Industry. Construction Insider EDB Sonoma County

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1 EDB Sonoma County Economic Development Board Industry Construction Insider 2009 E c o n o m i c D e v e l o p m e n t B o a r d C o l l e g e A v e n u e S u i t e D S a n t a R o s a C A

2 EDB Sonoma County Economic Development Board With Acknowledgment and Appreciation to Local Key Businesses Supporting Sonoma County Economic Development: Chairman s circle: Underwriters: County of Sonoma Board of Supervisors County of Sonoma General Services, Real Estate Division Sonoma County Health Services Sonoma County Transportation & Public Works

3 2009 Construction Insider September 2009 The Sonoma County Economic Development Board (EDB), in partnership with the Sonoma County Workforce Investment Board (WIB), is pleased to bring you the September 2009 Construction Report. Our research partner, Moody s Economy.com, produced much of the research for this report. The Sonoma County housing market may be close to bottoming out; the local peak-to-trough price correction is predicted to exceed 50%, or 15% more than the national average. However, the increase in housing affordability has spurred rising home sales, which provides a bit of relief to the influx of foreclosed homes on the inventory-heavy market. Operating expenses have moderated significantly; demand for energy and building materials has declined with the global recession. Builders are spending less on material transportation and heavy machinery operation, thanks to lower diesel fuel prices. Falling interest rates are assisting an increase in refinancing activity. The conventional 30-year mortgage rate has fallen roughly 1% since last summer. In addition, the Federal Open Market Committee s purchase of $300 billion in longer-term Treasury securities will further help lower mortgage rates. The number of residential construction permits has fallen more than 90% since its peak. Residential construction has fueled the decline in the local industry, due to the steep drop in Sonoma County housing prices. Sincerely, Ben Stone Executive Director 2009 Sonoma County Economic Development Board. The Economic Development Board (EDB) believes all data contained within this report to be accurate and the most current available, but the EDB does not guarantee that this report is accurate or complete. This publication can be made available in alternative formats, such as Braille, large print, audiotape, or computer disk. Requests can be made by calling (707) Please allow 72 hours for your request to be processed.

4 Recent Trends. Construction has been one of the hardesthit industries in Sonoma County during the recession. The industry is still far from turning the corner, although it has deteriorated more slowly recently. Residential construction is still leading the decline, due to the steep drop in local house prices. The county s median existing single-family house price has already fallen by nearly 45% since its peak in the middle of 2005, compared with about 25% for the U.S. Sonoma County s residential construction permit issuance plunged by about 90% since its 2005 peak and has been flat in recent months. Such a weak pace of homebuilding and improving home sales have helped the inventory of unsold houses fall moderately over the past year. However, the housing inventory is still well above its pre-housing boom level, according to the California Association of Realtors. The broad deterioration in mortgage credit quality is also constraining demand for housing. Nonresidential construction held up after the initial onset of the housing correction, partly offsetting the drop in homebuilding. However, the recession has prompted a sharp pullback in business investment in structures, and tight credit markets are keeping a lid on nonresidential building. As a result, nonresidential building has almost completely halted in Sonoma County in recent months. Macro Drivers. The recession, which is the worst since the Great Depression, is beginning to wind down. While the national unemployment rate is approaching 10%, retail, vehicle and home sales are stabilizing after free-falling in the last quarter of The deterioration of business and consumer confidence has also slowed, giving hope for a slight increase in U.S. GDP as soon as the third quarter of this year. The federal government s $787 billion stimulus package is helping to turn around the U.S. economy. To date, the stimulus has mainly helped by forestalling bigger job and program cuts by state and local governments. In future quarters, the stimulus will be contributing increasingly larger amounts of GDP growth as stimulus-related programs go into effect. Despite the additional economic growth provided by the stimulus, U.S. GDP growth will remain below 2% until the second half of Interest rates have eased in recent months, helping to fuel refinancing. The conventional 30-year mortgage rate fell from above 6% in the summer of last year to below 5% until recently. As a result, refinancing applications earlier in the spring reached their highest levels since In March, the Federal Open Market Committee announced that it would purchase $300 billion in longer-term Treasury securities. These monetary policy steps have provided a boost for would-be homebuyers in Sonoma County and will increase demand for the builders of new houses in the future. 2 Sonoma County s labor market has contracted at a much faster rate than the rest of the state or the nation. This will weigh on consumer conditions, reducing demand for both housing and retail space. Meanwhile, financial services have been one of the hardest-hit industries, reducing the total number of offce workers in the county and driving down demand for offce space. On the upside, food manufacturing employment has declined relatively gradually, because of sturdy consumer demand for reasonably priced wine. This will mitigate the downturn of the industrial market. House prices and sales began declining in 2006, but the backlog of unsold houses ballooned until mortgage foreclosures moderated briefly in The glut of foreclosed houses has significantly inflated the supply and put further pressure on prices. Increased home sales are gradually whittling down the inventory. In addition to the spate of foreclosure sales, the long-overdue rebound in housing affordability has unlocked a considerable amount of pent-up demand. Over the months ahead, home sales are expected to improve further, and prices will begin to stabilize. However, this outlook depends on the abatement of foreclosures. Moody s Economy.com, Inc. help@economy.com 2009

