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What Does It Cost? – Spring 2016

Two central cost trends remained consistent in January compared to one year ago. Low energy prices and a sluggish global economy continue to push down the prices of many building products and materials while, at the same time, scarcity of skilled workers in key trades pushes labor costs higher. The net effect of these opposing forces has been that finished construction costs are increasing at a pace that is slightly higher than overall producer inflation and slightly lower than in 2015.

Evidence of the former trend came in the February 17 report on January’s inflation from the Bureau of Labor Statistics (BLS). The producer price index (PPI) for inputs to construction fell 0.4 percent for the month and 2.7 percent from January 2015. The PPI for all goods used in construction fell 0.6 percent and 2.7 percent. A sub-index for energy declined 9.0 percent from December and 21 percent year-over-year. The BLS report also covered inflation for final demand, which includes goods, services and five types of nonresidential buildings that BLS says make up 34 percent of total construction. The PPI for final demand construction decreased 0.3 percent for January and increased 1.2 percent for the full year. That compares to a year-over-year hike of 1.8 percent from January 2014 to 2015.

Significant 12-month price changes in the costs of materials important to construction include a 35 percent drop in the price of diesel fuel, a 19 percent decline in steel mill product and copper and brass mill shape prices, an 18 percent decrease in aluminum mill shapes, and a 12 percent drop in lumber and plywood prices. Among the few costlier materials, cement rose 5.6 percent and flat glass 5.9 percent over the previous January.

Year-to-year changes in labor costs varied significantly by trade and were reflective of the relative supply of skilled craft workers. Costs declined two percent for plumbing contractors, but increased 1.2 percent for roofing contractors, 3.7 percent for concrete contractors and 5.4 percent for electrical contractors. According to the chief economist for the Associated General Contractors (AGC), Kenneth Simonson, the large increases in concrete and electrical subcontractors’ rates are consistent with the September 2015 AGC Workforce Survey, in which 63 percent of respondents said their firms were having trouble filling positions for concrete workers and 60 percent for electricians.

Procurement professionals seem to have factored the trends in construction costs into their plans for 2016. Consultancy IHS and the Procurement Executives Group (PEG) reported on February 24 that the current IHS PEG Engineering and Construction Cost Index fell to 41.3 at year’s end, down from 43.3 in November. A reading lower than 50 represents a downward pricing trend. The headline index has been below the neutral mark for 14 months. The current materials/equipment price index fell from 39.6 in January to 36.9 in February, which is the lowest mark in the fur-year-old survey’s existence.

 

 

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National Construction Outlook – Spring 2016

Lower gross domestic product and a shaky global economy have not yet put a damper on employment. February’s job growth was 242,000, stronger than January and slightly better than expected. Within the Bureau of Labor Statistics’ March 4 report were several bits of encouraging data for the economic outlook. Unemployment held steady at 4.9 percent, an indication that more job seekers were entering the market. Along those same lines, the workforce participation rate climbed to 62.9 percent and the broadest measure of unemployment – the U6 rate – fell to 9.7%. Private payrolls swelled by 245,000 jobs and private payroll wages grew more than 2.5 percent year-over-year. Within the employment sectors, construction employment grew at the highest rate, more than doubling the rate of total non-farm job growth.

Construction data and sentiment appear to be moving in diverging directions after the first two months of 2016. Government data released on March 1 estimated that total construction spending in January 2016 was $1,140.8 billion, and increase of 1.5 percent compared to the upwardly revised $1,123.5 billion total in December. January’s volume was ten percent higher than the previous January. The report, which also showed permits for construction trending higher than starts, supports the forecast from most construction economists of growth between five and ten percent for the full year. Public construction spending grew 4.5 percent over December, a continuation of a much stronger upward trend, while private investment was up modestly. The data portrays a market that may reflect the sentiment of mid-2015, however, as corporate profits, business investment forecasts and other economic metrics are less robust than construction.

The government’s report on the housing market two weeks earlier showed continued strength, with construction of multi-family remaining in an upward trend. But, in the context of data on new and existing home sales and builders’ sentiment, it’s also clear that the uncertainty about the economy is sapping momentum.

