Construction Still Faces Long Climb

At long last, there is some positive news to report in the non-residential construction industry's struggle to return to pre-recession business activity, but the industry still faces a long, hard trek.

The Associated General Contractors recently reported that nonresidential construction spending will rise between zero and 3% in 2011, which suggests a very gradual recovery. AGC attributes that to construction activity in hotels, hospitals, higher education and, surprisingly, retail. In the same report, however, AGC reported that construction unemployment was 18.8% nationally at the beginning of December 2010.

When the construction industry is strong, "it's not unusual to see annual growth of 10 to 15% on the commercial side," said Bernie Lange, president/CEO of The Renschler Co.

Eric Schmidt, general manager of the western region for C.G. Schmidt, predicted a flat performance in the very near future. "One of the metrics we track are the billable hours of the architects, and they have shown some minor expansion in the past quarter [Q4 of 2010]," he said. "That was really the first quarter in the past eight to show growth in that area. It offers a little bit of hope, but it's not substantial enough to indicate a statistical trend for business expansion."

Schmidt also cited the Non-residential Construction Index reported by the management-consulting firm FMI. The index has exceeded 50 for three consecutive quarters — anything below 50 indicates contraction in the non-residential construction market; anything above is expansion. Since construction work tends to lag this indicator by 12 to 18 months, this tells Schmidt that there will be relatively stagnant construction activity until late in 2011 and solid improvement in early 2012.

The firm views the numbers with some caution. While the improving index means that architectural firms are getting busier, they are getting busier with fewer people. In addition, TARP money has been cited as part of the increase starting Q2 of 2010, when the index reached 54.5.

The American Institute of Architects' Architecture Billings Index, which measures nationwide architectural activity, shows similar improvement. Design activity in November 2010 reached a reading of 52.0, up from 48.7 the month before. The September reading of 50.4 marked the first time since 2007 the ABI had broken the 50 threshold.

The key indicator, according to David Keller, managing partner of Keller Real Estate Group, is the unemployment rate, which continues to hover above 9% nationally. "In order for them to take the plunge and say, 'we need more space, let's go out and make a deal,' businesses need to make sure their sales are strong enough," Keller said. "From a retail perspective, obviously, retail sales need to be there, and obviously that falls back to the employment picture. Until the employment picture gets turned around, or people know they are not going to lose their jobs, they are probably not out there spending on anything above or beyond the normal consumption."

Lange presides over a design-build firm, so he understands what's happening from the standpoint of both design and construction. Consistent with what's happening in the construction industry, there has been an overall reduction of Renschler's design-build segment. "It has impacted our customers, other contractors, and architects," he said of the recession.

The industry slump has allowed Renschler to re-examine core competencies, evaluate how clients are changing, and determine how it needs to evolve. One conclusion is a greater emphasis on "high-performance" buildings, meaning structures that use energy more wisely than older buildings. That sustainable emphasis has prevented the industry from cratering even further.

There might be a 2% or 3% increase in construction costs associated with energy efficiency, but the energy savings during building operation more than offset that additional cost, Lange said. "That is really the direction the market is asking us to take, rather than just get in there and compete for being the low-cost provider," Lange said, "because there are so many people beating themselves up over that type of approach."

There still more competition for so-called downstream construction projects, where the larger players will compete in space formerly occupied by small and mid-sized firms — projects they would not have considered in the past.

"I think we're seeing a lot more competition, especially for public projects as well," said Schmidt, whose firm is completing work on the University of Wisconsin-Madison's $82 million Union South project. "Our

industry has been suppressed for so long that we're seeing a lot of competition from regional players that we typically don't see. It's a function of everybody looking for whatever work there is."

As the industry begins to regain traction, Lange believes this practice is on the wane. "We have not seen as much of that recently due to larger clinics that will be kicking off," Lange said. "Meriter has several going. UW Medical Foundation has got several going. I think what you're seeing is that people in those smaller markets have been more than reasonably competitive, and that has caused some fractures in people who need a construction solution in this environment. They are not always getting what they are expecting."

Outside of Greater Madison, where 2011 health premiums rose moderately, health care premiums are rising much higher, and some place the blame on controversy surrounding the new federal health care law. Schmidt said public work is still going strong, but private health care work has been impacted by some hesitancy on two fronts: uncertainty about rules and regulations still being written to implement the health care law, and the possibility that parts of it could be repealed or defunded in Congress or deemed unconstitutional in the courts.

"The impact on reimbursable rates has impacted their business as well," he said. "They blame the health care act, and the economy is impacting the health care market in terms of really expanding their physical plant at this time."

With bid numbers coming in "way too low," Lange said the industry is seeing a flight to quality, where people want to understand the numbers and are willing to pay more than the lowest bid to make sure that contractors are going to be in business a year from now.

The construction industry's client base has to realize there is no magic in the bidding process, Lange said. When they get several proposals on any given project, an extremely low bid does not mean the bidder has figured out some magic way to deliver the same quality for less money. "The numbers have reached rock bottom, so when you get these artificially low numbers, they are going to be made up later with change orders or in customers not getting what they expect," he stated.

The implications are profound for the businesses that want to expand or refurbish their existing facilities. Given the level of vacancies in the Madison commercial office market, the renovation approach seems to be the immediate market in front of local construction firms, and high-performance construction is available for upgrades, major plant expansions, and for projects of all sizes.

"Even though the construction costs are down, it still is a more economical bet to stay put so you don't have those moving expenses, and new infrastructure, and those kinds of things," Lange said.

McGraw-Hill Construction reported that green construction grew 50% in the past two years, from $42 billion to $71 billion, and that it will increase to $135 billion by 2015, a tripling of sustainable building activity.

This growth could be aided by projected higher material and fuel costs. AGC projects that fuel costs will go up 12.5% in 2011, while labor costs are expected to rise by 2.5%. That would put even more emphasis on sustainable trends like buying, high performance, and LEED (Leadership in Energy and Environmental Design) ratings.

"Those are discussions you have to have with clients up front when you are looking at proposals from different pre-engineered or pre-cast concrete suppliers because those shipping charges can have a big impact," Lange said. "That totally enhances the buy-local argument."

Keller (Keller Real Estate Group) looks at commercial construction from the standpoint of a realtor. He concurs with the "slow climb back" diagnosis. "I wish I had a crystal ball and could say definitely how, where, and why," he said. "There are so many different factors that come into play, but all of them have to align properly for the industry to get back to pre-recession levels."

From a commercial construction standpoint, those factors would include tougher lending requirements, especially the fact that banks now require more real cash in financing deals. In addition, lenders demand higher levels of pre-leasing requirements, and pre-leasing from people who investors and contractors are sure can pay the rent.

This impacts Keller because he mainly does commercial and development work, and the latter has obviously been slow due to the fact that the lender requirements are tougher than they have been. "There is a lot of activity," Keller said, "but it seems tougher to pull the lever and get it done. We all came through a time when the idea of real money in deals, cold hard cash, was something that wasn't necessarily a requirement, and now it is a requirement."

Keller has played a role in developing Madison's revised downtown development plan, which is still "under construction." Since the plan still is a work in progress, economic conditions have yet to work their will on its execution, but Keller sees a downtown market that is solid residentially, especially on the apartment end.

"There still are a lot of people who would like to live down here," he said. "The trick is finding locations or assembling locations that you can combine to create new development, and then to get that new development approved through all the rigmarole and so on."

The reference to rigmarole pertains to the controversial project-approval process in the city of Madison, which has been severely criticized by business interests. The city's economic development staff has produced a Development Process Improvement Initiative designed to streamline the approval process, but it has yet to be acted on and the existing process still is in effect. "It's the old saying, 'We can survive the downturn, but I don't think we can survive the turn down,'" Keller joked. "Standing on the outside looking in, what a process! Who wants to spend $200,000 trying to get your project approved, only to be turned down?"

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