Tuesday, September 1, 2009

Construction spending update

The huge decline in residential construction spending that subtracted significantly from GDP for the past three years is over, having stabilized over the past several months. This, coupled with the 125% rise in the prices of major homebuilders' stocks strongly suggests that residential construction has bottomed and should be on the rise by the end of this year.

Meanwhile, nonresidential construction has been flat for over a year. Most commentators, myself included, have been expecting to see outright weakness in this sector, so on the margin, stable growth has been a positive factor in the outlook. But it's no secret at all that commercial real estate sector faces a wave of foreclosures, and that vacancy rates are high and rising, all of which suggest that nonresidential construction spending could decline meaningfully.

Many people are wondering why the foreclosure wave that is building in the commercial real estate market hasn't received more attention already. Well, it has. The market for commercial real estate-backed securities was absolutely trashed earlier this year, as this chart (below) of CMBX prices shows, with prices plunging to 50-60 cents on the dollar, implying massive defaults. Despite all the evidence of rising foreclosure rates, however, prices have rallied over 30%. This can only mean that the market long ago priced in an expectation that is proving to be far worse than the reality, even though the reality is ugly.

I suspect there are some dynamics in the nonresidential construction sector that I'm not aware of, and I don't pretend to be an expert on the subject. I'm guessing that all the bad news over the past several years has left the industry quite cautious, and that building projects therefore were scaled back, with the result that spending never reached the boom level that brought the residential sector to its knees. Only time will tell, however. Meanwhile, the good news is that the bad news about commercial real estate foreclosures has already been anticipated by the market; the losses have already been absorbed; and the reality is turning out to be not as bad as had been feared. And it doesn't hurt that the economy is now turning up.


Bill said...


I'm a construction lawyer and I can tell you that most of the big commercial contractors are finishing up projects that started a couple of years ago and now have very little back log. I think we're going to see a big drop off in non-residential construction spending by the end of the year and it will probably take another year for it to pick up again based on the data I see in publications like ENR. The stimulus bill really only helps infrastructure contractors, and not the vast majority of commercial contractors who will have nothing to do soon.

Scott Grannis said...

Bill: Thanks for the info, that makes sense. We may end up getting lucky, as residential construction looks set to rise at about the same time nonres looks set to decline. Contractors are going to have to be very nimble to survive however.

MW said...

I think you're missing the technical in that market --- cash CMBS is not liquid, therefore the index was used as a hedging vehicle. Thus there's a simple risk premia argument (hedgers sell below fair value just to have the insurance, depressing the price) that may explain why the selloff and rebound were so deep. I don't think this is the whole story, of course, but it's a factor.

Scott Grannis said...

MW: Good point. Hedging most likely did contribute to depress the prices of CMBX. But does that invalidate the signal of CMBX prices? Fear and the demand for hedges were strongest in March, now they are much less. Why? Because the fundamentals have improved.

robert said...

The CMBS chart does give a different perspective as to how investors, probably more intune to the industry, are interpreting the commercial real estate challenges. I just know several developers who can't get financing to complete projects and are trying to just survive in the southeast and Florida. A good post though, Thanks!