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2020 FMI Overview, Featuring the 2019 U.S. & Canada Fourth Quarter Construction Outlooks | FMI

2020 FMI Overview,
Featuring the 2019 U.S. & Canada Fourth Quarter Construction Outlooks

 

FMI Managing Director Jay Bowman Discusses the Construction Forecast

Executive Overview

 

Navigating a Maturing Cycle in Uncertain Times

As we head into 2020, we find ourselves at the top of an extended economic cycle, confronted with polarizing geopolitical tensions and increasing uncertainty. Add to that another seismic event–the U.S. election in November–and we have a recipe for an interesting year ahead.

By Chris Daum, CEO, FMI

Having benefited from an unprecedented period of economic expansion and sweeping economic prosperity, the U.S. built environment (along with the companies operating within it) has experienced a very long run rate. With the domestic economy beginning to send mixed messages and indicating decelerating growth—and with the global economy flashing red through 2019 in certain pockets (e.g., China and the Eurozone)—in what direction it turns remains to be seen.

These high levels of domestic and international uncertainty are also playing out in the built environment: In 2020 FMI only predicts a small increase (1%) in engineering and construction spending levels over 2019.

Through 2019, year-end actuals are anticipated to remain flat or slightly down at 0% overall growth, with leading growth segments expected to include a mix of public infrastructure (e.g., power, highway and street, sewage and waste disposal, water supply, and conservation and development), alongside a small number of mixed public and private nonresidential building segments (e.g., public safety, transportation, lodging and office), all with growth rates of 5% or higher.

However, we saw a softening across all residential segments of the industry through 2019 year-end, and we expect further declines through 2020 in multifamily residential, residential improvements, commercial, religious, amusement and recreation, and manufacturing.

Conversely, however, it is encouraging that the latest Nonresidential Construction Index (NRCI) feedback suggests increased optimism heading into Q1 2020, at 53.9. This index score is up considerably from a neutral reading of 50.4 last quarter and is the highest score reported since Q4 2018.

No matter how you dissect the situation, it’s impossible to predict how these market and geopolitical dynamics will impact the built environment in the near term and midterm. And therefore, E&C leaders need to ask themselves: How do I create a coherent and flexible strategy that allows my company to take advantage of the strong operating environment we’re in today (in terms of backlog and available work) while also keeping a firm eye on the horizon? This is critical because any external factors could have a swift impact on today’s operating environment.

“In his book ‘Lords of Strategy,’ Walter Kiechel says, ‘It’s easy to conflate strategy with strategic planning, but it’s also dangerous.’ We would agree. Our experience is that many firms have a strategic plan, but far fewer have a clear strategy. With almost half of all construction spending to occur in just 20 metropolitan markets AND megaprojects projected to explode from less than 2% five years ago to 20% of total construction volume over the next three to five years, it’s clear the cheese has moved… and having a clear strategy has never been more critical.”

Scott Winstead, President
FMI Consulting

The Strategy Imperative

Planning for the future can seem overwhelming in today’s VUCA1 world, particularly since many firms have been lulled into complacency after operating in a strong market for more than a decade.

Furthermore, many E&C executives don’t realize that their markets have shifted dramatically over the past few years, influenced by ever-increasing urbanization that’s led to more complex and concentrated building activities. In fact, according to FMI’s latest research, annual nonresidential megaproject CPiP is expected to increase more than 400% over the next five years, growing from $47 billion to just over $247 billion.

Given this backdrop, it’s time to take a step back and take a deep look both within and outside of your organization. The U.S. economy has ebbed and flowed so many times over the last few decades that we now have historical information, data, strategies and insights needed to make smart decisions before, during and after a downturn.

