All things relative, 2017 finds the construction industry doing quite well. The industry has largely recovered from the Great Recession and is moving forward. Construction in the United States has historically been considered a highly cyclical activity. Beginning in about 1991, suddenly, cyclicality seemed suspended. The tech bubble and the associated recession of 2001 were not felt by most industry enterprises.
Generally, the entire industry had an unprecedented up cycle that lasted from 1991 until 2008. Our view is that this kind of extended up cycle is not likely to repeat itself. So, what the industry is experiencing right now will not last forever, but it will probably be several more years before the construction industry faces severe headwinds again. We believe this projection will hold, even in the face of a likely U.S. recessionary period in the near term.
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The construction industry generally constitutes somewhere between 6 to 9 percent of gross domestic product. In 2008, this was approximately 9 percent, whereas in 2016, it was only 6 percent. The question arises as to whether the industry has lost its place in the broader economy. However, half of this percentage reduction is attributable to housing, which has been an anemic part of the overall recovery. One of the reasons that this economic recovery has never “felt good” for the public is because it is the first time in modern history when an economic recovery was not led by housing. That has been highly contributory to the unstable and uneven recovery pattern that we have seen since 2008.
However, put-in-place construction has returned to almost $1.2 trillion, which was where the industry left off in its 2008 peak. Momentum in the industry is good, and most markets are experiencing positive growth. Over the long haul, the industry only grows at an inflationary rate. In 2015, the industry experienced 11-percent growth, which indicates that we were on the “ramp-up” part of the cycle. We expect growth for 2017 to cool to about 5 percent. So, the growth rate may be decreasing as we move forward, but it is still positive. Most vertical markets are growing at anywhere from an inflationary rate to rates as high as 7 to 8 percent. There are a few shrinking markets, but they tend to be the exception.
The industry is being buffeted by a number of important macro-level trends. These trends have already reshaped the industry and will continue to do so in 2017. While there may be some short-term pain for some industry players adjusting to the impact of these trends, they are likely to lead to an improved industry structure. This will have a net effect of improving conditions for most companies. Technology applications continue to proliferate, as do changes to delivery methodologies and various innovations improving the productivity and efficiency of the construction process.
While these phenomena are not new, both technological innovations and delivery innovations are accelerating at such a pace as to make it a challenge to keep up with the possibilities. The U.S. economy is in a state of revolution, probably analogous to the industrial revolution of the 1800s. The U.S. construction industry is as well. The next 10 years should see dramatic changes and improvements in how work is done. These same changes are also likely to change the roles of various industry service providers, and very likely will reorder the “food chain” of service providers.
Societal and demographic changes will be altering the context in which the industry performs. The millennial generation is the new driving force in society, and will continue to be so for the next 20 years or so. To the extent that they become involved in design and construction-related matters, millennials are probably going to be less accepting of construction’s status as a “laggard” industry.
It will also be virtually impossible for them to reinvent the experience of their forbearers before taking the helm of decision-making roles. Millennials will most likely be driving and demanding changes in the way business is done, most of which will likely be positive.
The overall economic indicators in the industry are sending positive signals. The Engineering News-Record Top 400 Contractors tend to increase their market share during recessionary periods, and this past recession was no exception. In 2010, the Top 400 Contractors performed over one-third of the market, or 35 percent. This was still at 32 percent at the end of 2015. The good news is that contractors of all sizes have seen margins return, as have engineers, designers, materials providers and other industry players.
Using contractors as an example, general builders averaged a pretax, net profit of as low as 1 percent at the height of the recession, and that average pretax net profit is now reported at 2.5 percent. The margins of specialty trade contractors, heavy highway and heavy civil contractors are ranging from 4 to 6 percent and even higher. Of course, even in good times, no one ever thinks that the margins are high enough. However, the returns on capital employed in the industry can be quite strong. Return-on-capital metrics are generally one of the best pieces of economic rationale associated with many companies in the industry. For those who can manage and mitigate the risk, the returns are at levels that are difficult, if not impossible, to find anywhere else. Reported average returns on equity capital now are ranging from 18 to 30 percent. Of course, they should, given the risk involved.
More than anything else, construction industry activity is driven by population trends. We continue to see general migrations of people to the Southeast and to the West. We have also identified 10 megapolitans that exist throughout the U.S. These tend to be large, mostly urban areas that benefit from population density, intermodal transportation access and, in most cases, access to deep-water ports. We are also seeing a significant migration of midsize and large, self-performing, union contractors looking to move to different geographies, where they can set up merit or open-shop companies. There has been some continued erosion of union activity around the fringes of certain large cities, such as New York. However, for the most part, the union/nonunion picture remains relatively static.
