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May 1, 2006

Poised for A comeback

The overcapacity in office space that weighed on the market after the dot-com bust finally is being worked off, making investment in big commercial construction projects attractive again.

The boom in single-family and multistory residential real estate of the last five years helped buoy an otherwise lackluster construction market. The bursting of the Internet bubble and the post-Sept. 11 economic downturn dragged down most other categories in the sector. But now, commercial construction seems poised for an upturn.

McGraw-Hill Cos. projects a 4% gain in starts this year for commercial construction, measured in terms of square footage, and 8% percent when measured by revenue. That compares with a modest 2% gain last year in square footage and 3% in revenue growth. Commercial construction includes offices, stores, hotels, warehouses, service stations and garages. The office market is projected to grow by 9% this year in terms of square footage.

“We’re seeing improvement—it’s a hesitant, modest improvement,” says Robert Murray, vice president for economic affairs at McGraw-Hill Construction in New York.

VACANCY DOWN, RENT UP

The impetus is coming in part from real estate investors, who see a downturn in office vacancy rates and an upturn in rents, says James Haughey, chief economist for New York-based Reed Business Information, which compiles construction industry data. In fact, as of the fourth quarter of last year, office vacancy rates in New York stood at 8%, down from 9.9% a year earlier, while the Washington, D.C., rate dropped slightly to 9.9% from 10.1%, reports CB

Richard Ellis, the commercial real estate brokerage. Nationwide, the brokerage says, legions of office workers filled 24.3 million square feet during the same period, helping reduce the nationwide office vacancy rate to 13.9% at the end of the year compared to 16% a year earlier. Pulling up the average: Several large markets, including Atlanta, Dallas and Detroit, still have vacancy rates of 20%.

Other CB Richard Ellis data show rents holding steady or rising modestly in many cities, but with some dramatic exceptions. Last year, for example, leasing rates for downtown Chicago office space rose more than 15% from a year earlier. Further north, a strengthening Canadian dollar helped cities such as Calgary and Edmonton chalk up even more dramatic rent increases of 22% and 41% respectively.

With long-term interest rates remaining stable, despite Fed hikes in short-term rates, Haughey says, investors saw the need to lock in financing and launch their projects quickly.

Murray, of McGraw-Hill, notes that the office market, after reaching a low of 18.4 million square feet in 2003, rebounded in 2004, but stalled last year. New office buildings were deferred in early 2005 as the industry dealt with the rising costs of steel and other raw materials. Construction of new commercial warehouses was flat last year, while building in the retail sector has rebounded steadily from a low in 2002 and is expected to taper off this year.

The American Institute of Architects, which collects data from McGraw-Hill and other forecasters, similarly predicts that non-residential construction will grow by 9% this year, with hotel and office construction each racking up double-digit gains.

AIA’s architectural billing index (ABI), a measure of the hours billed by member firms for non-residential construction projects, was positive in January for the 12th consecutive month, and 14 out of the last 15 months.

AIA Chief Economist Kermit Baker says that, in the case of commercial projects, activity in an architect’s office typically takes place nine months ahead of actual building. That bodes well for the commercial construction market through the rest of this year and possibly into 2007. Like Haughey, Baker says rising office employment whittled away the nationwide overcapacity, particularly in the suburbs.

Hotel occupancy rates also have been creeping up, particularly in the luxury end of the market, says Tennessee-based hospitality industry tracker Smith Travel Research. Smith data showed last year's occupancy rate in U.S. hotels rose 2.9% to 63.1%, while the average daily rate increased 5.3% to $90.84.

Smith projects average occupancy will rise 1.9% this year to 64.3%, while the average rate is to rise 6% to $96.29. That’s fairly typical of the recovery cycle in hotels, where demand takes off first, followed by an increase in room rates, says Jan Freitag, vice president at Smith. That means investors will begin to plan new properties in 2007, with the rooms expected to hit the market the following year.

