HOUSTON CONSTRUCTION OUTLOOK

Despite some private sector slowdown, we have a lot of contradictory activity for a supposedly down economy. In Texas and nationally, major multi-billion public and private sector projects are moving forward.

Locally major construction activity continues. MD Andersen alone plans $6.4 billion in new construction in the next 4 years. LBJ Hospital alone will have a $630 million addition. The Medical Center is underway with a major expansion which will add 100,000 new jobs. That is roughly 30 million more sf, which is going to eat up a lot of construction labor and pay higher wages, potentially driving up local costs.

This growth is going to strain infrastructure -as we have seen with a moratorium in Magnolia and larger capital recovery charges on Fulshear residential projects. Nationally California is having power problems-as, in a similar way, most people are experiencing here securing utility service.

What all these contradictions say, what all the economists are telling us in the constant daily predictions of recessionno recession - maybe a recession, is that all measures used for the last two or even three generations to evaluate and predict economic activity or a cycle, all the familiar terms and metrics that have been commonplace to use, are no longer applicable.

The ability of economic and political systems to adjust to events as they have in the recent past is no longer present to the same degree. Things will not return to what we knew them to be.

MD Anderson plans $6.4 Billion in project starts over the next 4 years.

The Urban Land Institute, PwC Emerging Trends 2023 report projects that Houston will add 100,000 residents per year for the next 5 years.

The easiest population scalable order of magnitude is house formation and educational impact: somewhere between 3,250,00) and 6 million sf of new K-12 projects per year are needed for this growth if a 250/sf/new student ratio is used.

Urban Land Institute/PwC Emerging Trends 2023 report:

• “Houston will add 500,000 new residents over the next 5 years.”

• At 50% household formation and 50% children, that equates to:

• 25,000 new students per year = 6,250,000 sf

• 13,000 new students per year = 3,250,000 sf

Everything has Changed

We have to adapt, be agile, adjust, and recognize potential issues we may have to face in the daily functioning of facilities/real estate/design/construction/and real property administration and ownership.

Below are some issues which potentially could impact us, and then the possible cost environment for the next three years. There are only 3 or 4 high public visibility figures who are speaking directly to Change.

One is the Managing Director of the International Monetary Fund, who is quite candid about how Covid restructured global economics, and the war in Ukraine has changed both economics and geopolitical structures -the realignment of both alliances and trading patterns-, and why it is necessary to defeat Russia in Ukraine. She openly states economic and geopolitical structures have changed because of Covid and that war.

Mohamed El Erian, former head of PIMCO, the Harvard Endowment and now Cambridge University, is an internationally recognized economist and fund manager. He also is candid about how the era of easy money to which we have become accustomed has ended, and how going forward things will be different. The financial market has transitioned. It has already Changed.

Potential Cost Impactful Wild Cards Which Can Affect Us

Wild Cards

A number of near term wild cards can have immediate or longer duration impact on our local cost structures and are areas where Change is already in process.

None of what we are going to review about should be viewed as advocacy or critique of any particular political position.

What we are looking at are the signals of changing direction and trends which can affect our local cost structure from a local to a global perspective.

Wild Card: Political

The political structure domestically and internationally has already Changed. Transition is in progress. Economic forecasters see polarized legislative bodies of all types and gridlock at all levels restricting important economic legislation.

The World Economic Forum, long promoting itself as the non-governmental pacesetter in addressing global issues, is now playing catchup with issues directly affecting everyday lives, in this case, from their most recent Davos gathering, waking up to the cost of living.

A recent Gallup poll shows a large number of Republican and Democratic voters - 42% of the electorate - now view the US government as the biggest problem in the US. Absent bipartisan resolution this percentage could increase and impact everyone.

Foreign Affairs,the Journal of the very influential Council of Foreign Relations, often articulates issues 6 months or more before those issues appear in the mainstream. It, too, is playing some catchup with the rapid current of Change. Both articles appeared in The December 2022 Issue.

In the same issue, an article advocating a shift from NeoLiberalism toward the center, echoes an article from the first term of President Obama which advocated a shift from NeoConservatism to the center.

Again, playing catchup with a transition already in motion. Moving away from countries advocating global economics to more localized economic structures and basis is a key theme in this article.

The article “The New Industrial Age” (right), by the Congressman representing Silicon Valley (which he likely did not write) advocates a shift back to domestic manufacturing with an emphases on skilled workers, which has been a key factor in German economic success. We are already seeing this shift take place. The CFR is playing catchup.

All these are symptoms that Change has already occurred. Institutions regarded as thought leaders setting the pace are playing catchup. This a barometer that more Change in the political and geopolitical arena is underway.

In his 2020 book, “The Storm Before the Calm”, former Stratfor Chairman George Friedman forecast ten years’ domestic turmoil before the US politically balances its ship.

