In our last update on the residential construction market in September 2022, the Global Insights Center flagged a likely slowdown and weakness in housing. Since then, our outlook has turned slightly more optimistic. Today, we'll also cover the nonresidential construction market before discussing the implications for regional banks.
Residential Construction Outlook
Residential construction grew at a healthy rate following the global financial crisis.
Up until the onset of COVID-19, the housing market and residential construction were showing healthy and steady improvements. In August 2010, the U.S. transacted 3.962 million housing units on an annualized basis. This included 282,000 new home sales (construction) and 3.68 million existing homes. The average price of a new home was $268,800, and an existing home was $177,300.
By December 2019, total transactions grew to 6.143 million units consisting of 693,000 new home sales and 5.45 million existing homes. This was cumulative growth of over 55% in transaction volumes. New home prices rose by 40% to $377,700 and existing home prices were up 54% to $274,500.
Shifts during the pandemic fueled strong demand for housing and construction.
COVID-19, however, disrupted many of these trends. The Federal Reserve moved to lower interest rates to a band of 0 to 25 basis points, which caused mortgage rates to tumble to less than 3.00%. Remote work provided people the ability to move to new areas. And strong equity markets fueled a “wealth effect," enabling home buyers to fund more expensive home purchases.
As a result, by October 2020, transaction volumes spiked to 7.587 million units including 1.027 million new home sales and 6.560 million existing home sales.
Starting in 2022, rising interest rates softened the residential construction market.
By March 2022, inflation was far outpacing initial expectations; the Federal Reserve raised rates at 10 successive monetary policy meetings. At one point, the Fed delivered four back-to-back 75-basis-point rate increases. The 30-year fixed mortgage increased to over 7.00%. The speed of the tightening caught markets off guard.
Higher borrowing costs naturally dampened the housing market, and transaction activity slowed. By the end of 2022, 4.666 million homes were sold, including 636,000 new homes and 4.030 million existing homes. However, price points were elevated: The average new home was $568,700, up 50% from just before the pandemic.
The slowdown in activity led us to conclude that housing construction would likely see headwinds, even if price points did not fall. The National Association of Home Builders' (NAHB) survey tumbled to a reading of 31 by December 2022—a figure below 50 indicates weakness.
Now, headwinds may be abating, and the residential market is starting to improve.
Looking ahead, we are cautiously optimistic about the outlook for housing demand and construction. Even though the Fed may raise rates again, the hiking cycle is closer to its end than its beginning. This is likely providing some clarity to potential home buyers. It's unlikely that mortgage rates will raise significantly higher, even if the Fed hikes further, because the mortgage market has largely priced in the Fed's future trajectory.
Quantitative Tightening (QT), however, remains a risk. During COVID-19, the Fed began to purchase U.S. Treasury securities to infuse liquidity and further lower interest rates in the market. Now, the Fed is running down its portfolio of Treasury securities, which is expected to drain liquidity in the banking sector. This in turn could continue to tighten credit conditions even after the Fed halts the rate-hiking process.
Still, the housing market has shown signs of promise in recent months. By May 2023, transaction volumes increased back above 5.0 million units, with new home sales at 763,000 and existing at 4.300 million. The number of housing starts and building permits also increased, and the NAHB index was back above 50 to a reading of 55.
Construction activity in the residential segment should improve, though tighter credit conditions could cause friction.
We anticipate housing demand to remain healthy, though the significant uptick in demand observed during COVID-19 is unlikely to return. Interest rates may remain elevated, but increased certainty and less volatility should help allay concerns for buyers.
Still, higher borrowing costs will likely impair affordability. Buyers may have to downsize to accommodate their monthly spending limits. Home price growth may flatten slightly in the elevated interest rate environment. If the Fed cuts rates later in 2024, we may see further uplift in demand and thereby an increase in transactions and construction activity. Some of this may already be transpiring, with consumers buying homes with the intention to refinance in 18 months when rates presumably decline.
But ultimately, QT could play a spoiler. If credit conditions tighten due to a reduction in the Fed's balance sheet, then the some of these trends could be disrupted as builders and buyers are unable to acquire loans at affordable levels.
Nonresidential Construction Outlook
Nonresidential construction spending has grown sharply this year, in part due to geopolitics.
Nonresidential construction has a slightly more optimistic outlook, with some caveats. Capital deployed for nonresidential projects is up nearly 25% year-on-year (YoY), compared to -10% YoY for residential. Within the nonresidential category, both public and private sector projects are witnessing strong growth. Geopolitics is likely playing a role in these trends.
U.S.-China relations continue to deteriorate, and a series of policies and laws are aimed at restricting technological linkages between the nations. For example, the U.S. has banned the export of technologies and products that could strengthen China's semiconductor industry. Western businesses are increasingly worried about the concentration of semiconductor manufacturing facilities in Taiwan. If a China-Taiwan conflict were to emerge, the world's supply of semiconductors could be at risk.