On February 17, the Census Bureau reported that total housing starts rose 1.8 percent from January 2015 to January 2016 despite a 3.8 percent decline from December to January and a 2.8 percent drop the month before. Single-family starts increased 3.5 percent but multi-family starts fell 3.8 percent. Building permits, however, rose 14 percent year-over-year, with single-family permits up 9.6 percent and multi-family permits increasing by18 percent. There were permits for more than 90,000 more multifamily units in January than starts, suggesting more projects may begin soon.

Also on February 17, the American Institute of Architects reported that the January Architectural Billings Index (ABI) slipped to 49.6, down from 51.3 in December. While barely negative – a reading below 50 merely indicates that more architects reported a decline in billings than an increase – the January decline is the third dip below 50 in the past six surveys. New project inquiries also fell significantly in January, although remaining positive at 50.3, a level that was ten points below the December reading.

To the extent that inquiries indicate the future billings, January’s survey raises concerns because the 12-month trend in inquiries has turned slightly downward. If the declining trend continues, it will lead to declining billings and eventually, declining construction activity. The modest downward dip in inquiries trending may also just reflect the growing slowdown in planning of multi-family and lodging development.

The hotel construction market continues to thrive but investor concern about overbuilding appears to be rising. According to data tracked by industry resource STR Inc., hotel occupancy rates hit an all-time high of 66 percent in 2015 and revenues and room rates climbed near record levels. Construction of hotels soared 31 percent in 2015 but slowed by 1.2 percent in the second half of the year. Hotel stocks, meanwhile, have been hit by investor selling. While strong performance is an incentive to develop more rooms, lenders are showing a diminished appetite for hotel deals, meaning developers proceeding with projects will see higher lending costs. STR nonetheless expects growth in room inventory in line with the industry’s 1.9 percent rate in both 2016 and 2017.

Concern about multi-family development is also rising, although several of the major financing conduits for apartment projects have added to their allocations for multi-family deals again in 2016. Analyses of the housing markets defy conventional or historical trends. For example, while the multi-family market has been seen as booming since the beginning of the recovery in 2010, the volume of actual starts only rose above the 50-year average of 359,000 units in 2015. Moreover, the peak of two earlier boom cycles – in 1985 and 1972 – reached 576,000 units and 902,000 units respectively. Construction of multi-family units appears to be peaking in early 2016 at somewhere above 425,000 units, but a slowdown below the average is more likely for the full year.

Even more inexplicable is the protracted sluggishness in the single-family market. Starts in this category of housing peaked in 1972, 1978 and again in 2005, when 2.068 million units were started. In the 48 years prior to 2005, the average number of single-family units started was above 1,546 units. Construction dropped off dramatically from 2006 to 2009, when only 554,000 single-family houses were started. The overextension of mortgages during the housing bubble created an excess inventory that had to be sold prior to the resurgence of new construction. By all measures that overhanging inventory has been absorbed for two years or more, yet new construction only recovered to the one million-unit level in 2014 and the average number of starts in the intervening eight years has been 809,400.

There have been a number of explanations for the housing market performance since the mortgage crisis: tight credit, enormous foreclosure inventory, low household formation, shifting housing preferences, changing social demands of the Millennial generation and the urbanization of the retiring Baby Boomers. All of these trends could have had minor and/or short-term impacts on housing activity, but the magnitude of the decline goes well beyond such influences. Even if any or all of these trends could have depressed demand for single-family homes, the reality is that a proportional boom in apartments has not occurred. New construction of single-family homes has slightly greater than half the 50-year average over the past eight years, but new construction of apartments remained below the 50-year average for seven of those eight years.

One possible explanation for the protracted decline in starts is that the overhang of excess and troubled inventory was much greater than estimated. Still, the number of units built from 2008-2015 was almost 5.9 million units than the average for half a century prior. The more likely explanation for the state of housing construction is that the severity of the Great Recession allowed for an extended deferral of household formation for an unusual number of Americans. That suggests pent-up demand that should drive another housing boom within a few years, regardless of the economic conditions.

Dodd Frank regulatory burdens have limited mortgage lending well past the time that lenders were anxious to renew higher volumes. Subdivision development also suffered from the effects of the recession and the heightened oversight that doing land acquisition and development loans would bring. There is no measure of the level to which these issues have suppressed construction but the data suggests that demand cannot be held back much longer.

Demand for commercial construction, on the other hand, has been less constrained by factors other than economic health. After suffering losses in value in excess of 50 percent following the financial crisis, commercial property values have recovered completely, reaching record levels per square foot in many markets and categories. As would be expected, commercial real estate saw steady gains in occupancy as employment gained strength. Stronger performance and property values allowed the large number of commercial loans written during the frothy days of 2005 to 2007 to refinance as they matured five and ten years after origination.