 

Exhibit 1. Construction Spending Is Concentrated In Fewer Markets


Total Construction Spending Put In Place by Metro Market (2018) Forecast by Metropolitan Statistical Area (MSA)
Source: FMI Q4 2019 Construction Outlook

 

Here at FMI, we like to point out the four pillars of good strategy that all E&C firms should consider at this time of the market cycle. They are:

  1. Pillar #1: Focus. At any economic stage, companies should be able to answer the critical “where to play” and “how to win” questions by identifying the right combination of markets, segments and delivery methods to outperform industry peers. This is about more than picking the right strategies and hoping that they work. It also involves understanding what drives value across different markets and segments. From there, you can determine how to deliver and compete on value. Focus on what you do best and stay true to yourself.
  2. Pillar #2: Choice. Even in challenging economic times, companies that make conscientious decisions about who to work with (and why) fare best. Clearly frame your company’s choices around future direction, knowing that good strategy depends just as much on deciding what not to do as it does on what to do. For best results, focus on reconciling the tyranny of the urgent (i.e., today’s fire drill) with the truly important (i.e., initiatives to create tomorrow’s future). And remember: One poor decision in today’s strong market can be devastating in a downturn.
  3. Pillar #3: Systems. Even if your project backlog is overflowing and your finances are healthy, it’s time to prepare for the next downturn. Look closely at how governance, corporate structure, rewards and incentives, and leadership accountability mechanisms (to name a few) align with your firm’s overall strategy. Without this alignment, decisions can often lead to tension within one or more of these systems. For example, if management wants to explore new geographic markets—but if governance isn’t onboard with the idea—the initiative may create friction among those stakeholders. To avoid such issues, evaluate the business for alignment between systems and strategy.
  4. Pillar #4: Impact. Strategy must be impactful for the organization as a whole, and it must have a positive impact on the company’s bottom line. Your strategy is not what you say it is; it’s a sum product of the day-to-day actions, decisions and behaviors of your people. That means every employee must be able to articulate the strategy, understand his or her role in it, and clearly understand how it impacts organizational success. Without these valued stakeholders onboard, strategy quickly falls by the wayside as employees go back to doing things the way they always have.

No one can predict the future. By placing energy into the factors that you can control and taking the right actions, your firm will be able to successfully navigate whatever comes its way.

1 VUCA stands for volatile, uncertain, complex and ambiguous.

“Focus does not mean saying yes, it means saying no.”

Steve Jobs
Former CEO of Apple

The Changing Face of Leadership

According to the Pew Research Center, the U.S. labor force is declining by about 5,900 baby boomers daily on average.2

As these employees exit the workforce, empty seats will increasingly be filled by millennials and Generation Z workers, both of which bring their own set of values, requirements and capabilities to the leadership table. Today’s E&C leaders must keep these realities in mind as they prepare their firms for long-term success, understanding that a significant generational transformation is already underway.

Both the millennials and Generation Z are giving very clear, global signals around their demands of society, government and the economy. These values are going to shape the priorities and the environment in which the global construction and infrastructure industry operate. For example, issues like diversity, inclusion, transparency, sustainability and environmental responsibility will all be fundamental hallmarks of the next generation of leadership’s priorities and values.

These values will also show up in other political, social, governmental and regulatory fronts, all of which significantly impact the built environment. Smart companies realize this and are examining how they attract new talent, how they steward their resources, and how they design and build new structures differently. As the handoff among the baby boomers, generation X and the two younger generations continues to accelerate, this forward thinking will help create an industry that’s more adaptable, sustainable and responsive to change.

Flexibility will only become more paramount as we move further into 2020 (and beyond). Put simply, the industry is going to need agile leaders who can play across several different functions and/or at least be competent and conversant within those functions. Additionally, attaining this flexibility will require an investment of time and energy into recognizing the needs of the new generation of leadership and then responding with thorough leadership development, nurturing and training. Absent of these initiatives, even today’s largest and most influential E&C companies could quickly find themselves falling behind the industry curve.

2 Richard Fry. “Baby Boomers are staying in the labor force at rates not seen in generations for people their age.” Pew Research Center. July 24, 2019.

“Millennials have now surpassed Generation X to become the largest generation in the American workforce. This group’s preferences for sustainability, wellness and business transparency are expected to be major influences on building design.”