Wild Card: Labor Shortage and Subcontractor Default

For some time there has been a growing construction labor shortage and slow rise in labor costs. At present, the skilled workforce is limited. Employees just shift from company to company. In the near future there will be a breakout of labor costs.

The Urban Land Institute, again as for ranks the last several years, availability of qualified labor, as the 2nd most important economic issue facing the entire built environment, outranked by only interest rates and cost of capital.

Despite some economic slowing, new jobs are adding to the economy month after month in excess of forecasts and traditional patterns, aggravating the construction workforce problem. By April 2023, construction unemployment was at a record low.

National forecasts of a rising labor shortage is an impactful -and performance restrictive- construction issue for which there is no quick solution. It is only a matter of time before it translates into increased costs.

Inflation is pushing up wages into higher construction paying jobs. ABC predicts that the construction workforce continues to face a 500,000 plus job opening gap vs. personnel available. National construction recruiter Birmingham Group’s annual salary survey showed 70% of contractors had to pay new employee salaries over their budgets and predicts a 5% wage increase in 2023.

In 2022, 70% of construction companies had to pay more than was budgeted for new hire salaries. In 2023, salaries will increase another 5%.

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Many contractors report higher backlogs but are struggling to find staff.

A recent NY Times essay (below) on why construction productivity is continuously falling, linked it to the same drop in the overall economy labor productivity and offered a researched conclusion that the productivity drop is due to an increasing regulatory environment.

Even the annual AGC Risk conference of bonding agents sees the worker shortage as the #1 construction risk. Risk #3 is subcontractor default (failure/bankruptcy).

Many General Contractors are experiencing more and more subcontractor failures. This failure rate will accelerate over the next 18 months. This is important to project owners and design teams because it can delay and financially impact projects, regardless of who the General Contractor may be.

We saw this cash curve earlier but need to revisit this example (Table 38) for illustrative purposes of how the rise in materials prices has drained down subcontractor and some general contractor cash reserves. A drain down leaves a firm in a weakened position and more susceptible to potential default.

The same regulatory symptom surfaced a month later in another Times article on why chip plants cost so much to build in the US.

Table 38

Over the next 18 months, subcontractor selection will be a critical part of project performance. Owners would be prudent to consider General Contractor subcontractor recommendations.

The key aspect of this part of the report is that we can, at some near term future date, expect labor cost to rise as the qualified labor supply further reduces and should prepare for potential subcontractor defaults. Owners can reduce some regulatory cost impact by securing earlier all utilities, permits, and services.

Wild Card: Weather

National weather has been severe and disruptive for several years. Media reports completely miss the rebuilding cost caused by tornadoes, flood, and the impact we have yet to see from heavy snow melting.

Some cost impact on key electrical equipment - the need to replace storm damaged transformers, switchboards, switchgear and electrical lines - may arise. If replacement needs are widespread, it could further negatively pressure delivery dates for already slow to procure materials.

However, if we look at conservative Northern Trusts’ 2023 and 2024 forecasts for real GDP growth, they were healthy at 4.6% and 3.9% respectively - contradictory to recessionary forecasters. They recently lowered their forecast - a sign of confusion in economic indicators. The Federal Reserve is less optimistic (Table 39).

Wild Card: Capital Markets and Banking

Larry Summers is a well credentialed financial leaderformer Treasury Secretary; Former Chairman of the Council of Economic Advisors; Former Harvard President, among other positions.

He predicts 3 upcoming strains on the capital system: of commercial real estate loans valued at $1.5 trillion are due in the next 3 years with commercial real estate owners foreseeing a disaster. A negative, major drop in real estate valuations would affect public sector tax revenues. There are systemic consequences if this happens.

(1) People seeking higher yield after years of a lower yielding market.

(2) Defense spending driven by the repercussions of the Ukraine war-and this will be a worldwide trend - plus conventional and asymmetric threats from increasingly aggressive states such as China, Russia, and Iran and its proxies. This spending will require significant capital from the government.

(3) Capital demands for infrastructure, debt repayment, and for-profit entities needing to replace older, low-cost debt with equity.

A salient sign that everything has permanently Changed is no forecaster is able to predict with any semblance of past accuracy what is going to happen in the economy. Every forecast is different. Methods which no longer have the same accuracy due to systemic structural changes are being used.

Our take-away is: there is no consensus. Past measures are not working. We have to be prepared for good or for worse. Even one of the Federal Reserve Presidents thinks interest rates are too low to cool inflation, as does JP Morgan Chairman Jamie Dimon. It is unlikely rates will rise again at this time and inflation will stay with us. It takes about 12 months for rate changes to impact the markets and 2024 is an election year. The Fed always sides with lesser electorate impact in an election year.

JP Morgan Chairman Jamie Dimon is one of the few articulating things have changed and who has the courage to cry out in the wilderness. In this case, as you can see from the face of the Fox interviewer, he is calling out serious future economic dangers. His point is shown at the bottom graphic in a CBO projection (Table 40). While Congress tries to cut federal spending by cutting social security (but not Congressional pensions), interest on national debt will in a relatively short period exceed both Social Security and Medicare costs. This issue has been discussed for decades but at this level could cripple the economy if unresolved.

Goldman Sachs is the sole source stating it will not be as bad as predicted.

Table 40

Another looming financial issue is commercial real estate mortgages, (Table 40) with over $270 billion coming due this year in a down commercial real estate (CRE) marketespecially for office buildings - and 380 million square feet

This March 2023 Newsweek bulletin sums up 3 of our potential Wild Card themes: banking issues, weather impact, and defense spending.

Overlooked is a simultaneous observation from Stephanie Pomboy, who seldom speaks publicly but provides very expensive, insightful, and accurate by subscription only advisory services to financial institutions and major investment firms. She states the US banking system currently has a $620 billion problem. Banks typically invest in government securities. When interest rates were very low they bought heavily into 1% +/- US T Bills and still hold them. T Bills are now in the 4-5% range. As a result, the older T Bills are worth less than their face value in the current market. They will pay off face value and yield at maturity. However, if forced to follow mark to market accounting policies (i.e. value the securities at present market value), which (for example) in the last few years bankrupt a number of oil companies in reserve value write downs, then the banking system is under water with losses and equity write-offs, and bank failures will rise.

Presumably they will be allowed to forego market to market, but no such relief is presently in sight. They will have to raise both their loan underwriting standards and the rates they charge, affecting contractors and materials supply cost inputs. Big banks currently report much higher earnings. The largest banks may not be the ones most damaged, as high earnings can offset some mark to market hits.

The banking/financial sector creates private sector project cancellations due to higher underwriting, interest, and equity contribution required. If so, we may see a migration of public sector inexperienced private sector contractors into public sector work at possibly artificially or erroneously low prices. This is a period requiring caution and prudence.

Wild Card: Energy

Over the last several years, the media and the current administration have worshiped electric vehicles while castigating and threatening electricity suppliers and energy companies. Traditional energy suppliers see the administration as their adversary and traditional energy supplies are less available than in the past. Even OPEC recently cut production by 1 million barrels per day.

Domestically, Pioneer Natural Resources CEO Scott Sheffield predicts domestic production cannot be grown, and more working rigs will simply raise cost and energy prices due to a shrunken oil services sector (Table 41).

Such a rise will directly and quickly impact construction cost on your projects if either comes to fruition, both in manufacturing and transport cost inputs. Based on recent painful experiences, contractors and manufacturers will not hold down pricing if they see an increase. Others may be trapped in a cost structure which is prohibitive under new energy costs. The consequentials for project cost could be meaningful.

Beginning late last year, a diesel problem was already appearing across the country and some diesel suppliers are beginning to require a 3 day delivery notice.

If an energy price rise hits, here is insufficient spare production capacity available to respond to it. As this graphic shows, (Table 42) it was available during the pandemic but is not presently available. Additionally, the government drew down the national strategic petroleum reserve to below 1985 levels - but has not replaced it and has significant additional draw downs scheduled. The chart on the right tracks the reserve draw down to oil prices. A reserve replacement will force prices up, unless executed by expert traders (Table 43).

Similarly, during the pandemic, the US had a significant inventory of DUC (Drilled but Uncompleted) wells ready to put into production ( exists and drilling is not at past levels due to the adversarial industry relationship of the administration and media and the destruction of the oil services industry. Nor is the workforce available to restore it.

The CEO of Pioneer predicted $90 barrel oil (bbl) by summer. In mid-April it sat at $82. In mid-May it was $71/bbl. (Table 45) Raymond S. James energy analysts predict it will break $100/ bbl this summer based on demand, reserve levels, DUC’s, and lack of drilling incentives and capacity (Table 46).

Annual Averages 2021A2022 RJ Est.2022A'21-'22 Change2023 RJ Est.'22-'23 Change

CrudeOilPrice(WTI)$67.07$75.00$94.0040%$100.006% CrudeOilPrice(Brent)$70.53$78.00$99.0040%$105.006% NaturalGasPrice(HenryHub)$3.89$4.00$6.5268%$6.00-8% U.S.RigCount47065072254%80011% Year-End Index Values 2021YE2022YE RJ Est. 2022YE'21-'22 Change2023YE RJ Est.'22-'23 Change S&PTotalMarketE&PIndex36864707-5084510338%6124-663420-30% PHLXOilServiceIndex53NM8154%98-10620-30% S&P1500IntegratedOil&GasIndex422465-50870868%814-84915-20% S&P1500Refining&MarketingIndex1,3721579-1819220461%2535-275515-25% WilderHillCleanEnergyIndex149181-19676-49%99-10630-40% AlerianMLPIndex179210-21921319%245-25615-20% Source:Factset,RaymondJamesresearchNote:2022RJestimatesdenoteRJforecastsatyear-end2021

Oil price outlook: We forecast prices averaging in the triple-digits in 2023, with an upward trajectory during the year.