Accordingly, both the U.S. government and businesses are eager to boost U.S. manufacturing of semiconductors. We are witnessing a significant uptick in capital expenditure deployed towards the construction of manufacturing facilities. Spending on manufacturing construction is up over 100% YoY to nearly $190 billion.
Stimulus funding has also bolstered nonresidential construction.
A series of government spending initiatives intended to boost economic performance during COVID-19 are likely finding their way into the market. Some of this money may be incentivizing private sector development, and infrastructure projects are also starting to see significant capital deployment.
For example, spending on highway projects is up nearly 20% YoY, while transport is up 14%. Lodging is up 40% YoY, likely due to the strong growth in travel and tourism demand as U.S. consumers shift back from goods to demand more services.
Even spending on office space construction is up 14% YoY, but this is one area of concern. Demand for office space may weaken, and the commercial real estate price index is below last year's levels, according to Green Street Advisors. While some of the spending in this area may be on account of projects already under development, there are worries that there may be too much office space capacity in the near term. As a result, valuations may fall, which could lead to lower construction demand.
On-the-Ground Developments from The Hartford's Surety Team
Project backlogs loom for contractors; even as construction prices normalize, some products remain elusive.
Given the strong tailwinds in the nonresidential construction sector, The Hartford's Surety department notes that in the near term, many of its customers have a large backlog of projects. Many of these projects need to be completed before customers take on new bonding.
The medium-term outlook varies. Data from the Global Insights Centers suggests that products and building materials for construction are increasingly available, helping goods inflation normalize across the board. But availability is not evenly distributed, leaving pockets of challenges. Clients of the Surety department have flagged delayed deals with switchgear, generators, valves, and certain steel components, all with lengthy lead times.
Our data also indicates that overall labor conditions remain tight. Construction labor is at a historic high and thus in ample supply, but specialized labor is likely lacking. Within the general construction labor pool, training standards and efficacy may vary. Nuestra página
Surety clients also flag labor challenges as an ongoing issue they continue to manage.
Higher interest rates and slowing demand for retail and office space could affect the commercial real estate sector.
The elevated interest rate is also a major source of concern for the industry. Multifamily—and in particular commercial real estate (CRE) properties, defined by retail of office rental properties—are expecting to see a rise in balloon payments over the next few years. Overall debt servicing costs are set to rise.
While multifamily rents can absorb interest rate hikes, especially given the recent rise in rents, CRE properties will likely have a harder time absorbing the additional debt servicing costs given the rise in vacancy. This means a likely slowdown in new CRE projects. A slowdown could be further exacerbated if the Fed increases reserve requirements for banks, which would increase the cost of capital for these projects.
These concerns are likely specific to CREs. After all, we've observed a large increase in funding for other forms of commercial construction, similar to manufacturing centers and infrastructure.
General contractors may see increased competition for fewer projects.
A slowdown in CRE construction would likely affect the overall commercial construction landscape. The Surety team's commercial building general contractor clients are planning for fewer projects in 2024 and 2025. They also anticipate more competition: As their backlogs wind down, these contractors may seek to expand geographically for market share, thus increasing the number of bids on a smaller pool of projects. This could dampen general contractors' revenue potential.
Bottom line, CRE projects may slow while non-CRE projects will likely see growth. Collectively, this should slow the commercial construction projects in aggregate. The residential housing market, as noted previously, is starting to improve. But overall, as backlogs clear and competition increases for new projects, this could drive down revenue potential for contractors.
Implications for Regional Banks
Remote work coupled with higher interest rates could give rise to higher carrying costs and compressed margins for CRE portfolios.
Our Financial Lines team continues to closely track the concentration of commercial real estate loans as well as the performance of banks loan portfolios, specifically on non-conforming home loans and any exposure to CRE loans. Loans issued against commercial or residential real estate on an adjustable rate have likely been impacted by the Fed's series of interest rate increases over the past year.
The Finance Lines team believes that loan terms on a bank's CRE portfolio should be reviewed to determine the quantum of maturities due over the next 24 months and ascertain potential risk stemming from refinancing at a higher rate. Remote work has likely dampened demand for CRE, which in turn could reduce a tenant's office footprint, thereby adding more real estate capacity to the market. As a result, a real estate owner's margins could be impacted as occupancy rates fall. In such an environment, as interest rates rise, so too will carrying costs. This could increase the potential for loan defaults, or at a minimum, portfolio valuations.
Adequate financial analyses are necessary for prudent risk management.
These factors make it all the more important to closely monitor non-performing loan metrics and loan delinquency rates for various banking institutions to identify any budding concerns. The Financial Lines team believes that banks themselves should also maintain diligence in their lending processes, including monitoring lending activity and loan qualification discipline.
Overall, dynamics in the construction market are likely to present opportunities and challenges for both the Surety and Financial Lines products. Monitoring changes in the industry, and in particular in the interest rate environment, can help provide appropriate solutions to risk management as it pertains to construction and the banking sector.
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