Greg Powell
Managing Director

FMI Capital Advisors


U.S. Engineering and Construction Outlook

 

Key Takeaways

Total engineering and construction spending for the U.S. is forecast to end 2019 flat with 0% growth compared to 2018.
Looking ahead to 2020, FMI forecasts a 1 percent increase in engineering and construction spending levels over 2019.
Primary growth segments in 2019 are expected to include a majority of the public infrastructure segments (including power, highway and street, sewage and waste disposal, water supply, and conservation and development), alongside a small number of mixed public and private nonresidential building segments (public safety, transportation, lodging and office), all with growth rates of 5 percent or higher.
Most other nonresidential building segments (health care, education, amusement and recreation, communication and manufacturing) are expected to end the year with growth roughly in line with rate of inflation and therefore be considered stable.
All residential segments (single-family, multifamily and improvements), along with commercial and religious, are expected to end 2019 in decline. Multifamily residential, residential improvements, commercial, religious, amusement and recreation, and manufacturing are anticipated to experience declines in 2020.
The latest Nonresidential Construction Index (NRCI) feedback suggests increased optimism heading into Q1 2020, at 53.9. The score is up considerably from a neutral reading of 50.4 last quarter and is the highest score since Q4 2018.

 


Total Construction Spending Put in Place 2018 and Forecast Growth
(2018-2023 CAGR) by Construction Segment

* Improvements includes additions, alterations and major replacements. It does not include maintenance and repairs.
Source: U.S. Census and FMI Forecast

 

Total Construction Spending Put in Place 2018 and Forecast Growth
(2018-2023 CAGR) by Metropolitan Statistical Area


Source: FMI Forecast


 

Residential Construction Put in Place

 

Single-Family Residential
  • Falling mortgage rates, low unemployment and an uptick in wages have alleviated some pressure in single-family construction late in 2019. However, affordability remains a significant challenge across the industry with bloated home prices and consumer credit levels allowing far too few qualified buyers to lead any significant rebound.
  • A recent report by ULI and PWC suggests that only 35% of median earners can afford median-priced homes, and the housing recovery since the Great Recession has been driven largely by new home purchase activity among current homeowners.
  • Smart home features, single-family rental properties and co-living spaces will influence buyer behaviors in the coming years while builders navigate rising costs of labor, materials and land acquisition. Builders are only beginning to deliver a meaningful supply of entry-level homes.

Drivers: Unemployment rate, core CPI, income, mortgage rate, home prices, housing starts, housing permits

Multifamily Residential
  • Both domestic and foreign investment in multifamily construction stalled over the past two years as larger, high-growth cities backed off from new supply and pivoted to absorption and rent compression. The overall investment climate will remain contested over the next 12-18 months as low and declining returns stabilize. Further, increased and new municipal and state-led rent controls will shape regional markets.
  • Opportunities in multifamily construction will be driven by institutional-anchored markets. Urbanization trends continue with secondary and tertiary submarkets experiencing higher growth in coming years, mimicking larger mixed-use projects with low-rise and garden communities.
  • Demand for multifamily housing is split between individuals who need to rent (e.g., young professionals and a large portion of the workforce) and those who choose to rent for convenience (e.g., late-career/retired baby boomers or transient midcareer professionals). Oncoming supply in recent years has catered largely to Class A luxury space, working against many buyers’ aspirational path to ownership.
  • Long-term demand is expected to remain healthy, with an estimated additional 4 million new rental units needed over the next decade (source: PWC). Additionally, 3 of 4 new jobs created in the current economy are low-paying and contribute to forming approximately 1 million new rental households each year.

Drivers: Unemployment rate, core CPI, income, mortgage rate, home prices, housing starts, housing permits

Improvements
  • Weakness in new home sales, moderated growth in home prices and rent appreciation, decreased rental turnover and moving activity, and rising labor and construction costs have all worked against residential improvements spending through 2019. However, recent adjustments to lending rates have owners pursuing refinance, which typically stimulates improvements spending.
  • Property owners seeking improvements and renovations will benefit in the short term from eased demand in new single-family and multifamily construction, alleviating project hurdles tied to cost, labor and schedule constraints alongside relaxed competition.

Drivers: unemployment rate, core CPI, income, mortgage rate, home prices, housing starts, housing permits

 

Total Construction Put in Place
Estimated for the United States

Source: U.S. Census and FMI Forecast


 

Nonresidential Buildings Construction Put in Place

 

Nonresidential Construction Index (NRCI)

NRCI scores are based on a diffusion index where scores above 50 represent improving or expanding industry conditions, a score of 50 represents conditions remaining the same, and a score below 50 represents worse conditions than last quarter (or contraction).