Wild Card: The Ukraine War

Jamie Dimon, JP Morgan CEO, has accurately stated that the Ukraine War is the greatest existential Geopolitical threat since WWII and that its outcome will determine the course of the rest of this century. The IMF head and Larry Summers agree with him. It is important to understand why they have this view and how dangerously it can impact us. To do that, we need to ignore the fog from the media and Washington and follow the 25 year progression which has manifested into this situation.

• “This is the most serious geopolitical thing we’ve had to deal with since World War II,” Dimon said Monday, also highlighting the war’s impact on relations with China.

With the fall of communism, Russia lacked a focus and unifying vision, like defeated post WWI Germany. It struggled with its identity and its future as a nation. Then in 1997, questionably balanced Russian PhD Alesander Dugin published his book “Foundations of Geopolitics”. It proposed a galvanizing vision for Russia which quickly found supporters in the disenfranchised political, intelligence, and military elite: disrupt western political and information systems; conquer and destroy the Ukraine and quickly retake all former Soviet satellite states; threaten the remaining European states into submission with nuclear weapons; and, aligned with China and Iran, first isolate then later destroy the UK and the US. This book, as incredulous to us as its premise may seem, is taught in the Russian General Staff College to all top Russian military leaders. The people around Putin support it as the vision for their regime, and Russian national actions follow its playbook. The first phase was to sow confusion, polarization, and distrust in the American political system and media. The second phase is delayed in the Ukraine; the third phase is underway. This is really what Dimon, Summers, and the IMF head are speaking to. It is why Finland joined NATO and Sweden has applied. This information is not at all hard to find. American media and many politicians appear oblivious to it.

War effects at this point are far reaching. Chatham House a London based International Affairs Think Tank, has issued an early report on how this war has impacted the world so far in major strokes.

This war has already started massive spending worldwide on new defense systems. The US this year has an $886 billion defense budget. The navy is asking for $380 billion more for additional submarines. Larger expenditures will be forthcoming. Other countries are taking similar steps. This will result in more capital markets pressure.

And Ukraine may be the unfortunate prototype for future regional wars, in this case, one which could arise in Asia although the Persian Gulf would seem more likely. The Ukraine war is another demonstration that Changes with major consequences have already altered past paradigms.

Local Construction Cost Impactors

2-4 Year Events

Inflation High probability it will continue through 2025

Materials Cost and delays continue through Q3/2022 and are bumpy in 2024.

4-7 Year Events

Infrastructure Work, especially at Houston metro level, raises steel / concrete / underground / site costs. Buy America impact.

Texas Medical Center 3 More construction begins, drawing down skilled labor supply. In Billions.

Metro Area Residential

Subdivisions Increase and multi-family work pushes some costs.

K-12 $8 billion+ of Houston metro area K-12 2022 bonds on 2022 ballots

Banking Work out of systemic issues

Political Rebalancing

15 + Year Event

Labor Costs appear likely rise for skilled labor. This can become a long-term impact / Davis Bacon Impact.

Energy Cost Appear likely to rise and filter into all product costs due to petroleum-based components. Expect price increases

Defense Spending rises causing some metals and critical materials and electronic costs to increase. Expect large expenses

Reshoring/Restructuring of Supply Chain Increases manufacturing/distribution construction and costs

Ukraine war consequences Impacts rest of the century

Source: Durotech Inc. proprietary Texas market wide cost survey.

Table 47

Last year we offered this list of contributors to the causes for the cost explosion and supply chain issues.

Nothing among them has changed. There are other factors arising which have been added and which could be impactful in our immediate future (Table 47).

Looking at possible wild card cost impacts, the following near term possibilities may appear:

We may continue to see a slide in costs during the year as some alternate non-electrical supply chain issues improve or resolve (electrical will continue to be problematic). However, it appears possible that later in the year, as a consequence of some of the wild cards we have discussed, we could see a rise in costs. (Table 48).

Table 48

The first would be oil price increases starting this summer with construction costs responding quickly. (Table 49).

Table 49

The second would be banking and construction bond underwriters raising loan and bond underwriting requirements. This would raise costs to contractors and be passed through to projects. GL cost have already been scheduled to rise in single digits this year (Table 50).

Table 50