5 Sonoma County s labor market is still weakening amid the recession. Almost 19,000 jobs have been lost since the employment peak of Manufacturing, construction and retail have been the largest contributors to job losses over the last 12 months. However, layoffs in the county s high-tech manufacturing sector have surged in recent months. The unemployment rate passed 10% in the second half of The housing market in Sonoma County is rebalancing and seems closer to approaching a bottom. The county s peakto-trough price correction is expected to exceed 50%, compared with about 35% for the nation as a whole. Foreclosures have added to the excess supply of houses for sale in the local market, fueling downward pressure on house prices. As a result, the county s improving affordability led to a rebound in home sales starting last year. According to Equifax and Moody s Economy.com, the mortgage write-off rate briefly decreased in the fourth quarter in response to extended foreclosure notification requirements and voluntary moratoriums by some lenders. Since then, write-offs and delinquency rates have risen once again. Some upside risk exists in the possibility that the county s foreclosure rate will moderate in the second half of this year as a result of the successful implementation of federal and state government mortgage modification efforts. Industry Drivers. Sonoma County s improving demographics bode well for future residential housing demand. Population grew in both 2007 and 2008 after three consecutive years of decreases. Furthermore, greater housing affordability is helping attract more young families and first-time homebuyers. Indeed, the share of the county s population in the prime homebuying ages of 25 to 39 increased in for the first time in decades. Both net migration and population are projected to increase over the next few years. Nonresidential construction has been weakening because of both the recession and the almost decade-long contraction of manufacturing in Sonoma County. Technology manufacturing facilities in the county remain closely linked with the fate of companies in nearby Silicon Valley. Manufacturing employment peaked in early 2001 at more than 31,000 jobs. Since then, manufacturing jobs have fallen by 11,000 positions. Since August of last year, more than 1,000 employees have been laid off by manufacturers including 3M and Agilent Technologies amid declining spending on computer and other business equipment. Demand remains limited for large blocks of warehousing and distribution space, although there is still moderate demand for smaller tracts, according to Keegan & Coppin Co. The industrial vacancy rate increased from 11.4% in the second quarter of 2008 to 14.4% in the second quarter of Vacancies will rise further through the remainder of the year because of the ongoing contraction of technology manufacturing. Moody s Economy.com, Inc. help@economy.com 2009 High vacancy rates across all types of commercial real estate will significantly hamper the construction of new space. The retail vacancy rate has increased particularly sharply, as job losses and declining home equity have dealt a major blow to the county s personal income. Vacancy rates are also rising for industrial and offce space, and net absorption remains firmly negative. There are no major industrial projects under construction in Sonoma County, which will limit the oversupply problem in the industrial market. However, there is still new offce space in the pipeline, and offceusing industries continue to downsize, which will result in a slower recovery in the offce market. One important positive development for construction is the moderation in the cost of most building materials. The lower prices of cement and most industrial metals will be particularly important for nonresidential builders. Homebuilders will also benefit from the lower cost of lumber, and although the cost of gypsum has inched upward recently, it is well below its peak. However, the cost of materials will gradually rise over the months ahead as homebuilding begins to steady in the U.S. Energy costs are also expected to increase, which will put pressure on the cost of most building materials, but they will not reach their previous high. 3