The data in the NRCI is presented as a sampling of construction industry executives voluntarily serving as panelists for this FMI survey. Responses are based on their experience and opinions, and the analysis is based on FMI’s interpretation of the aggregated results.

 

 

Lodging
  • Low unemployment rates, the global trade environment and the presidential election should boost demand for travel through 2020, but not enough to offset a significant jump in supply coming online.
  • Construction and engineering spending in the sector is expected to stall over the forecast period due to declining occupancy and lower than anticipated increases in revenue per available room (RevPAR) rates, as realized through 2019. Additionally, expected lower GDP growth, consumer spending, a strong U.S dollar and rising costs related to labor and tariff implementation will all weigh heavy on the hospitality industry in the year ahead.
  • Uncertainty, along with significant attention surrounding the outcome of the 2020 presidential election, will dampen capital expenditure expectations, potentially reforming immigration policies (impacting industry labor) and adjusting the existing business-friendly climate under the Tax Cuts and Jobs Act of 2017.

Drivers: Occupancy rate, RevPAR, average daily rate, room starts

Office
    • The political and economic backdrop of 2020 will temper demand for new private office development. Additionally, U.S. unemployment rates are stabilizing at or near 40-year lows.
    • Continued high demand for top-quality space in niche segments is expected; segments include technology, life sciences, data centers and coworking spaces. Growth will remain tied primarily to larger urban metropolitans.
    • Incoming 5G infrastructure will fuel demand for new data centers in or near large population and business centers.
    • Higher leasing activity (especially across technology tenants) as well as an increasing use of flexible office space are two key drivers behind the gradual decline in conventional office construction.

Drivers: Office vacancy rate, unemployment rate

Commercial
  • Trade negotiations and world commerce have slowed through 2019, tempering short-term demand for larger warehousing hubs. However, consumers are increasingly selecting online sellers that are able to provide convenient and fast delivery, thus driving demand for more last-mile (and return center) facilities.
  • Middle- and lower-market retail space is finding pressure from multiple angles, including a rise in entertainment and luxury-focused shopping experiences. Traditional retail has been gradually pressured to hybridize across amusement and recreation, logistics, lodging and office.
  • Well-positioned Class A malls, fitness and health, and food and beverage remain in high demand. Additionally, some online brands are beginning to invest strategically in smaller brick-and-mortar storefronts.

Drivers: Retail sales, CPI, income, home prices, housing starts, housing prices

Health Care
  • By the end of the decade, the youngest baby boomers will reach 65, and more than 1 in 5 U.S. residents will be 65 years or older. Over this span, Medicare enrollments are expected to increase approximately 50 percent (reaching 79 million), and the program will see a larger share of patients managing multiple chronic conditions, such as combined high blood pressure and diabetes.
  • Though industry trends continue to favor medical offices and outpatient facilities, a small number of very large health care campuses are in the design pipeline. Modular and prefabrication techniques, using less on-site labor, are allowing tighter engineering and construction practices and a higher degree of precision across various facility types.
  • Advancing technologies across wearables, medical records and customer interface are all improving diagnostic and proactive care. These tools ultimately help people live longer, but require an ongoing and extended need for health care services.
  • The Affordable Care Act was recently ruled unconstitutional, given that it now lacks the individual mandate. A complete reversal of the Affordable Care Act could leave 20 million people uninsured.

Drivers: Population change, population change in ages 75 and up, uninsured population, government spending, nonresidential structure investment

Educational
  • K-12 districts in major cities (e.g., New York, Washington, Los Angeles) are building new schools and expanding, as growing population demands have resulted in increased capacity needs. Additionally, approximately half of all K-12 public schools in the U.S. are at least 50 years old and require significant renovation and upfit.
  • Higher education enrollment growth is slowing as the millennial population has outgrown the typical college age range. Additionally, millennials are taking longer than previous generations to marry and have children, which will impact future K-12 enrollments.
  • Weakened endowment returns through 2019 will stall short-term higher education construction spending. However, increased demand for on-campus housing continues with a preference for more high-rise structures closer to campus.