The construction upsurge already is boosting metals usage in everything from structural steel and aluminum panels to brass fittings and copper roofs. U.S. steel mill shipments of structurals and plates for construction have been flat for the past several years at around 23.8 million tons a year, says the American Iron & Steel Institute (AISI). But service center shipments of carbon structurals began to post gains of 19% to 25% in the last five months of 2005 after showing mostly monthly declines or modest gains for the previous 18 months. Shipments rose nearly 28% in January, MSCI data shows. The data reflects usage for all types of construction, not just commercial projects.

Construction represents about 21% of steel mill shipments, says the AISI, and is the single largest end-use category.

In dollar terms, the U.S. Census Bureau says that private non-residential construction rose 3% last year to a predicted annual rate of about $250 billion, up from a $242 billion actual rate in 2004, on a seasonally adjusted basis. The government includes lodging, office, retail and medical facilities in the non-residential category. And while the quarter of a trillion dollar figure is dwarfed by the approximately $642 billion the nation spends on residential construction, private non-residential construction is roughly comparable to the $254 billion the Census Bureau estimates was spent on public construction by states and the federal government last year.

THE CYCLICAL VIEW

Gregg R. Mueller, of the Denver-based investment firm Dividend Capital, tempers a generally optimistic view on commercial construction with some caveats. Mueller says that office vacancies must fall to about 12% before a true resurgence will take place, something he believes won’t happen until 2008. For now, although some markets are strong, “office is still recovering” from the dot-com era overbuilding, he says.

Hotels, by contrast, already are in comeback mode. However, from the point of view of metals suppliers, the large high-rise downtown hotels that typically use more of their products can take two years to complete the planning and permitting process—meaning that, as with office construction, it could be awhile before metals suppliers notice an uptick in demand.

COMMERCIAL CONSTRUCTION STARTS IN MILLIONS OF SQUARE FEET
  1999 2000 2001 2002 2003 2004 2005 2006 FORECAST
Stores 311 309 279 258 283 296 303 285
Warehouses 259 304 274 195 188 206 205 220
Offices 278 298 225 157 144 164 158 173
Hotels 82 70 53 40 45 47 48 56
Garages/Service Stations 185 198 184 161 136 158 172 186
Total Commercial 1,115 1,180 988 811 795 870 8866 920
Source: McGraw-Hill Construction, a division of The McGraw-Hill Companies
*Totals may not add up due to rounding.

Meanwhile, others worry that a series of Federal Reserve rate hikes could deter spending on commercial projects. Baker says that supply and demand trump interest rates in commercial construction. Because higher interest rates reflect expanding economic activity, real estate investors see those rates as an expense that can be passed on in the form of increased rents.

Likewise, volatility in materials and energy prices might lead to caution. That volatility, resulting from heightened demand, became particularly acute when Hurricane Katrina shut down the Port of New Orleans and disabled factories and supply chains in the region.

However, John Cross, vice president of marketing at the American Institute of Steel Construction (AISC), says capacity exists to meet growing demand at least for structural product as commercial construction expands.

Still, others suggest that deep-rooted and hard-to-control global forces may hinder commercial construction in ways not yet fully understood. Cross says, for example, that volatility from energy prices and foreign demand is not about to disappear.

One global trend that could limit office-building construction in particular over the long term would be a continuation of the offshore outsourcing of knowledge-industry jobs. Fewer U.S. white-collar jobs might quell demand for office space throughout the country, says a forecast by PricewaterhouseCoopers and the not-for-profit Urban Land Institute (ULI) in Washington, D.C.

“No one knows how significant the outsourcing trend will be,” says Stephen R. Blank, ULI senior fellow, finance. But he notes that major U.S. companies are building huge facilities in India, which has to reduce office-filling jobs in the United States. In December of last year alone, U.S. tech giants Microsoft Corp. and Intel Corp. each announced $1 billion-plus building projects in India.

Taken to the extreme, the outsourcing of untold thousands of white-collar jobs could depress the prime office space market as severely as manufacturing outsourcing did the now-padlocked factories in the American Midwest back in the 1980s.