The closer correlation to the overall economy means that commercial development is getting long in the tooth as the economy is in 2016. In addition to the dynamics of the apartment and hospitality segments, growth in retail and industrial development is also slowing. The office market is seeing above-average levels of construction in the first quarter of 2016, with demand still outstripping supply in a number of U.S. cities – including Tampa, Raleigh, Atlanta, Miami, San Diego, Phoenix, Washington DC and Pittsburgh. Development in some of the hot spots in the U.S. – Houston, Dallas, San Francisco, Seattle and San Jose for example – remains very active, but evidence is growing that the party is winding down in those cities.

Integra Realty Resources (IRR) looked at the commercial real estate property types in its 2016 Viewpoint report. One of its evaluations looks at the major U.S. markets and judges where those cities are in the lifecycle of recession to recovery to expansion and oversupply. Its findings concluded:

  • Nearly half the office markets are still in expansion mode, with 41 percent more than two years away from supply/demand balance.
  • All multi-family markets except one (Jackson MI) were in expansion, with 83 percent of suburban and 70 percent of urban markets in balance.
  • Retail markets were still in an expansion phase, with 63 percent of the cities recovering or expanding. The central and western regions of the country had more cities in recovery than other regions.
  • Expansion was still underway in 46 of 61 industrial markets, with no markets in the oversupply phase.

Like multi-family, most hospitality markets were expanding, with 75 percent in that phase. IRR forecasts that hospitality will begin to decline in 2017.

The consensus forecast from these commercial real estate observers, along with the economists for Dodge Data & Analytics and Construction Market Data, is that commercial construction should see another five-to-seven percent more growth in 2016. Even if a softer economy dampens demand earlier than expected, investors will continue to push supply higher. Yield from other investment vehicles simply won’t offer sufficient risk-adjusted returns and pressure to place cash in real estate will encourage development, even if demand for the space isn’t as robust.

Public construction has begun to emerge from an extended funk. Spending on public construction rose again in 2015, following an uptick in 2014. Long-term demographic trends are still unsupportive of revenues, at least until the next generation makes its move into home ownership, but the improved economy and labor market have given a boost to sales and income taxes that support state and local construction. And at the federal level, the long-overdue highway bill – known as FAST Act – will provide a reliable funding stream for repairs to highways and bridges through 2020.

In addition to the surface transportation funding, federal construction spending will also be driven by the extended period of deferred spending on government facilities that followed the expiration of the American Recovery and Reinvestment Act of 2009. Spending by the General Services Administration has increased during the past two years and more projects are in the pipeline to address obsolescence and space needs at federal offices and courthouses.

Beyond 2016, forecasts of greater public construction are built upon the assumption of continued economic growth of more than two percent, an assumption that looks less certain than it did six months ago. Political ideology battles will likely have a bigger impact on public construction than economic expansion, however. The growth of government debt and pension obligations have choked out room for capital spending without increasing revenues, which is at the heart of most ideological debates between the two major parties. There is inevitability to the ravages of time on the built environment, so maintenance and repairs cannot be deferred indefinitely.

One glimmer of hope on the revenue piece of the equation is the public response to referendum. The sample size is very limited but voters in a number of states have approved borrowing or revenue increases to support needed construction. In California, where referendum is the rule for major public bond programs, voters have said yes to as many as 80 percent of the projects on the ballot in recent years. That suggests that while Americans may be split on the concept of higher taxes, fees or debt, they are generally agreeable to such measures in practice in their own backyards.PublicBuildingStartsnonres five yearus housing sfd vs apts

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Surety Market Update – Spring 2016

Financial conditions for contractors continued to improve in 2015, making the year another healthy and profitable one for the surety industry; however, some significant individual losses, coupled with significant changes among the insurers is making the outlook for 2016 more dynamic than in recent years. Even with public construction making a comeback from almost a decade of under investment, buyers of surety bonds will be in the driver’s seat. That’s good news for contractors looking to add capacity or improve conditions but it’s worth noting that the construction industry has rarely benefited from a soft surety market in the long run.