Drivers: Population change younger than age 18, population change ages 18-24, stock markets, government spending, nonresidential structure investment

Religious
  • Religious organizations are shifting away from a content-based delivery platform toward shared experiences, missions and movements in an effort to stimulate and attract new members. Similarly, building construction spending is being redirected into structures that help service the broader community’s needs, including housing, community and recreational centers, child care, etc.
  • Recent updates to a survey from the Pew Research Center identify that religious affiliation and regular attendance have declined steadily across the U.S. over the past decade. Also, similarly, the study highlights an increasing share of the population identifying as agnostic or atheist. This group, labeled “nones,” has grown to a 26 percent share of the population in 2019, up from 17 percent in 2009.

Drivers: GDP, population, income, personal savings

Public Safety
  • Violent crime and theft have been down in recent years, due to improving economic conditions and low unemployment levels. However, high-growth metropolitans continue to require additional emergency response and correctional resources.
  • A few significant prison projects are underway in select metropolitan areas (e.g., Salt Lake City), though the overall U.S. prison population has been in decline for nearly a decade.

Drivers: Population, government spending, incarceration rate, nonresidential structure investment

Amusement and Recreation
  • Expected slowed growth throughout the economy, led by political and economic uncertainty, will stall private investment in amusement and recreation structures over the next year.
  • As construction winds down on multiple big-budget stadiums and arenas through 2020, few large sports projects remain in the design pipeline. Demand for new, large-scale convention centers and casinos has similarly faded.
  • Future mid- and large-scale amusement and recreation project opportunities across sports, convention centers and casinos will be led by the success of current and planned transportation (airport and rail) investments. Smaller projects are moving into available retail space while also following multifamily suburban expansion.

Drivers: Income, personal savings rate, unemployment rate, employment

Transportation
  • Large-scale investments in aviation will remain a primary focus through the short term, with 15 airports across 10 states undergoing billion-dollar or more capital expansion programs.
  • An increased number of transit and light rail megaprojects are expected to break ground over the coming years across large and densely populated states (e.g., Florida, Texas, California, Massachusetts). Conversely, freight rail investments will be concentrated to a limited number of markets with expanding trade and/or logistics and distribution infrastructure (e.g., Gulf Coast).
  • Political uncertainty will weigh heavily on transportation construction spending through 2020 and 2021, against the backdrop of the 2020 presidential election and the expiration of the FAST Act. Likewise, P3 support has shifted to lower-risk and nontraditional transportation ventures, including ticketing, people movers and other smaller and supplementary components of existing systems.

Drivers: Population, government spending, transportation funding

Communication
  • Major cities are building out their fiber optic network in efforts to fully integrate all homes and businesses. Estimated capital expenditures in fiber and 5G cell towers will need to grow as much as tenfold in order to upgrade current networks to meet projected demand.
  • 5G infrastructure rollout and implementation will allow higher bandwidth across mobile devices, improved machine-to-machine communications and ultra-low latency communications between humans and machines.
  • Cisco estimates that internet traffic will double within the next two years as a result of wide-scale interconnectivity, creating an enormous amount of new data generated, processed and stored.

Drivers: Population, security/regulation standards, private investment, innovation/technology investment

Manufacturing
  • Signing of a Phase 1 China trade deal entails a dramatic expansion of U.S. food and agriculture product exports as well as an agreement by China to end a requirement of foreign companies to transfer technologies. The deal includes a commitment by China to buy at least $200 billion in U.S. exports over two years.
  • Transportation equipment subsectors will weigh heavily on 2020 spending levels, with declines in production anticipated across aircraft equipment (e.g., Boeing), heavy-duty trucks and light vehicles.
  • Recent trade negations and new tariffs have boosted steel manufacturer profits, spurring expansion investments across the industry. US Steel, Nucor and Steel Dynamics all recently announced billion-dollar capital plans.

Drivers: PMI, industrial production, capacity utilization, durable goods orders, manufacturing inventories


Nonbuilding Structures Construction Put in Place

 

Power
  • A series of major LNG projects in Texas and Louisiana as well as various large-scale renewable generation projects (e.g., solar and wind farms) across the East Coast and in Texas and California are projected to drive increased spending levels through 2020.
  • Electric and gas transmission and distribution projects will remain active over the next several years as a result of resiliency improvements and regulatory requirements.
  • The attack on Saudi oil production facilities and the capture of an oil tanker in the Strait of Hormuz have curbed fears of future oil price volatility related to diminished supply from the Middle East.

