Construction Spending: Hard to Get Excited over 30% YOY Decline

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Includes: HST, SPG, VNO
by: Zacks Investment Research

According to the Census Bureau, total construction spending edged up to a seasonally adjusted annual rate of 965.7 billion in June -- a 0.3% increase from May, but down 10.3% from a year ago. However, private construction spending fell 0.1% for the month. Public spending, mostly for schools and roads (via the Stimulus Bill) rose by 1.0% to an annual rate of $321.7 billion, and was the primary reason that total construction spending was up.

Within private spending, a rise of 0.5% on residential spending was more than offset by a 0.5% decline in non-residential construction spending. As the first graph below (both graphs are from Calculated Risk) shows, non-residential construction spending is now substantially larger ($397.9 billion annual rate) than is residential construction ($246.1 billion annual rate). This has not been the case historically and reflects the massive decline in the housing market over the last few years.

We have seen some upward movement in housing starts in recent months, so the increase in residential construction spending from its deep valley should not be too much of a shock. The increase barely registers on the graph.

The second graph shows the year-over-year changes in spending, and there the slightly slower rate of decline is visible for residential spending. Still, the decline has been going on for far more than a year, and it is hard to get too excited about a year-over-year decline that is "only" 30%.

Also, during the decline there have been several instances where residential spending rose, only to decline even more sharply in later months, the most recent of those being in April. I would want to see a few more months of increases before we can declare the decline of residential spending to be over, but this was a good step in the right direction.

What is surprising is that the decline in non-residential construction spending was not bigger. With commercial vacancies soaring and commercial rents falling, one would have expected a bigger decline in new construction spending. I suspect that what we are seeing is already-started projects being finished up, and that the fall in non-residential construction spending will be steep in the coming months.

Spending on non-residential construction was not quite as exuberant as the housing boom was, so the decline will probably not be as steep -- but it has also just barely begun. As the second graph shows, there is a fairly clear pattern of non-residential spending following residential spending with a substantial lag. Historically, there would be nothing particularly unusual about non-residential construction spending deteriorating at the same time that residential spending is starting to recover.

Surprisingly, the reason that non-residential spending has held up is because of spending on manufacturing plants, which is not what one would expect in a deep recession. That category of spending is up an astounding 45.7% year over year, and now accounts for 21.4% of all non-residential construction spending -- up from just 14.0% a year ago.

Some of the other big categories of spending are off much more sharply. Spending on construction of office buildings is down 21.1% year over year, hotel construction is down by 25.5% and building new commercial (retail) space is down 30.1%. Eventually, this will help relieve the current oversupply of space, but that is not something that happens overnight.

In the office area, there is significant negative absorption as layoffs result in empty cubicles and companies trying to sublet their extra space. Store closings mean that there are empty stores. The last thing the REITs need is more new space coming on line to add to the problem. This is a difficulty that is going to last for a few more years, and I would be very wary of owning the big REITs like Vornado (NYSE:VNO), Simon Property Group (NYSE:SPG) and Host Hotels (NYSE:HST).

Overall, this was yet another report that shows the economy has stopped sliding but has not yet started to actually recover. Much of the activity we do see is a result of the policy actions by the government. The rise in construction spending is a result of government spending. Some might claim that this is artificial, but the people working on those jobs probably don’t care about that.

If the government stimulus were removed right now, it seems likely that the economy would resume its slide. We have not yet reached the point of a self-sustaining recovery. However, we seem to have found some stable footing, which is a precondition for starting a climb back up.