We estimated that 2016 closed with power, highway and street and education being some of the largest volume sectors put in place. On a percentage basis, lodging, office, amusement and recreation and power will all do well. Some of the weaker percentage markets include public safety, water and wastewater.
From a macro view, the market trends are generally good. Most forms of construction are underfunded, and, therefore, undersupplied, and have been for some time. As a result, we see few examples of supply/demand imbalances, and thus a positive, intermediate-term outlook.
Of course, our world remains in a state that the military refers to as “VUCA,” which stands for volatile, uncertain, complex and ambiguous. Despite this overall context, we see certainty in many of the trends impacting the world as it relates to construction activity. Globalization is one such trend. Design-related activity is most easily transportable, and cross-border activity in that world continues unabated. The entry into the U.S. market of foreign contracting enterprises has now been going on for 25 years, and increasing over that time. While we see more U.S. contractors participating in international markets, the impact on the U.S. construction industry by foreign entrants is perhaps the most significant trend overall.
We now have 7 billion people on planet Earth, and this is projected to grow to 9 billion by the year 2030. The U.S. will have commensurate gains in overall population. The rise of the middle class and the continued movement of population to urban centers are global trends, but also very specific in their impact in the U.S. market.
Most of the foreign companies that have entered the U.S. are very large, multibillion-dollar, global corporations. Combined with the rise of more megaprojects in both infrastructure and building, the impact of these companies has been, in effect, to stratify the U.S. construction industry. The industry has always been highly fragmented, and its essential disaggregation does not really make it possible for it to be consolidated, in the pure sense. Too few forms of construction have significant entry barriers to facilitate consolidation.
What has happened, though, is what we call bifurcation; a trend that has, in effect, restructured the industry. We now find a situation where at one end of the market, scale actually matters because of what large corporations can bring to bear in terms of intellectual capital, service optionality and the ability to provide turnkey project delivery. On the small end of the market, there continues to be localized and nimble companies that can compete effectively. There will continue to be midsized companies, although we expect that there will be fewer of them and they will be more challenged in their overall ability to develop a competitive strategy and position.
Sustainability and green building-related trends will continue. Designers and owners are all keenly interested in this area and, of course, drive many decisions in the industry. The emerging millennial generation is attracted to environmentally friendly causes, which will keep the interest in developing this trend at a high level. Technology and productivity improvement initiatives will combine. The import of lean manufacturing principles into the construction process is an example of the ongoing interest in better delivery.
Future delivery of design and construction will also take place in a dramatically changed societal context. Most baby boomers grew up in an era of the “traditional” household, in which fathers worked and mothers generally stayed at home to take care of children. Today, only 7 percent of U.S. households operate that way. Almost half of today’s workforce is single, and almost one-third of all homes have only one person living in them. In various forms of professional endeavor, such as law and medicine, females make up over half of the degrees awarded. The construction industry is lagging here, but we expect that diversity will be increasingly on the agenda of companies, and that the composition of the workforce will finally begin to demonstrate this over the next decade.
One of the most significant phenomena at play in construction right now is the mass wave of retirement facing the industry. Owners of many firms are reaching the ages where they need to consider their exit strategy and/or what will happen to their companies. As an industry, we have to be asking: “Who is going to own, lead and manage design, construction and related enterprises 10 years from now?”
We see a dramatic failure to plan adequately for these issues, especially in the midmarkets and in the smaller end of the market. It is surprising how large some of these companies can become without having a well-addressed, viable plan for the orderly transition of ownership and succession of management. Selling construction-related businesses to a third party is actually not possible for most firms. The vast majority of firms are well served to develop an internal transition plan. In our experience, these plans take at least a decade to be developed and thoroughly implemented. Because this planning is not adequate in many places, we expect that the next 10 years is likely to see numerous liquidations, especially on the small end of the market.
Almost 40 years ago, revered Harvard management strategist Michael Porter published what he called his “five forces” of evaluating industry attractiveness. Barriers to entry, bargaining power up the food chain and down the food chain, degree of rivalry and how easily an individual firm can be substituted were forces that determined industry attractiveness.
We believe there is an emerging scenario where many of these forces may be improved because of industry restructuring. Improved overall structure could mean a brighter future for the U.S. construction industry long term. Meanwhile, short-term conditions are good, and we believe they will stay that way for a while. As the old saying goes, this is a good time to “make hay while the sun shines.”