Drivers: Population, industrial production, government spending

Highway and Street
  • The FAST Act is due to expire in 2020, and a successor has been historically slow to follow. As seen in prior cycles, federal funding after 2020 is expected to remain mostly stable through extensions until a new bill is implemented.
  • Most states have been successful in recent years boosting revenue sources, but growth in highway and street investment across the country will become increasingly unbalanced, depending on the tools employed. Further, future efforts to expand revenue sources will become difficult if economic growth continues to slow.
  • Owners have restructured contract language to transfer project risk more so onto contractors. Similarly, an increasing number of megaprojects are anticipated over the forecast period, with fewer contractors willing to take on that work.
  • Use of design-build as a project delivery method is anticipated to expand with owners that historically have had minimal or limited adoption of the process. An emphasis on owner education will be critical to successful utilization of this method.

Drivers: Population, government spending, nonresidential structure investment

Sewage and Waste Disposal
  • The upcoming U.S. presidential election is expected to pull attention away from passing federal legislation through most of this year, placing a higher emphasis on states and municipalities to lead continued expansion.
  • Based on a 2019 Water and Waste Digest (WWD) State of the Industry survey, a majority of municipalities are not anticipating new facility or infrastructure construction, but will require short-term and midterm system renovations.
  • Given the critical social functions of the water/wastewater infrastructure, ongoing industry spending will be heavily insulated against economic downturn through the forecast period.

Drivers: Population, industrial production, government spending

Water Supply
  • The most recent draft of the Water Quality Protection and Job Creation Act of 2019 would introduce nearly $17 billion to the Clean Water State Revolving Fund over the next five years. If enacted, a significant increase in state-level involvement would be required to take advantage of available funds.
  • Smart systems are slowly being implemented to monitor volumes, leaks and water quality. Solutions, however, are still fragmented and in early development, but there is a driving interest across ratepayers increasingly demanding transparency.
  • Industrial water supply (and wastewater) needs, alongside increased production and larger and more complex industrial facilities, are expected to continue to expand over the outlook period.

Drivers: Population, industrial production, government spending

Conservation and Development
  • Recent wildfire activity in California and hurricane damage in the Gulf and Atlantic regions between 2018 and 2019 led to the passage of a $19.1 billion relief package.
  • Significant cuts to the EPA’s budget are proposed for FY 2020. Additionally, over the past several years the agency’s workforce has been reduced to near 30-year lows.
  • Stabilized oil prices will stall future investments in petrochemical facilities and diminish some need for ongoing remediation and conservation efforts.

Drivers: Population, government spending

Chris Daum is the president and chief executive officer of FMI Corporation. Chris oversees the management of all FMI businesses and services and leads the firm’s strategic growth efforts. Previously, Chris served as president and senior managing director of FMI Capital Advisors, the firm’s investment banking subsidiary, where he also led the firm’s utility infrastructure practice. Chris can be reached at cdaum@fminet.com.
Jay Bowman is a principal with FMI. Jay assists a broad range of stakeholders in the construction industry, from program managers and general contractors to specialty trades and materials producers, with the identification and assessment of the risks influencing the strategic and tactical decisions they face. In this role, Jay’s primary responsibilities include research design and interpretation, based on developing an understanding of the context within which these organizations operate. Jay can be reached at jbowman@fminet.com.
Brian Strawberry is a senior economist with FMI. Brian’s expertise is in economic and statistical modeling. He leads FMI’s efforts in market sizing, forecasting, and building product/construction material pricing and consumption trends. Brian’s combination of analytical skills and creative problem-solving abilities has proven valuable for many contractors, owners and private equity groups as well as industry associations and internal research initiatives. Brian can be reached at bstrawberry@fminet.com.
Emily Beardall is a senior analyst for FMI’s strategy practice. Emily is responsible for creating and developing tools to deliver innovative solutions for our clients. She is committed to utilizing these strategic tools to improve company performance and profitability. Emily can be reached at ebeardall@fminet.com.