Tuesday, May 13, 2008

Non-Residential Investment Overview

by Calculated Risk on 5/13/2008 01:00:00 PM

Here is an overview of non-residential investment and commercial real estate (CRE) from our most recent newsletter.

Recently many companies have announced plans to cut capital spending in 2008. This probably means non-residential fixed investments will decline in 2008, as compared to 2007.

This decline in investment is an important indicator for the economy, since changes in fixed investment correlate very well with GDP. The first graph shows the change in real GDP and Private Fixed Investment over the preceding four quarters through Q1 2008.

Private Fixed Investment vs. GDP Click on graph for larger image.

The red line is the year-over-year change in fixed investment, and the blue line (scale on left axis) is the year-over-year change in GDP. Correlation is 79%.

A decline in residential investment is one of the best indicators of a future recession, and that has been flashing a recession warning for some time. Now some of the focus is on non-residential investment, especially on commercial real estate, to determine if a recession has started.

The second graph shows two components of private fixed investment: residential (shifted 5 quarters into the future) and nonresidential structures.

Investment in non-residential structures vs. Residential Investment This graph shows something very interesting: in general, residential investment leads nonresidential structure investment. There are periods when this observation doesn't hold - like '95 when residential investment fell and the growth of nonresidential structure investment remained strong.

Another interesting period was in 2001 when nonresidential structure investment fell significantly more than residential investment. Obviously the fall in nonresidential structure investment was related to the bursting of the stock market bubble.

However, the typical pattern is that residential investment leads non-residential structure investment. The normal pattern would be for investment in non-residential structures to have turned negative now.

There is plenty of evidence of an imminent slump in non-residential structure investment. Research firm Reis recently reported that the strip mall vacancy rate have risen to 7.7%, the highest level since 1996. For offices, the vacancy rate has risen to 13.6% nationally according to Grub & Ellis, and they expect the vacancy rate to rise sharply:

“With demand turning negative at the same time that the construction pipeline will deliver the 94 million square feet still underway, [office] vacancy is expected to peak at 18% by the end of 2009.”
Grubb & Ellis economist Robert Bach, April 2008
CRE Loan Demand vs. Non-residential Investment Structures The Fed survey in April of Senior Loan officers provides further evidence of an imminent slump. The April survey showed an increase in tighter lending standards for Commercial Real Estate (CRE) loans. This graph compares investment in non-residential structure with the Fed's loan survey results for lending standards (inverted) and CRE loan demand. This suggests investment in non-residential structures should decline soon since lending has tightened considerably.

Another indicator is the architectural billing index from the American Institute of Architects. From the AIA (emphasis added):
“[T]he Architecture Billings Index (ABI) dropped two points in March and fell to its lowest level since the survey’s inception in 1995. As a leading economic indicator of construction activity, the ABI shows an approximate nine to twelve month lag time between architecture billings and construction spending.”
AIA Architecture Billing Index Clearly the CRE slump is here. Now the question is how deep and how fast CRE investment will decline. One way to think about this is to look at previous declines in non-residential investment.

The following graph shows non-residential investment in structures as a percent of GDP since 1960. Over time there has been a decline in spending (as a percent of GDP), probably related to globalization (more factories were being built overseas).

Non-Residential Investment as Percent of GDP The non-residential investment boom related to the S&L crisis (and energy investment) is obvious on the graph, and we should probably ignore that period when looking at a typical CRE bust.

The two light red circles show the investment busts during the '90/'91 and '01 recessions.

The decline in non-residential investment was fairly rapid during the previous two recessions (a decline in non-residential investment is usually more rapid than a decline in residential investment). In fact most of the decline in investment happened within four quarters.

During the '90/'91 investment slowdown, non-residential investment declined 17% in total, and about 14% in the first year. For the '01 investment slowdown, non-residential investment declined almost 20%, and 19% in the first four quarters.

It is very possible - based on tighter lending standards that the decline in non-residential investment will be greater (on a percentage basis) than the previous two busts. However, based on commercial vacancy rates, it doesn't appear that some segments of commercial are as overbuilt as in the '90/'91 and '01 periods.

These two factors somewhat balance out, and my guess - based on these two previous busts - is that non-residential investment will decline about 15% to 20% over the next four quarters, from a $501 billion seasonally adjusted annual rate (SAAR) in Q4 2007, to about $400 billion to $425 billion in Q4 2008 - and that most of the bust will happen during 2008.
Read on ... there is MUCH more!