Residential Recovery May Top Expectations

November 13, 2009

New York–"The bigger the rise, the bigger the drop; and the bigger the drop, the bigger the rebound," said Peter Linneman, a consultant and professor the at Wharton School of Business, speaking of the housing market's historical performance, at the 2009 Building and Infrastructure Conference hosted by Lincoln International and L.E.K. Consulting. Evidence that the economy is strengthening will become more visible next spring, he predicted, and the exceptionally weak levels seen in jobs and housing will begin to translate into pent-up demand.

Keynoting a session featuring several panelists representing building products companies and private equity investors, Linneman suggested residential remodeling and replacement activity will also rebound due to renewed housing activity and pent-up demand.  Linneman, along with most of the speakers, however, was significantly less optimistic about the commercial construction market. 

Linneman pointed to a complete lack of financing available now and nothing new going into the pipeline.  Lost jobs also contributes to higher vacancy rates and low demand.  While the residential recovery is going to be better than expected, noted Ted Hathaway, chief executive with Oldcastle Glass, "the commercial market downturn is going to be worse than expected."

In providing his optimistic forecast for the housing and the economy, Linneman pointed to the impact of the current lows.  Housing activity is so weak that "we're not even replacing homes being destroyed." With exceptions in areas like Las Vegas and South Florida, excess inventory is disappearing and most of the country's housing markets are "close to equilibrium or are seeing slight weakness on the demand side," he continued.

Basic demographics play an important role in housing, Linneman said. With the weak economy, new household formations have been tracking below normal for the last three years. As the economy improves, that will translate into an above-trend number of household formations for the next three to five years.

Household formations will increase as new jobs are created, he explained.  Normal job growth is about 1.8 million jobs per year. With job losses, beginning sometime after April next year, he said, we can expect a period of job creation at an annual rate of 3 million per year for several years.  Given the current economy, Linneman noted that companies have not even been replacing workers that die or retire. "Even without real strong growth, people will start replacing workers.  That will start to add up to a rebound in employment."

"This recovery will stun people," Linneman said, but he did caution that inflation could reappear on the scene like it has not for decades.  Pointing to vast increase in cash reserves banks are now holding after the economic meltdown of last year, he suggested that inflation could easily reemerge once that money starts making its way into the system.

Panelists' Views
The Lincoln conference featured several panel discussions. Asked what they are doing for the next three years, a number indicated they were going to be holding tight. Fareed Khan, president of USG Corp.'s Building Systems Group, said his firm remains focused on getting its business "as sustainable as possible." It is cautious about increased activity in new home construction and foresees significant declines in commercial construction. Noting that his company's products go into projects late, USG sees activity winding down significantly over the next year until 2011, and foresees very weak demand after that. Khan expressed some optimism for residential remodeling, suggesting that "that may be the sector that starts pulling us out of this." 

Oldcastle's Hathaway noted that up until last year, commercial construction had enjoyed 15 years of unprecedented growth.  "Last year, I was talking about staying close to our customers. This year, I can't find any customers," he said. Suggesting this downturn is not just cyclical, but structural, and will fundamentally change the business, Hathaway asserted "it's time for innovation and revolution. We had a great business model, but as a company, we really have to think totally out of the box."

With the conference geared toward private equity and strategic investors, several panelists commented on their expectations for merger and acquisition activity for the near future.  "Next year will be a good time to be a buyer," suggested Robert Newbold of Graham Partners. Prices for companies have come down and meanwhile, "it's pretty clear we're at the bottom or past the bottom for residential building products at least." 

Panelists expressed some reservations, however, about the inherent benefits of scale.  Kevin O'Meara of Golden Gate Capitol, a one-time Builders' FirstSource executive, noted that despite the success of several companies developing large footprints in building products distributions, "large builders didn't change. They continued to source locally."  That has continued, even with the downturn in housing, he continued, when pressure to cut costs would suggest that these large builders would look to take advantage of volume purchasing. 

Consolidators and roll-ups, O'Meara continued, have had some success in industries that are more capital intense and have heavy fixed costs, but have been less successful in others.  "Building products remain a local market business," he said.  Many sectors have low barriers to entry and there are minimal costs to customers to change suppliers. In such markets, it is much harder to show the benefits of scale.

Speakers were also asked about the potential impact of increased activity related to energy efficiency enhancements. Most foresee continued gains in green building and demand for higher performance, but see government programs and spending targeting this area as having marginal impact.  USG's Khan said that with energy prices remaining in check, the residential market will continue to see increased demand.  In the commercial market, he suggested LEED certification will become increasingly important.  Brand name companies will avoid locations that are not seen as environmentally friendly, he explained.

Oldcastle's Hathaway predicted government spending on energy efficient projects will be "inconsequential" in the market.  Pointing to strong demand for low-E glass already, he also suggested many are still looking for the "next leap of faith" as far as enhancing energy efficient technology.