Based on premiums and losses recorded through September 30, 2015, the total loss ratio for all surety companies is forecast to be around 17.5 percent for the full year. That’s the seventh year in the past ten that the industry’s loss ratio was below 20 percent. The benchmark for profitability is 25 percent so sureties should have prospered again in 2015.

“In January my partners and I jump on a plane or hop in a car and visit every one of the insurers we represent. We go see the decision-makers, the policy-makers, even though they may have an office in Pittsburgh,” notes Brian Jeffe, managing partner of surety bonds for agent Seubert Inc. “For the third year in a row the surety industry did well in 2015. [Surety] mirrors the construction industry. 2014 was better than 2015 and 2016 should be better than 2015. Losses are still well below 25 percent.”

Much of the credit for the strong loss ratio performance goes to simple market improvements over the past five years. As volume has returned, contractors were able to land profitable work that enabled them to work through any weak projects with fewer defaults. Surety underwriters obviously deserve a share of the credit. Proactive during the wrenching downturn in 2009 and 2010, sureties avoided repeating many of the mistakes that plagued the industry during the 2002-2004 recovery. It also helped the insurance business in general that the years since the Great Recession have seen far fewer major disasters like those that occurred between 2001 and 2005.

The need to recover from losses like 9/11 and Hurricane Katrina pushed sales ahead of prudence. That was reflected in high premium growth, which spilled over into surety premiums and surety underwriting standards. By comparison, 2015 premiums were roughly $4.5 billion, down almost 20 percent from the heyday, and up about two percent from 2014. That means there is still plenty of excess capacity and room for growing premiums. Conditions in the general property and casualty insurance market are even softer, with even more appetite for premiums. That has made for a buyer’s market.

“I’ve seen a couple of deals come through that surprised me in terms of rate and capacity, especially capacity,” observes Jeff Ream, executive vice president for Willis of Pennsylvania. “The property and casualty market is relatively soft.”

Still, few surety agents expect to see pressure for revenue impact underwriting. More to the point, the expected conditions for contractors should allow for growth even with the same underwriting standards.

“No one panicking to where they feel like they have to write everything,” says Jeffe, pointing out that being in Pittsburgh is an attraction at the moment. “Sureties are coming to us, wanting to take advantage of a good construction market. They like Pittsburgh because sureties have seen very few big losses here over the years.”

Although the industry is profitable overall and the outlook for publicly-bid work is positive, problems with several major insurers and consolidation among top insurers have caused turmoil among the sureties. There appears to be a yin and yang for every issue facing the industry but in general, surety bonding will be less predictable in 2016.

Among the factors impacting surety bonding is the continued fallout from a number of very large losses experienced in 2014 and 2015 from contracts awarded in 2010 and 2011. These losses caused the departure of XL Insurance from the surety market, taking with it $1 billion in capacity. Another of the industry’s bigger players, Zurich North America, experienced large write downs in surety and losses in it Subguard subcontractor default insurance (SDI) product that have changed its approach to the marketplace. In fact, the competitive dynamics of the insurance companies are having a bigger impact on the surety market than the usual concerns about construction volume and contractor finances.

In the case of the SDI market, increased competition in recent years pushed the threshold lower for the size of contractors for which the SDI product made sense. SDI is purchased by the general contractor in lieu of having the project’s subcontractors bonded individually. In the event of a subcontractor default, the general contractor files a claim with the SDI insurer, which then subrogates the claim to the subcontractor’s insurance. The advantage of default insurance over a bond is that the contractor has access to the cash to complete the work without the delays of defending the bond claim.

SDI was originally aimed at companies doing $750 million or more, but SDI market competition created opportunities for pricing that worked for companies with annual volumes of $200 million to $300 million. SDI competition broadened the base of contractors who get feasibly get coverage and increased the opportunity for default. Moreover, the kinds of prequalification that general contractors applied to subs were different from the financial prequalification that an insurer would do. Contractors focus on performance and experience; sureties focus on balance sheet and financial benchmarks that would produce different red flags. As a result, claims rose.

As market leader, Zurich was hardest hit and has taken steps back to revise the product by changing the coverage, capping the limit on any loss. They are re-launching Subguard and going through a transition in the market.

Subcontractor default insurance is still attractive to general contractors, who can also profit by pocketing reserves for claim deductibles if they manage risk well. Jim Bly, managing director for Alliant Construction Services Group, says that Zurich’s problems haven’t diminished the demand for SDI.

