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United States Construction Industry in Death Spiral

Economics / Recession 2008 - 2010 Jun 16, 2010 - 02:51 PM GMT

By: JD_Rosendahl


Best Financial Markets Analysis ArticleHow bad are things in the construction industry? Worse than many really know as Housing Starts in U.S. Fell to a 593,000 Pace in May

June 16 (Bloomberg) -- Builders broke ground on fewer U.S. homes in May than anticipated after the expiration of a government incentive.

Housing starts fell 10 percent, the biggest decline since March 2009, to a 593,000 annual rate, from a revised 659,000 pace in April that was less than previously estimated, Commerce Department figures showed today in Washington. Building permits, a sign of future construction, unexpectedly fell to a one-year low. Single-family starts suffered the largest drop since 1991.

Construction of single-family houses slumped 17 percent, the biggest drop since January 1991, to a 468,000 pace in May. Permits declined 9.9 percent after a 10 percent drop in April. Work on multifamily homes, such as townhouses and apartment buildings, jumped 33 percent to an annual rate of 125,000.

Last Monday I had coffee with a client. He's a sub-contractor with gross revenues down from $20 million at the peak to something between $5-8 million currently. He's had to trim staff from 200 plus to something less than 50 and keep a lot of other employees on call to keep costs down.

We were discussing his business and the industry.   He said, "The construction industry has been, and still is, in a death spiral." He voiced some interesting concerns why the industry is still headed the wrong way.

Financing: He said, "There's new business ready to go with projects to be built, but no one can get construction financing to get these new projects going. Even large publicly traded companies are finding it hard to get construction loans."

He's absolutely correct. Getting a construction loan is next to impossible. Construction lending is one of the lending areas that got so many banks shut down by the FDIC. Banks have no desire in this world to finance a new building if the loan payoff is tied to the speculative sale of units or lease up of space.

There's too much inventory for sale or lease.  No bank wants to end up owning a building in this environment. 

There's too much risk in hoping a building project will eventually sell units or lease out units, and payoff the construction loan. Only the most AAA projects and platinum of borrowers with large cash equity in a project will get construction financing. Those situations today are indeed rare. Yes, bank lending standards are impacting the construction world intensely.

Second: He then said, "Real estate is still not moving, which is impacting the industry." He discussed a particular large condo project he's been working on for years that shut down in the middle of the project as the owner went out of business and the bank now owns the project. In this project, only 3 of the 7 large condo towers have been completed. The remainder of the project is on hold because they can't sell units.  At the peak, these condo units were supposed to sell for $700,000.  Now existing units list for sale at $280,000 and they still aren't moving.

Again, this is one of the reasons banks have little to no appetite to lending. If an investor or developer can't sell real estate, then neither will the bank if they own it. Banks aren't interested in the speculative risk of selling real estate. They are more likely to finance smaller owner occupied real estate to very strong clients.

Lastly: He said, "There are many competitors that have closed shops, or scaled so far back they are barely in business, and many hang by a thread of survival.

We've already seen contractors and sub-contractors go out of business mostly due to a contraction coupled with too much debt.  There's another wave of contractors on the verge of failing and going out of business because there's not enough business, and they've had a hard time scaling back expenses as fast as the contraction in business.

As long as real estate sales and financing remain in the current status, I can't imagine how improvement will come to the industry because real estate sales and financing are what keep the pulse of the business going.

Absolutely, the construction industry is in a death spiral. It will force more companies within the industry to close. It will force wages to decline within the industry (wage deflation), so those remaining companies can remain competitive and obtain the little work that does exist and turn a profit. Profit being the only reason to be in business, otherwise you're just wasting time and capital.

The industry shows no signs of improving. The construction industry is a leading indicator of economic health. Given the death spiral, why would anyone believe in the nascent recovery?

Hope all is well.

By J.D. Rosendahl

J.D. Rosendahl was a former stock broker/investment consultant (currently not licensed) before becoming a Commercial Banker for the past 14 years. He manages his family's wealth, helping them avoid the high tech bubble and the real estate bubble melt downs and preserving wealth.

© 2010 Copyright J.D. Rosendahl - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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