More than 20 years later, the Pricewaterhouse ULI report says, “the Midwest struggles for relevancy in the face of economic decline,” and could be bypassed by the real-estate boom. Other U.S. regions are liable to fare better, the report says—in particular Southern California, New York and Washington, D.C. “Investors favor coastal markets,” the report says. One notable exception, however, is Phoenix, which Pricewaterhouse/ULI named this year’s likely “top growth market.”

ASIA’S MEGA CITIES

Regardless of the pace of office expansion, other construction niches could boost the market for metals. Focusing on structural steel products, Cross sees increased use in open-deck parking projects and expanding use of structural steel in multistory (five-plus story) residential projects.

Bolstering future commercial construction growth will be $1 billion-plus mega projects such as New York’s Freedom Tower at the site of the World Trade Center. Also, Goldman Sachs’ new global headquarters in Manhattan is in the design phase.

Large as they are, however, those projects could be dwarfed by commercial construction projects overseas. The same rising rents that are pushing demand for office space in the United States are even stronger in the rest of the world. CB Richard Ellis notes that the $40-plus per-square-foot total cost of occupying office space in Ho Chi Minh City—despite that nation’s low labor costs—is roughly double the rate in Atlanta.

Elsewhere in Asia, the square-foot price for prime office space has reached astronomical levels, the brokerage reports: roughly $62 in Seoul and $131 in Tokyo.

In Shanghai, where occupancy costs still are roughly in line with those of Ho Chi Minh City, officials have unveiled grandiose designs to meet an expected long-term surge in demand. Recently, city development officials retained the British consulting firm Arup to create plans for a so-called eco-city called Dongtan that will equal the size of Manhattan. Dongtan will house several million people and high-tech research and manufacturing facilities, and will utilize sustainable technologies. It is the first of several mega cities planned for the PRC.

Such giant Asian projects echo the halcyon development that took place in North American cities a century or more ago. The boom in Asia, as well as expansion and renewal in North America’s high-growth regions and its refurbished downtowns, suburbs and exurbs, could mean good news for metals.

NEW ORLEANS: STILL WAITING

When the clouds from Hurricane Katrina finally moved on, many Americans hoped there would be at least a meager silver lining—that a new New Orleans would be built to replace the city that was 80% flooded by the storm.

Those in the metals construction materials industry are understandably cautious about any near-term boost the Katrina rebuilding effort will have on their business, however. John Cross, vice president of marketing for the American Institute of Steel Construction, says rebuilding the region “will not be a significant factor on either demand or price as structural projects.” The reason, he says, is that large-scale projects, including infrastructure upgrades and new buildings, “will have a longer lead time and a gradual impact, as opposed to a significant spike in immediate demand.”

In fact, Katrina’s longer-term effect may be to promote the use of metals over competing materials, such as wood. Metal roofs can better weather the 100-plus mile-per-hour winds accompanying hurricanes, according to the Metal Roofing Alliance. Currently, metal roofs make up only 8% of the re-roofing market, though their use has doubled in recent years.

Likewise, the American Iron and Steel Institute (AISI) and the organization it launched, Steel Framing Alliance, is pushing the use of steel framing as a more weather-resistant alternative to wood frames for the estimated 200,000-plus homes that will be needed to replace those destroyed by Katrina. If half of those newly constructed homes utilize steel framing, it would require 691,000 tons of sheet steel, the AISI says.

Indications are that investors—who typically place their bets well in advance of anticipated revenue-enhancing events—already have spotted the long-term potential for metals suppliers. A beneficiary could be Brazilian steel giant Gerdau Group SA, which provides the U.S. southern region with reinforcing rods that may be needed for the repair of bridges damaged by the storm. U.S.-based steel companies such as Nucor Corp. and U.S. Steel Corp. could benefit even more, since Congress-approved rebuilding funds require that they be given priority as suppliers.

– Mark Ingebretsen