Sustained & Accelerating Recovery Path

Edward Sullivan

Happy days are not quite here yet, but they are clearly in the near term vision. There are more reasons for optimism this year than for at least eight years. Optimism is based on emerging trends for the economy, construction activity and cement/concrete usage. Portland Cement Association (PCA) expects volume growth this year equal to 2012 levels – yielding 8% growth in consumption in 2014.

Don’t focus on whether it’s an 8% growth rate or a 12% or a 6% growth rate for 2014. The longer term fundamentals are the reason for optimism – optimism with upside potential.

Residential construction is on the upswing. Nonresidential is entering the third year of recovery, although at a slower pace than residential, but that pace is expected to accelerate significantly during the next several years. Finally, the public sector’s cement consumption has reached a trough point and is expected to record sustained gains during the next several years based initially on improving state and local fiscal conditions. Historically, when all three sectors of construction activity beat positive, large volume and percentage gains materialize and the magnitude of the gains are often surprising to industry analysts.

Economic Outlook During the second half of 2013, real GDP exceeded 3.5% growth (PCA was among the few brave enough to call that one right a year ago). Another round may materialize in debt extension negotiations, potentially derailing first quarter economic growth. In PCA’s view, political drama on Capitol Hill could represent a temporary setback early in the year. Continued improvement in underlying fundamentals, however, is expected to reassert its influence and generate a return to stronger economic growth in the year ahead. Consider the following:

• Private Debt: In decline as a share of disposable income since 2005. As a result, cost to service this debt has approached an 18 year low. By reducing interest portion of payments, consumers have effectively increased their discretionary spendable income – to the benefit of economic growth. • Corporate Liquidity: Flush with cash. In addition to high liquidity, many businesses have benefited from favorable debt levels, low bond rates and improved earnings. It is tough to argue that businesses do not have the means to fuel private recovery. • Banking Strength: Healthy again. Depository institutions have raised hundreds of billions in new capital, putting important benchmark ratios near all-time highs. Resulting in gradual easing in lending standards and willingness to loan – providing greater access to capital by business and consumers. • Pent-up Demand: Sub-trend economic growth has generally characterized the economy for the better part of six years – an extraordinarily long period of time and implying huge pent-up demand has been generated and may be waiting on the side lines for its release – adding to possible future real GDP growth.

Residential Nearly half of the anticipated growth in 2014, cement consumption is expected to be generated from gains in residential construction. Home inventories are lean. Home prices are rising. This sends a clear signal to homebuilders to accelerate building activity. This assessment is further amplified in the con text of stronger 2014 economic growth. Job creation and consumer sentiment. Housing starts are expected to reach more than one million units, with single family construction near 750,000 starts during 2014.

Dynamics shaping single family sales are rapidly changing. The combination of low mortgage interest rates and declining home prices in the context of steady job growth result in dramatic improvement in home affordability measures. This affordability improvement was amplified due to the large presence of distressed properties resulting from short-sales and property defaults. At its peak, roughly 36% of total single family sales during 2010 involved distressed properties. These bargains enabled marginal prospective buyers unprecedented opportunity to purchase a home. In addition, bargains attracted cash-paying real estate investors. Both factors played a significant role in single family sales gains during the past two years.

Currently, distressed properties account for 18% of total sales. Distressed sales will account for an even smaller share of overall future sales. As foreclosures and short sales exit the market, new home sales are expected to increase. Based on a 20 year average, new homes represented 14% of all home sales. Since 2009, this number was cut more than in half to 6.7%. This gradual refocusing on new homes is expected to add support to stronger new home construction outlook going forward.

The burden for generating sustained gains in home sales going forward will increasingly fall on the underlying improvement in homebuyer fundamentals. PCA believes the fundamentals support continued strong gains. Consider the following:

• Job Growth: Job creation is critical in generating house hold formation and favorable homebuyer affordability. PCA expects roughly 2.2 million additional jobs to be created during 2014 and roughly 2.5 million in 2015. • Lending Standards: Since the second half of 2012, lending standards for conventional mortgages have eased on a significant and sustained basis. Easing has also begun to materialize for non-traditional mortgages. Lending standards for home mortgages are expected to ease as the perceived lending risks subside. • Consumer Affordability: Mortgage interest rates have increased nearly 100 basis points since the start of the year, but remain 230 basis points below the past cyclical peak. Mortgage rate increases coupled with on-going recovery in home prices have combined to increase the average monthly payment by $150. Average monthly payments, however, remain 32% below the past cyclical peak. Affordability may be a concern in the back-end of the forecast; it is not expected to pose a significant threat to near-term stronger sales activity. • Consumer Willingness to Buy: Attitudes, according to our scenario, increasingly focus on positive economic fundamentals rather than adverse political uncertainty. This leads to rather significant second half gains in sentiment. Furthermore, rising home prices may stir potential homebuyers to act more quickly.