6 Offce construction has ceased amid weak business activity and mounting job losses. Employment in offce-using industries, particularly in financial services, has fallen sharply in Sonoma County since 2007, with nearly 3,000 offceusing jobs lost. No new offce building construction permits have been issued since October 2008, according to the Construction Industry Research Board. However, the lack of new construction will limit the potential for the offce market to become oversupplied while demand remains weak. The offce vacancy rate remains high at 21.7% in the second quarter of 2009, although it is not dramatically higher than its year-ago level of 20.2%. Vacancy rates are not expected to begin decreasing until mid-2010, when offceusing industries begin to expand payrolls again. Construction of retail buildings surged in late 2008 and, although it has moderated since then, remains relatively sturdy. After plummeting in 2008, retail trade employment is inching upward again. The 8.8% retail vacancy rate in the second quarter of 2009 is more than double its year-ago level, although it is almost unchanged from the first quarter of this year. Retail vacancies are expected to inch upward over the months ahead until consumer spending begins to recover in early Pricing. Homebuilders will face limited pricing power in the near term because of the weakness in the local housing market. Existing-house prices have declined more modestly in recent months, but the ongoing correction will keep the pressure on prices for new houses. Once the housing recovery takes root around the beginning of 2010, year-to-year house price appreciation is expected to briefly reach a low double-digit pace before settling at a more sustainable longer-term growth rate of about 5% per year. The pricing outlook for industrial space is a bit more upbeat than it is than for residential construction. Rents have generally been steadier for industrial space, and not all landlords have been forced to lower their asking rents. However, landlords who have not lowered rents are making other concessions such as free months of rent and greater allowances for tenant-installed improvements. The outlook for retail space is more negative. The departure of anchor tenant retailers such as Circuit City and Mervyn s last year increased the amount of available retail space in Sonoma County. As a result, retailers can now seek to upgrade into larger spaces at more affordable rates compared with recent years, and existing anchors are negotiating price drops. Operating Expenses. Lower operating expenses are helping to lessen the blow from the recession on construction. Prices have plummeted for most building materials and fuels, but they are gradually firming as economy begins to stabilize. The prices of key industrial metals such as copper, aluminum and steel are about 35% below their peak levels last year. Also, builders are spending much less to transport materials and operate heavy machinery, as the price of diesel fuel is now about half of what it was in July The price decline in lumber and wood products has been more modest over the past year, and the price of gypsum has actually inched upward. However, the prices of some commodities, including crude oil, copper and aluminum, have already begun to increase. The projected recovery of U.S. housing starts in the second half of 2009 will eventually boost the prices of lumber and other construction materials. Nevertheless, the projected layoffs of more construction workers in Sonoma County through the first half of 2010 will help counter rising building materials costs and will increase the quantity of available workers. Residential Non-residential Value of Residential & Non-Residential Building Permits Issued ($Millions; Residential Includes Single- and Multi-Family Units, Alterations and Additions) $250 $200 Source: Construction Industry Research Board ( $150 $100 $50 4 $0 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 Moody s Economy.com, Inc. help@economy.com 2009

