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By Frank Byrt
January 21, 2008

With its prospects tied tightly to the availability of credit, the construction industry is bracing for a nerve-wracking 2008. Residential construction is on the ropes in the wake of the subprime mortgage meltdown, while the commercial side of the business is starting to show cracks in its foundation as financing for new projects dries up.

Given the construction industry’s roughly 10% contribution to gross domestic product, its problems are likely to affect everyone from nail-bangers and building materials suppliers to truckers and home-goods retailers.

Still, there are silver linings for some. If supply in the office sector outpaces demand, as some anticipate, it could result in more reasonable lease terms for companies in other industries looking to tighten their belts in an economic downturn. And builders capable of taking on government infrastructure and industrial projects, particularly in the energy and chemical industries, are said to be holding their own. Infrastructure investment has become increasingly attractive to many corporations and institutional investors.

The general construction industry’s woes may be just beginning, however. ¨The building materials people are the canary in the mine, and they started scaling back during 2006 and 2007¨ in expectation of the residential building slowdown, said Vicki Bryan, senior high-yield debt analyst for the credit rating firm Gimme Credit. ¨And now commercial [construction] has started to slow all over the country.¨

¨I see lots of failures as part of this cycle in a snowball effect¨¨—ranging from lenders and developers to building suppliers¨—before the market starts to recover in 2009 from a trough reached later this year, Ms. Bryan added.

A report from Reed Construction Data last Thursday supported her take on commercial construction.

Non-residential building starts in the fourth quarter of 2007 fell 17.6% from the third quarter, it found, and ¨this decline was more than the usual seasonal decline at the beginning of the winter... Starts of commercial buildings in 2008 will be restrained by higher financing costs, tighter credit standards and subpar growth in the economy already under way.¨

But some think the commercial side’s downturn will be short-lived. Robert Murray, McGraw-Hill Construction’s chief economist, said that while he expects the residential housing sector to continue its steep decline in 2008, the commercial construction industry ¨will basically be settling back from the elevated levels of construction seen from the 2005 period on.¨

That’s because fundamentals, particularly for office space ¨are still in good shape,¨ he said. ¨So, the decline in non-residential [construction] will be measured and not precipitous.¨

There are those, however, who think that the impact of the credit crunch on the commercial sector has yet to be felt, as the prospects for new building projects getting financed are rapidly waning.

¨We’ve seen a pullback in construction lending¨ as more and more banks and commercial lenders pull in their horns in anticipation of an economic slowdown, said Josh Zegen, managing partner and cofounder of Madison Realty Capital, a New York-based private commercial real estate lender. Lenders are also keeping a tight leash on projects already under way.

Among the most recent causes for concern is weakness in the office market, which has been one of the fastestgrowing and most profitable commercial sectors over the past five years. CB Richard Ellis said last Thursday that, nationally, office vacancies rose to 12.8% in the fourth quarter of 2007, up from 2006’s year-end rate of 12.6%.

Although that’s not a big change, it comes at a time when much more space is coming to the market, and that could result in oversupply. Reis Inc., a New York real estate research firm, reported that more than 19 million square feet of new office space was completed in the fourth quarter, the most since the fourth quarter of 2000, while about 75 million square feet of new office space is scheduled to be completed this year, up from about 53 million square feet in 2007.

The picture is brighter for builders in the infrastructure sector. Jim Haughey, chief economist at Reed, said that since builders of power plants and oil refineries can’t meet demand, prices have been soaring 20% to 30% annually.

One company benefiting from that is Shaw Group, based in Baton Rouge, La., a builder of big commercial and governmental projects worldwide. Last week, the company, whose revenue increased 20% last year to $5.7 billion, forecast similar growth for 2008.

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