Commercial market downturn could be 'worse than expected'

Pointing to a complete lack of available financing and new projects going into the pipeline, Peter Linneman, consultant and professor, Wharton School of Business, said supply and demand fundamentals for the commercial construction market will remain weak through 2013, during a keynote session at the 2009 Building and Infrastructure Conference hosted by Lincoln International and L.E.K. Consulting, Nov. 12, in New York.With its long lead times, commercial construction is still winding down from projects that started prior to 2008’s financial meltdown, Linneman said. Since that time, financing for commercial construction has come to a standstill, and it will be two years before it begins to come back, he told the audience.

Linneman was not alone in his predictions. While the residential recovery is going to be better than expected, "the commercial market downturn is going to be worse than expected,” said Ted Hathaway, chief executive officer, Oldcastle Glass, Santa, Monica, Calif., at the conference.On a positive note, Linneman said evidence that the economy is strengthening will become more visible next spring, and the exceptionally weak levels seen in jobs and housing will begin to translate into pent-up demand. Residential remodeling and replacement activity will also rebound, he predicted.

RecoveryIn providing his optimistic forecast for housing and the economy, Linneman pointed to the impact of the current lows. Housing activity is so weak that "we're not even replacing homes being destroyed," he said.With exceptions in areas like Las Vegas and South Florida, excess inventory is disappearing. Most of the country's housing markets are "close to equilibrium or are seeing slight weakness on the demand side," he said.

Basic demographics play an important role in housing, Linneman said. With the weak economy, new household formations have been tracking below normal for the last three years. As the economy improves, that will translate into an above-trend number of household formations for the next three to five years.

Household formations will increase as new jobs are created, Linneman explained. Normal job growth is about 1.8 million jobs per year. With job losses, we can expect a period of job creation at an annual rate of 3 million per year beginning sometime after April next year, he said. Given the current economy, companies have not even been replacing workers that die or retire, he said. "Even without real strong growth, people will start replacing workers. That will start to add up to a rebound in employment."

"This recovery will stun people," Linneman said, but he cautioned that inflation could re-appear on the scene like it has not for decades. Pointing to thevast increases in cash reserves that banks are now holding after the economic meltdown of last year, he said that inflation could easily re-emerge once that money starts making its way into the system.

Panelists' viewsThe Lincoln conference featured several panel discussions. When asked what they are doing for the next three years, a number of participants indicated they were going to hold tight. Fareed Khan, president, USG Corp., Building Systems Group, Chicago, said his firm remains focused on getting its business "as sustainable as possible." It is cautious about increased activity in new home construction and foresees significant declines in commercial construction. Noting that his company's products go into projects late, USG sees activity winding down significantly over the next year until 2011, and foresees very weak demand after that. Khan expressed some optimism for residential remodeling, suggesting "that may be the sector that starts pulling us out of this."

Hathaway said that up until last year commercial construction had enjoyed 15 years of unprecedented growth. "Last year, I was talking about staying close to our customers. This year, I can't find any customers," he said. Suggesting this downturn is not just cyclical, but structural, and will fundamentally change the business, he said "it's time for innovation and revolution. We had a great business model, but as a company, we really have to think totally out of the box."

With the conference geared toward private equity and strategic investors, several panelists commented on their expectations for merger and acquisition activity for the near future. "Next year will be a good time to be a buyer," suggested Robert Newbold, managing principal, Graham Partners, Newton Square, Pa. Prices for companies have come down and meanwhile, "it's pretty clear we're at the bottom or past the bottom for residential building products, at least," he said.

Panelists expressed some reservations, however, about the inherent benefits of scale. Kevin O'Meara of Golden Gate Capitol, San Francisco, a one-time Builders' FirstSource executive, noted that despite the success of several companies developing large footprints in building products distributions, "large builders didn't change. They continued to source locally." That has continued, even with the downturn in housing, when pressure to cut costs would suggest that these large builders would look to take advantage of volume purchasing, he said.

Consolidators and roll-ups have had some success in industries that are more capital-intense and have heavy fixed costs, but have been less successful in others, O'Meara said. "Building products remain a local market business," he said. Many sectors have low barriers to entry and there are minimal costs to customers to change suppliers. In such markets, it is much harder to show the benefits of scale.

Speakers were also asked about the potential impact of increased activity related to energy efficiency enhancements. Most foresaw continued gains in green building and demand for higher performance, but said government programs and spending targeting this area have marginal impact. Khan said that with energy prices remaining in check, the residential market will continue to see increased demand. In the commercial market, he suggested Leadership in Energy and Environmental Design certification will become increasingly important because developers know "tenants are risk averse." Brand-name companies will avoid locations that are not seen as environmentally friendly, he said.

Hathaway predicted government spending on energy-efficient projects will be "inconsequential" in the market. Pointing to strong demand already for low-E glass, he also suggested many are still looking for the "next leap of faith" as far as enhancing energy-efficient technology.