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Strong Economy and Robust Construction in 2016 Drive Increased Cost Escalation

Market Outlook 2016 Q4
Published 2/22/2017

Construction prices increased an average of 6 percent in 2016, as energy and commodity prices remained at levels not seen since the 1990s, due in large part to the strength of the U.S. dollar. Five consecutive years of above-average cost escalation has driven the construction cost trendline to 3.3 percent. Price increases are attributed to robust construction activity allowing contractors to increase their margins as demand grows. The construction sector is also reaching full employment levels, which is expected to drive wage increases in the near to mid-term.

Overall, economic growth appears stable, with the consumer price index (CPI) increasing by 1.7 percent year over year. Inflation is expected to rise to 2 percent over the medium term, as the impact of past declines in energy and import prices dissipates, and the labor market strengthens.

Construction Costs

Construction costs have trended toward a 3.1 percent annually compounded escalation rate for the past 30 years, according to Vermeulens, but five consecutive years of above-average growth has now pushed the construction cost trendline from 3.1 percent to 3.3 percent.

The Federal Reserve Board raised short-term rates a quarter point at its December meeting, with another two- to three-quarter-point hike expected this year. Although the target range has increased, the Board’s stance on monetary policy remains accommodating. Continued low interest rates are expected to support stability in the rate-sensitive construction sector.

Construction Volumes

Construction dollar volume is the number one factor for construction costs, because bids increase as contractor opportunities and project backlogs grow. Average selling prices increased by an average of 6 percent nationally in 2016. By comparison, Vermeulens saw an average selling price increase of 3 percent in 2011, followed by a 6 percent increase in 2012, 8 percent in 2013, 6 percent in 2014, and 8 percent in 2015.

Construction dollar volume increased 5.8 percent year over year (November 2015 to November 2016), with most of this increase attributed to price increases, since construction employment increased by only 1.6 percent in 2016.

Non-residential spending declined 1 percent year over year (November 2015 to November 2016), and continued weakness in non-residential construction spending could reduce cost escalation in this sector. Overall, infrastructure spending offset non-residential declines to hold the total essentially even.

AIA Billings   

The Architectural Billings Index (ABI) is a key indicator of expected construction volumes nine to 12 months in advance. A score greater than 50 indicates growth.

Architecture firms saw an unexpected surge nationally in December, resulting in the highest monthly growth of the year and closing 2016 with an average monthly score of 51.3. The strong December came from a billings uptick in three of the country’s four regions. Firms in the Northeast (50.8) and Midwest (50.9) experienced their strongest monthly growth of the year, while firms in the South (51.3) continued healthy growth. The West (48.6) was the only region to post a decline in billings, a trend that now stretches over five of the past six months

Growth at architecture firms specializing in commercial and industrial projects (50.4) continued to be flat, while multi-family residential (51.7) and mixed-practice (51.3) firms improved, and institutional (49.5) firms softened.

Labor Market

Nearly 2.2 million payroll positions were added in 2016, bringing the national unemployment rate to well under 5 percent, though the construction industry accounted for only just over 100,000 of those new positions, compared to almost 300,000 positions in 2015.

Sustained construction activity has increased industry employment by more than 1.2 million workers since 2011. The current slowing of employment growth in the sector is likely due to a lack of available workers. Wage increases are expected to draw employment from new entrants and other sectors.

Labor Capacity Utilization

Labor capacity utilization is calculated by comparing the ratio of current construction employment to peak employment, and allowing for a sustainable rate of growth. A utilization rate of greater than 85 percent (yellow) puts upward pressure on construction labor costs. While regional imbalances in capacity utilization are leveling out, inflation in local urban markets will continue to be driven by supply and demand in each location.

The construction labor growth rate is calculated by comparing the current 12-month average for construction employment relative to the previous 12-month average. Currently, half of the top 20 U.S. cities (by GDP) are experiencing above-average construction labor growth.

Forecast

The New York Stock Exchange (blue line) is a strong indicator of construction prices, as improving equity markets provide capital and investment spending for construction. The stock market continues to trade in a range consistent with the previous three years.

While the American economy grew at a modest rate in 2016, expectations for continued growth remain high. Analysts are predicting a more than 2 percent growth in GDP for 2017.

Current construction prices are firm and stabilizing above the long-term trendline, and construction employment is at full capacity. This means that construction costs will continue to remain above the construction cost trendline for the medium term.

By Johnathon Allen

This report is based on the Vermeulens Q4 Market Outlook report.