Multifamily starts are expected to grow 13% in 2014 to 345,000 units. Household formation continues to strengthen while damaged credit due to foreclosure activity and tight mortgage lending standards have combined to create robust apartment demand. The US population is aging causing future demand for multi-unit assisted living complexes and condominiums to increase further. Finally, many would-be entry level home buyers are burdened with high student loan payments – delaying their entry into the single family market to the benefit of multifamily demand. This bright outlook for demand has reduced banks’ perceived lending risk to multifamily investments resulting in greater access to capital markets. The formula of strong demand conditions and easier access to capital equates to sustained gains in multifamily construction.

Nonresidential construction declined 45% during 2008-2011. Amplified by severe intensity weakness, non – residential cement consumption declined 75% during the same period. The nonresidential sector has shown a solid recovery since 2011 and is expected to achieve sustained gains in both construction activity and cement intensities throughout the forecast horizon. These factors are expected to result in moderate-to-strong gains in cement consumption. Nonresidential cement consumption showed a 22% year-over-year gain for 2013. PCA expects nonresidential cement consumption will increase near a 20% growth rate through 2016. Even with these strong growth rates, 2016 nonresidential cement consumption will remain roughly 17% below 2007 levels.

Roughly 25% of anticipated growth in 2014 total cement consumption is expected to be accrued to expected gains in nonresidential construction. These gains are expected to be driven by growth in the expected return on investment (ROI) for commercial properties. ROI, according to the PCA model, has two essential components including net operating income (NOI) and asset appreciation potential. Between the two, PCA believes NOI is the more important metric to focus on early in the recovery. Its strengthening will play an increasingly important role in determining future asset appreciation – influencing total ROI.

Several issues still confront the recovery in nonresidential construction. Expected ROI will continue to be hindered by high, but improving, vacancy rates, soft but improving leasing rates. Commercial asset prices are expected to rise gradually with slow easing in tight lending standards. In each instance, conditions are improving to add to the fundamentals supporting growth in nonresidential construction activity.

Rate of improvement will depend on job creation. Job creation, either directly or indirectly, translates into higher occupancy and leasing rates. Combined, these factors determine the expected ROI for most commercial properties. Nearly 7.5 million jobs have been created since the economic collapse. PCA expects 2.2 million additional jobs will be created in 2014 and an additional 10.3 million created by the end of the fore – cast horizon. Such growth translates into stronger NOI for nonresidential properties – and sends a signal to investors for the need for commercial expansion. Rate of improvement will vary widely among regions in the US.

Improved NOI sends a signal to banks that risks associated with loans to commercial real estate are declining as the economy gains traction. The commercial real estate market has been plagued with refinancing issues and tight lending standards. According to the Federal Reserve’s senior loan officer survey, lending standards facing commercial real estate loans have eased significantly – reflecting 10 consecutive quarters of decline. This adds to the fundamentals facing commercial construction.

Regional Outlook While PCA’s outlook regarding residential and nonresidential markets is decidedly optimistic, growth will not occur evenly across the US. Employment levels tied to specific nonresidential sectors give insight regarding leaders and laggards of nonresidential recovery. By comparing previous past peaks in employment against prevailing employment in retail, office, manufacturing and hospitality sectors leaders and laggards in the recovery can be identified. According to this analysis, Texas, the Dakotas, Carolinas and portions of the northeast are leading the recovery. Portions of the southwest, at this point, are lagging.

The recession was particularly harsh on this segment of the industry with consumption declining 67% in trough year 2011 from the peak of 5.5 million metric tons in 2005. Masonry cement increased 4% in 2013. PCA expects masonry cement will increase 11% in 2014 with similar double-digit gains recorded through the end of the forecast horizon (2018). With each passing year of the recovery, the differences between stronger and weaker performing markets is expected to narrow.

Edward Sullivan, is chief economist and group vice president for PCA, where he heads PCA’s Market Intelligence, Market Development , Corporate Communications, Codes and Standards as well as PCA’s Research and Technical efforts and directs all PCA’s as sessments for target markets and provides fore cast guidance on the economy, cement consumption, and the construction industry. Sul livan has been named among the top 10 influencers in the concrete industry domestically and internationally. Various forec asting surveys have placed him among the most accurate construction economists in the country. His analysis and views regarding the construction, cement and concrete industries is widely used in corporate planning efforts, government policy and media. esullivan@cement.org |847.966.6200

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