7 Profitability. Falling property prices and weak demand for new construction will lower profits for builders in the near term. With prices for new homes still falling, homebuilders operating margins are firmly negative, although they have improved slightly thanks to the recent decline in costs. Commercial builders have fared better, but they are also currently unprofitable. The National Council of Real Estate Investment Fiduciaries property index, which measures the rate of return on investments in nonresidential real estate, remains near its lowest level in its 30-year history. Over the past year, the index has plunged from its long-running average of just over 3% to -8% in the fourth quarter of 2008, before rising slightly in the first quarter. The return on investment is currently the lowest on hotels and apartments, while retail stores have held up the best. The weak outlook for nonresidential construction in the near term will keep returns at their low current levels this year. Long-Term Outlook. Despite construction s recent struggles, the long-term outlook is still upbeat for both residential and nonresidential building. However, construction already accounts for a large share of Sonoma County s employment base, and the industry is not expected to be a leading source of job growth over the years ahead. House prices will be the key driver of long-term residential construction trends. Prices are expected to begin bottoming by the end of 2009, before settling into a pace of longterm appreciation. Price growth will remain below its average of the years leading up to the housing boom, which will support a much higher degree of affordability. Further improvement in Sonoma County s demographic trends will be supported by increased affordability. As a result, homebuilding is expected to recover quickly once the recession subsides and to persist at its pre-housing boom pace over the years ahead. The long-term outlook following the initial recovery period for nonresidential construction is also encouraging. Construction of industrial buildings is expected to accelerate the most over the years ahead, driven by the county s expanding wine industry, once demand for high-priced wines recovers. Increasingly large grape crushes will require the addition of space for processing and storage. High-tech industries will also be critical to the county s long-term growth, creating another source of demand for industrial space. However, the focus of high-tech companies will increasingly be on research and development activities instead of manufacturing. Meanwhile, offce-using industries are expected to lead the county s long-term job growth, supporting demand for new offce space. Finally, Sonoma County s strong income trends and improving population growth will underpin construction of retail space, although the spate of retail construction between 2004 and 2006 will limit the need for additional space. Upside Risks. Construction now faces a few upside risks in the near term. After declining sharply over the past two years, house prices are expected to decline further through the second half of However, affordability has already recovered substantially, which could spark a recovery in prices sooner than expected. This, in turn, could lead to an increase in new homebuilding. Meanwhile, some of Sonoma County s smaller offceusing employers are still expanding, which could generate more demand for offce space. Downside Risks. Risks for construction are weighted to the downside. The main downside risk for the industry is the inadequacy of the state and federal governments efforts to reverse the rising tide of mortgage foreclosures. Without more aggressive government action, increasing foreclosures will add more inventory to an already-bloated housing market and impede the recovery of prices. Additionally, consumer confidence is gradually improving, but another blow to confidence will stifle the demand for major purchases such as housing. While previously frozen credit markets have experienced much improvement this year, accessing credit remains diffcult for businesses and consumers. If the availability of credit does not improve more significantly over the months ahead, it will severely hamper the recovery of both residential and nonresidential construction. Sean Maher September 2009 Median Price of an Existing Home Sold In June ($Thousands) June 2009: $300,000 $600 $500 $400 $300 $200 $100 $0 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 ' % Decrease Since June % Decrease Since June 08 Source: California Association of Realtors ( Moody s Economy.com, Inc. help@economy.com

8 EDB Sonoma County Economic Development Board 2009, Moody s Analytics, Inc. ( Moody s ) and/or its licensors. All rights reserved. The information and materials contained herein are protected by United States copyright, trade secret, and/or trademark law, as well as other state, national, and international laws and regulations. Except and to the extent as otherwise expressly agreed to, such information and materials are for the exclusive use of Moody s subscribers, and may not be copied, reproduced, repackaged, further transmitted, transferred, disseminated, redistributed or resold, or stored for subsequent use for any purpose, in whole or in part. Moody s has obtained all information from sources believed to be reliable. Because of the possibility of human and mechanical error as well as other factors, however, all information contained herein is provided AS IS without warranty of any kind. UNDER NO CIRCUMSTANCES SHALL Moody s OR ITS LICENSORS BE LIABLE TO YOU OR ANY OTHER PERSON IN ANY MANNER FOR ANY LOSS OR DAMAGE CAUSED BY, RESULTING FROM, OR RELATING TO, IN WHOLE OR IN PART, ERRORS OR DEFICIENCIES CONTAINED IN THE INFORMATION PROVIDED, INCLUDING BUT NOT LIMITED TO ANY INDIRECT, SPECIAL, INCIDENTAL, PUNITIVE, OR CONSEQUENTIAL DAMAGES HOWEVER THEY ARISE. The financial reporting, analysis, projections, observations, and other information contained herein are statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities. Each opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein.