched the 2013 spending round on Feb. 13, when he sent his budget request to Congress. The proposal seeks some construction program increases but also recommends many cuts. Final word on which line items will be trimmed—and how severely—won’t come until late this year. But industry officials say the outlook isn’t bright.” ENR 1Q Cost Report. Construction prices are firming and have begun to increase. With the current labor market capacity and continued lows in construction volume being put in place it is Vermeulens’ opinion that construction cost will escalate closer to the CPI Trend Line rather than the historic Construction Trend Line for the medium term. 2012: 3%-6% 2013: 4%-8% 2014: 4%-8% Vermeulens congratulates James Vermeulen for becoming President of the Canadian Institute of Consulting Quantity Surveyors.