Spending on the construction of buildings increased by over 20 percent last year. Some sectors that saw outsized gains included manufacturing (up a whopping 70 percent) due to onshoring and federal funding under the CHIPS and Science Act, lodging (up 20 percent), healthcare (up almost 15 percent), and education (also up almost 15 percent).

What does the industry do for an encore? Even with ongoing funding under the Chips and Science Act, the Inflation Reduction Act, and the Infrastructure Investment and Jobs Act, the building construction sectors will face some serious challenges over the next 12 to 24 months. These headwinds include tighter credit conditions, high input costs, falling prices for commercial property values in several sectors, and structural changes in demand for key commercial categories.

Rising long-term interest rates, even with their recent easing, has put pressure on many regional banks that account for a significant share of construction lending. As a result, credit standards for construction have tightened significantly. The most recent Federal Reserve Board’s Senior Loan Office Opinion Survey reports that almost 60 percent of lenders tightened credit standards for commercial real estate loans over the prior three months. No respondents reported easing them.

Second, while costs for most construction commodities have levelled off recently, inflation remains a problem for the construction industry. Inputs have stabilized at levels 35 percent to 40 percent higher than they were pre-pandemic. While price volatility seems to be under control, there is little likelihood that they will revert to early 2020 levels anytime soon. Additionally, while commodity prices have steadied, construction labor costs are still rising at a 4 percent annual pace.

Third, weak demand has put downward pressure on property values for most commercial sectors. Multifamily, commercial and industrial property values have declined 8 percent on average over the past year. Office values lead the decline, down almost 15 percent over the past year, but apartments (down 12 percent) and retail facilities (down almost 7 percent) have also seen significant declines. Only industrial facilities (up almost 2 percent) have withstood this downward trend.

Finally, while construction is a notoriously cyclical industry, some of the current trends affecting the office and retail sectors are more structural than cyclical. At present, about 30 percent of paid workdays nationally are worked remotely. Prior to the pandemic, that share was under 5 percent, underscoring the need of most companies for less office space. Also, the pandemic gave a boost to e-commerce over traditional brick and mortar retail facilities. E-commerce sales have been increasing at a 15 percent annual pace and are projected to exceed $1 trillion nationally this year.

In fact, leading indicators for construction activity confirm that a slowdown is already underway. By the latter part of 2023, construction starts had either slowed dramatically or turned negative in virtually all construction sectors. Architecture firms also report weaker business conditions. Softness in the AIA’s Architecture Billings Index (ABI) during the first eight months of 2023 turned even more negative toward the end of the year. Architecture firm billings are unlikely to rebound anytime soon since new project work coming into firms has also seen a slowdown, and firm backlogs are beginning to slowly trend down.

So, overall, the 20 percent overall increase in spending on building construction last year is expected to ease to just 4 percent this year and 1 percent in 2025. The commercial sector — offices, retail facilities and lodging — is expected to see no increase over the next two years. Manufacturing construction still has some momentum heading into 2024, but that should stall out by next year. Institutional construction — education, healthcare, government, amusement and recreation and other related sectors — is the one sector expected to continue to see some gains. So, hold on tight, the roller-coaster ride has already begun.

Kermit Baker is the chief economist at the American Institute of Architects. He can be reached by email at [email protected].