As the U.S. real estate market continues its downward slide, commercial construction firms are suddenly finding themselves on the other side of the looking glass. For the past several years, builders of retail space benefited from a booming market as retailers expanded and developers built shopping centers, lifestyle properties and mixed-use complexes wherever there was an empty patch of land. The biggest issue for contractors had been inflation in materials prices brought on, in part, by tremendous global demand. That trend came to a head in early 2008 when the price of a barrel of oil eclipsed $140 as part of a broad run–up in prices in all sorts of commodities.

Now, however, the situation has reversed.

Commodities prices have fallen precipitously from 2008 peaks. The price of a barrel of oil is now down around $40 and the costs of asphalt, diesel fuel and structural steel have also dropped significantly. In the month between October and November 2008, the most recent period for which data is available, the price for asphalt paving mixtures and blocks decreased 15.3 percent, according to Reed Construction Data, a Norcross, Ga.-based construction data provider, while the price of diesel fuel fell 20.3 percent. Precast concrete prices declined 0.7 percent month-over-month in November, while prices for fabricated building steel dropped 4.6 percent.

Prices for those products that are still registering gains, including gypsum and cement, have moderated significantly, with increases ranging from 1.5 percent for cement to 0.7 percent for gypsum. Overall, the construction materials price index fell 3.2 percent in November, reports Reed Construction Data. “There was a lot of panic in the construction industry in the early part of [2008], but now they are buying things at less than they bid for,” says Jim Haughey, chief economist with Reed. “We’ll probably see a few more declines this year and much more modest increases next year. It’s going to make the construction budget stretch a little further in the coming months.”

However, that seeming good news has been tempered by the fact that work has dried up for retail contractors as a result of the sharp retail pullback. Shopping center developers and retailers are postponing or canceling new projects, leaving less work to go around for retail contractors.

New construction starts in the commercial sector from November 2007 to November 2008 fell 13 percent, according to the Associated General Contractors of America (AGC), a national trade group. That’s not as sharp as the pullback in residential, however, where starts are down 23 percent. Another measure, the American Institute of Architect’s Architectural Billings Index, is also down sharply. In November, the index fell to an all-time low of 34.7. This represents a very steep drop from October levels, which already were well down from levels earlier in the year. (Readings below 50 in the index indicate a decline in activity.) As a result, many contractors are finding themselves in dire financial straits. And since borrowing money for supplies has become much more difficult and most industry insiders expect further declines in new construction starts next year, buying materials in advance just because they are cheap no longer makes sense, says Haughey.

Waiting for the paycheck

If that’s not enough, the sudden precarious state of some retailers and developers is also hurting contractors. For example, B.R. Fries & Associates, a New York City-based construction firm, recently got stuck with a $1.2 million bill when Steve & Barry’s, the discount apparel chain that filed for Chapter 11 bankruptcy in July 2008, pulled the plug on a new store project in New York only four days before it was scheduled to merchandise the property. “We are filing a lien on the property and I am working hard on the creditor’s committee, but we don’t have much hope of getting any money from Steve & Barry’s,” says Barry R. Fries, CEO of the company.

As a result, contractors have been taking a closer look at the credit-worthiness of their clients. B.R. Fries, for example, has to deal with the fallout from the bankruptcies of both Steve & Barry’s and the electronics retailer Circuit City. And Warren Johnson, vice president of business development with Bayley Construction, a Mercer Island, Wash.-based firm, says he expects one or two retail developers his firm is currently in contract with might not be able to pay their bills on time.

“We are very careful about the clients we work for to make sure they are financially solvent,” says David L. Wing, vice president and general manager with Graycor Construction Co. Inc., a Homewood, Ill.-based construction firm. “Even if they are a good client, if they are struggling financially, we would not do business with them.”

At the same time, 2008 was the first year in B.R. Fries’ 30-year history when it hasn’t completed one big box project. Neither was there any out-of-the-ground retail work, adds Fries. As of December, the firm had no retail contracts signed for 2009, though it was bidding on three projects all which fell below its $10 million average value. From 2002 through 2007, B.R. Fries completed 1.6 million square feet of both shell and interior space work.

Delayed projects have become an all too familiar phenomenon as well, says Wing. Last year, for example, Graycor was scheduled to start work on a $75 million open-air lifestyle center in Plainfield, Ill. But the developer failed to meet the lender’s pre-leasing requirement to have 40 percent of the tenants in place. As a result, the project has been postponed until 2009. “Two years ago, a national developer we work with had no requirements from the lender about how much leasing it had to have in place,” Wing says. “They basically had an open checkbook. Now that 0 percent requirement went to 50 percent,” prolonging the amount of time it takes to move a property from conception to groundbreaking.

As a result, Graycor expects a significant decrease in retail work this year, at approximately $75 million. In 2007 and 2008, its retail development work amounted to several hundred million dollars, according to Wing.

What’s more, with less work to go around, construction firms are competing more fiercely for available projects. Two years ago, B.R. Fries would be going against three or four other contractors on any given bid, says Fries. Today, the number has gone up to 14 or 15. The increase also stems from the fact that firms that used to specialize in residential work—where the drop in construction has been even more acute—are now vying for commercial work. Moreover, some contractors that previously would only go after large assignments are now trying to get any work they can and bidding on smaller properties.

Some players are also switching the focus of their work from retail and office construction to industrial, healthcare and public projects, says Kenneth D. Simonson, chief economist with AGC. The volume of Graycor’s workload in any given year, for example, included 40 percent in retail properties, 30 percent in hospitality properties and 30 percent in office/healthcare/entertainment construction. This year, the retail portion of its portfolio will decline to 20 percent, with 20 percent devoted to hospitality projects, 20 percent to office/healthcare/entertainment and the remaining 40 percent to light industrial, a relatively new sector for the firm.

“We are making a concerted effort to grow our light industrial business because it’s a market that won’t be as deeply impacted” by the downturn, according to Wing.
Meanwhile, B.R. Fries will attempt to concentrate on education and hospital work, compared to its traditional focus on approximately 50 percent to 60 percent in retail projects, says Fries.

To deal with this new reality, many in the commercial construction sector have been forced to take a defensive stance. In December, for example, as a result of the drop in demand for new work B.R. Fries had to cut its workforce, letting go 20 percent of its office staff and 10 percent of its field staff. Graycor plans to lay off approximately 10 percent of its employee base in the near future, including site superintendents, project managers, project engineers and potentially, those who serve in administrative functions.

In December, the construction industry lost 101,000 jobs following a loss of 82,000 jobs in November, according to the U.S. Bureau of Labor Statistics. Overall, the sector has shed 899,000 jobs since its peak in September 2006. The unemployment rate in the construction sector hit 15.3 percent in December, more than double the national rate of 7.2 percent for all workers. Construction professionals who have not lost their jobs are also feeling a sting, however, since many are now working fewer than 40 hours a week, according to Haughey. With the downturn in new construction expected to last at least into 2010, many firms have no choice but to cut corners, says Wing.

Still, even with all the adjustments the contractors are making to survive in these harsh new conditions, a certain number of bankruptcies seems unavoidable, according to Simonson. Some firms may have borrowed too much during the boom years, while others have focused almost exclusively on residential or retail work, making it harder to keep going when no new residential or retail projects are coming out of the ground.

One aspect of this downturn that could be considered a silver lining is that this would be a good time to attract and train new talent, says Wing. While Graycor plans sizeable staff reductions, it’s still going to hire about six college graduates for its engineer training program in 2009. The program, which takes up to three years to complete and has a final exam requirement, will provide the firm with talented, highly trained professionals when demand for work should begin to climb up, around 2011.

“We need to be prepared to have our best teams moving forward when this is over,” Wing notes.