Private nonresidential construction spending declined for the third straight time in February. In the same month, the Architecture Billing Index, a leading indicator for the sector, plunged to its lowest level since September 2001. Taken together, these signs indicate a sector slipping into recession.

　　Private nonresidential construction spending declined for the third straight month in February, according to the Census Bureau's latest put-in-place estimates. Prior to these three drops, nonresidential construction had been one of the economy's fastest-growing sectors. Between July 2005 and December 2007, spending increased an astonishing 28 times in 29 months, posting broad-based gains. Although it makes up about 3% of the economy, nonresidential construction added about 0.5 percentage point to real GDP growth in each quarter of 2007.

　　In February, the Architecture Billing Index, a leading indicator for nonresidential construction, plunged to its lowest level since September 2001. The index was down in all regions except the Northeast. Its commercial and industrial components were especially weak. This reading, along with the three straight monthly declines in nonresidential construction spending, signals a sector slipping into recession. The question now is how bad the downturn will be. Recent signs indicate it will be hard one, but not as severe as the downturn that accompanied the 2001 recession－which lasted five years.

　　Four forces are converging to bring this sector down: the housing/economic downturns, the credit crunch, rising construction costs, and payback for recent excesses.

　　The housing downturn was bound to eventually undermine nonresidential spending, since fewer houses started require fewer new gas stations, restaurants, schools, medical buildings, and other construction projects associated with new residential developments. However, since the housing downturn has now become an economy-wide slowdown, office building and other construction categories sensitive to the business cycle will take also take a hit. The lag between housing starts and nonresidential construction can be up to two years, so nonresidential construction will be feeling the aftershocks from the housing recession for some time.

　　Labor costs may be easing because of the weakening economy, but builders are being hit from increases in the costs of gasoline, diesel, copper, and steel. One reason that it took nonresidential construction five years to recover from the 2001 downturn is that construction costs took off in the second half of 2004, and did not let up for another two years. Indeed, while inflation remained tamed in 2005 and 2006, the price deflator for nonresidential construction, which measures construction costs, rose 11.7% in both years. Builders responded to these surging costs by scuttling or postponing projects. They are likely to respond similarly this time if the recent surge in costs persists.

　　In its January Survey of Bank Loan Officers, the Federal Reserve reported that a record 80% of banks raised standards on commercial property loans over the previous three months. Unfortunately, conditions have worsened since the survey was taken. Morgan Stanley's 10-year fixed conduit spreads, a measure of the cost of commercial real estate lending, widened to 335 basis points in mid-March, a 200-basis-point increase in just two months. Not only have credit spreads widened, most commercial-backed securities are no longer being securitized because demand has vanished. Thus, an important source of funding has nearly dried up.

　　Although builders showed restraint in putting up buildings during the recent boom, there were excesses. For example, Moodys/REAL Commercial Property Price Index, a commercial real estate price index similar to the Case-Shiller price indexes for housing, has jumped more than 80% since 2002－a higher growth rate than the Case-Shiller index of 10 cities. Other signs of excess are evident in the surging growth rates for hotel, recreation, and higher education buildings. Spending on mining exploration, mines, and shafts, although not excessive, has been growing at an unsustainable rate. As a result, we expect real spending in this construction category, which accounted for 25% of nonresidential spending in 2007, to contract over the course of 2008.

　　Real spending on private nonresidential construction increased 8.4% in 2006 and 13.1% in 2007. We expect growth to slow to less than 2% in 2008－and then drop about 9% in 2009.