Optimism Persists in Commercial Building

The last time IB broached the subject of development and construction (February 2011), people in the industry were more optimistic than they have been since the onset of the recession, and a gradual recovery was expected. Given the economic difficulties we've seen with energy and inflation, and the resulting impact on material and fuel costs, is there still reason to be optimistic for 2011 and 2012?

To get a snapshot of industry health, and what businesses that use these services should know, we spoke to a builder, a developer, and a design/build company.

Jeff Madden, general manager of Mortenson Construction, believes there is pent-up demand for new construction, and therefore there is still reason for a more optimistic mindset. While it will take awhile for design work to be translated into construction revenue, especially on large projects, those precursors are in place. "Design teams are seeing a lot more action in estimating and pre-construction, which is a clear indicator that there is construction coming down the road," Madden said, "so I think the optimism from three or four months ago has continued."


Survival mode

Larger construction firms still are fishing downstream in terms of project size and they continue to expand their geographic reach for projects, although there is disagreement about the lingering intensity of this trend. Lawrence Barton, president of Strang, Inc., sees strength in the industrial sector, and gradual improvement in the commercial office market. "It started with an uptick in renovations to existing commercial office space and tenant build-outs, and has recently progressed to early planning for new construction," he commented. "This should be good news for contractors."

For Strang, expanding geographic reach is much more of a strategic initiative than a reaction to the recession, Barton indicated. Even as Strang focuses on Wisconsin-based clients, some of these clients have additional out-of-state facilities that require its design services, which expands the firm's visibility in other regions. "Most everyone in the construction industry has operated in survival mode for the past 18 months and are competing at all levels," added Dan Fitzgerald, a principal with Horizon Design Build Manage. "We have moved a bit in the opposite direction in terms of size and have picked up some larger jobs in excess of $25 million. However, those larger jobs are for clients outside of Wisconsin."

Fitzgerald indicated his firm is "very optimistic" about the balance of 2011, but guarded about the second half of 2012 due to the impact of higher oil prices on material costs. "We are seeing 10% to 20% increases in material prices from just a few months ago," he noted. "In 2011, we are seeing jobs that were in the queue for 2009 and 2010 that are finally closing and starting construction. This is giving us a bump in revenue for 2011 that will carry into the first quarter of 2012. The true test will be if 2011 deals close this fall or the first half of 2012."

One key metric that determines future construction activity is architects' billable hours as measured in the American Institute of Architects' "Architectural Billing Index." If they are rising, it's a good sign, and they rose significantly in March, to 58.7 from 50.5 in February, after barely moving for several months. At this writing, the April numbers were not yet available, but the energy costs and commodity inflation that arose in that period did not affect the outlook at Horizon Design Build Manage.

"Not yet, due to the planning and design process of a construction project," Fitzgerald explained. "The concern is more of what happens once it comes time to pull the trigger and start the job. What we saw happen in 2009 was that projects made it through the planning and approval process and then were put on hold until late 2010 and early 2011. If oil prices continue to rise, and we see an increase in interest rates, momentum that we are gaining in 2011 will hinder us in 2012."

For construction, another metric to watch is the employment picture, which is picking up nationally, where more than 200,000 private sector jobs were created each month in February, March, and April, and statewide, where nearly 25,000 new jobs were created in the first four months of 2011. After two dismal years, construction industry employment has increased somewhat but won't really come back to full strength until designs turn into construction.

According to Fitzgerald, Horizon has more than doubled its field staff in the past six months, but for the overall industry he gets the sense that firms are still cautious with hiring "to see if this recovery has legs."

For commercial developers, some recessionary realities will carry over for quite some time, especially with regard to financing. Contractors, architects, and builders have to accept the fact that, at least for the foreseeable future, they will need more skin in the game and have to deal with higher pre-leasing requirements demanded by lenders, but Madden indicated that some have used this time wisely. "Some companies are starting to get that nest egg built up to where they feel more comfortable putting more money in," Madden noted. "That's allowed them to start moving on some of their capital projects, which is a good thing."

Conditional considerations

The most important piece of advice for a commercial business owner who is contemplating a project is to consider the opportunities and the environment, and these days, sustainable renovations provide an affordable way to mitigate future price spikes.

Society's emphasis on sustainable building hasn't helped the industry weather the recession because it hasn't necessarily resulted in more new construction, Madden said, just different types of new construction.

In some firms, new construction projects still represent upwards of 75% of construction revenues, but the "adaptive reuse" of existing buildings has been an important revenue stream, especially since 2007.

Companies have increased their knowledge base in sustainable construction and clients are getting more green-savvy, too. "The majority of our clients are investing in the solutions that provide them with a long-term return and operational cost savings, but are mindful of balancing overall project feasibility," Fitzgerald stated.

"In other words," he added, "clients are not really constructing buildings for the purpose of being sustainable. They are constructing cost-effective buildings and implementing as many green features as practical to improve operating performance and achieve sustainability goals."

According to Barton, the recession officially ended more than a year ago, but a slow recovery might be the "new normal" for at least another 12 months. Interest rates still are historically low, and comparatively high vacancy rates in commercial office space have created a tenant's market. Barton indicated that economic recovery will lead to more inflationary pressure on materials and shipping, higher construction costs, reduced government incentives, and lower vacancy rates.

Meanwhile, quality properties are available for adaptive reuse, and grants and incentives still are available for sustainable upgrades. Noted Barton: "Sustainable upgrades will help curb the impact of rising energy costs on your bottom line."

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