Morgan Stanley: Commercial Construction Is the Recession's Next Victim

Commercial construction is the recession's next victim, according to Richard Berner, writing in Morgan Stanley's latest Global Economic Forum. The sector is under pressure from all sides: tightening financial conditions (until last week, no commercial mortgage-backed securities [CMBS] had been issued so far this year —the longest such dry spell since October 1990); rising construction costs; weakening demand; and over supply. All of which will have a significant effect on GDP:

A downturn in [commercial construction] activity would represent a significant turnaround from last year’s boom: Although nonresidential or structures investment accounted for only 3.4% of (nominal) GDP, the 16% jump in real outlays contributed half a point to overall real GDP growth over the four quarters of 2007. Such a gain — the sharpest 4-quarter rise since 1984 — is unsustainable, and we think this economic asset is about to turn into a liability.

In the past year, commercial construction abandoned its traditional 'capital discipline', Berner argues, resulting in excess supply in financial services office building, retail and lodging: 19 million square feet of office space came onto the market in Q4/2007 according to Reis, Inc., the most since Q4/2000. As for costs, steel and copper prices are on the up again, the latter possibly exacerbated by severe snowstorms in China.

The exposure of the nonresidential construction sector to the downside is not uniform, according to Berner:

In my view, the commercial, lodging, manufacturing, and amusement areas, comprising 45% of total nonresidential outlays, are the most vulnerable [to downward pressure on rents, tightening credit]. Commercial building proper — including offices, facilities for retailers, restaurants and warehouses — accounted for 28.8% of private nonresidential outlays last year, and hotels, amusements, and manufacturing consumed 7.6%, 2.4% and 6.1% of outlays, respectively. Two other categories were much bigger than these last three, and look much less vulnerable: Spending on power generation and communications structures represented 12.2%, while mining and exploration accounted for fully one-quarter of the total. Slower growth is likely; annualized gains in those two infrastructure components of 16.6% and 17.9% over the past two years are unsustainable.

Despite, or rather, because of these downside risks for the commercial construction sector, Berner concludes that this may, selectively, provide investors with a 'reasonable buying opportunity in the highest-quality securities'.

Comments

[johnthebear:]

Your exactly right in your analysis... as far as it goes. You did not mention that in 2007 L/V ratios expanded to 118% and that 59% of commercial loans were interest only, meaning they were financed with short term financing that must be refinanced (like much of the loans in the last couple of years) but refinanced at sharply higher rates as revealed by the interest rates paid in the auction market for high quality munis. This means that the higher mortgage payments will make many commercial investments unfeasible... leading to foreclosure of a lot of prime real estate of all types... possilby leading to fire sales. I suggest shorting REITs or SRS and gain from this mess that is sure to get worse in short order.

2008 Feb 21 05:29 PM