“The good news is that there’s a new SDI coming into the market through a [managing general underwriter] from California called Cove and Lloyd’s is going to be the carrier,” he explains. “They are coming into the market to fill the void or some of the void for business that Zurich couldn’t renew or had problems with.”

As the market leader, Zurich’s problems were having a significant ripple effect throughout the SDI market. Initially Zurich’s two other competitors, XL and Arch, were overwhelmed with requests for quotes from agents and effectively put a moratorium on new SDI business. That overreaction has settled down since then but Zurich’s problems clearly created the opportunity for another carrier.

Because of the emphasis on prequalifying subcontractors, insuring against subcontractor default isn’t going to decline. Bly says Alliant has a proprietary financial bench marking service, called Contractor Credit Model (C2M) that uses the analytical tools that sureties use to qualify subs and risk rates them for the contractors, assigning capacity limits for single projects and total capacity.

“We’re getting a lot of interest in that. Sureties are the best at prequalifying subs in the market. That’s what they do; it’s all they do,” says Bly. “People are hungry for that. There are other services in the market that are emerging because all the underwriting with sub default has been pushed out to the general contractor or CM and they are not really equipped for it.”

In addition to XL’s exit from the surety market, there are several other competitive situations that are creating a frothier surety environment. The January 2016 merger of Chubb Corporation and ACE Ltd. created the fourth largest surety in the market, with $700 million in business written globally. Industry observers expect the merger to make Chubb more growth-oriented than in past, as evidenced by its increase in participation with one client to $5 billion, which was only the second instance of a single insurer at that volume.

“They’re going to get a mandate to grow and Chubb had a tendency to keep its powder really dry. That will be worth watching,” notes Bly.

The loss of XL’s capacity in the market will also likely be negligible because of inflows of new capital into the surety insurance sector. Unsatisfactory investment returns and poor performance in other markets is driving new money into surety in the hopes of boosting return on equity.

Global giant Allianz is entering the U.S. surety market through its Euler Hermes surety business, bringing $500 million in capacity per account. Tokyo Marine purchased HCC Surety Group to add to its U.S. surety business, which it serves with Philadelphia Insurance Group. The move makes the combined companies the equivalent of the sixth largest surety. Nationwide, which opened surety lines in 2014, is expecting to aggressively expand its business and offers $200 million in single-project capacity and $400 million aggregate capacity. Commercial surety companies have grown construction surety profitably and are expected to continue expanding capacity. Names like ARGO, Berkeley and One Beacon are each capable of adding $150 million in capacity.

Experienced surety professionals see the changes in competitive landscape as potential precursors to increased problems. Even without the new capital, utilization of surety capacity was inconsistent and less than potential. The addition of insurers that will immediately be among the ten largest sureties is likely to have some liberalizing of underwriting standards so that new capacity can be utilized. History has shown that such market dynamics can influence underwriting flexibility about pay on demand capacity, security and indemnification in the pursuit of market share.

“Stay tuned. Fasten your seat belt,” jokes Bly. “It’s still relatively soft but if anything, the needle is starting to move towards potentially hardening the market if the losses continue.”

At the Pittsburgh regional level, the biggest negative factor for surety bonding is the continued high level of competitive bidding. Prior to mid-2015 the bridge and highway market was mired in below average volumes for three or four years. School districts have been faced with slumping demographic support, political pressure against raising taxes and two separate moratoriums on the PlanCon process by two different governors. All of these factors have limited school construction volume. For more than a decade, both the city of Pittsburgh and Allegheny County have drastically under investedin capital spending due to fiscal crises. Some of the frozen conditions began to thaw in 2015 and the taps should open wider in 2016 for public construction, but the pressure to get work hasn’t abated yet.

“It’s still very competitive. Contractors just don’t have backlog and backlog is life,” Jeffe points out. “They don’t have backlog like they did coming into 2008 and 2009, so bidding is still very tight to build backlog.”

There are significant increases in spending on highways and bridges planned for 2016 and beyond. Some $700 million more will be spent in PennDOT District 11 for example.

Brian Jeffe has seen plenty of early signs that 2016 will be a year of further improvement and says Seubert is counseling clients to avoid the trap of filling up on the first course of the meal.

“Seubert had the best January and February in its history. We’re writing 80 bid bonds a day,” he explains. “We’re preaching to be patient, be margin hunters. The opportunities will be there.”Surety Trend 2015