With a potential economic downturn on the minds of many firm leaders, it’s a judicious time to stay focused on business conditions. And while it may not be possible to fully recession-proof your firm, an achievable goal is to develop a strategy for minimizing the negative effects of a slowdown. The U.S. economy frequently goes through recessions, and the way that architecture firms have dealt with previous downturns can provide useful lessons for coping with future economic adversity.
Many architecture firms are seeing healthy business conditions at present. Others are at least enjoying the continuation of an extended period of prosperity for the design professions and construction industry. Our economy is currently in the midst of a more than decade-long economic expansion, the longest ever recorded for the United States. With this longevity, however, comes increased anxiety. Some might wonder, aren’t economic recessions inevitable? Are we on borrowed time in terms of the next downturn? While business cycles often come around and end in downturns, economic recessions are not inevitable. For example, it has been widely reported that Australia last had a recession in 1991, even though they have had a number of slowdowns in their economy over the ensuing almost three decades.
Economists like to say that economic expansions don’t die of old age. Instead, recessions occur when there are fundamental imbalances in the economy: a housing price bubble prior to the 2008 recession; a technology investment (dot-com) bubble prior to the 2001 downturn; and an oil price surge that generated unsustainable energy costs and inflation throughout the economy from the mid-1970s through the early 1980s, and again in the early 1990s. These economic imbalances often are magnified by external “shocks” to the economy, such as the Iraqi invasion of Kuwait prior to the 1990 recession, or the 9/11 attacks on the U.S. prior to the 2001 recession.
Where are we now, economically speaking?
There are clear signs that the U.S. economy has been slowing in recent quarters. GDP probably grew a bit over 2% last year, compared to almost 3% in 2018. The growth in payroll employment nationally was about 1.6 million last year; a healthy figure, but below the 2.2 million in 2018. Yet, in spite of more than a decade of continuous growth, inflation remains surprisingly subdued and interest rates extremely low, conditions that would suggest a favorable economic outlook.
Still, there are signs of mounting headwinds. Businesses are increasingly concerned regarding the large amount of debt that they have built up in this low interest rate environment, and the impact that uncertain tariff and trade policies might have on the level of exports and the cost of imports. Consumers have benefited from the lowinflation environment and labor shortages that have helped to lift wages, but even they are beginning to grow nervous about future economic conditions. The Federal Reserve Board didn’t raise interest rates much during the last expansion, so it has limited ability to lower them if needed this time around. And since the federal government ran a budget deficit of almost $1 trillion last fiscal year, and is projected to run similar deficits for the foreseeable future, there is limited interest in increasing the deficit even more for fiscal stimulus programs should the economy weaken more than expected. Some see these emerging economic headwinds pushing the economy into a recession. In fact, a recent survey of forecasters by the National Association of Business Economics put the probability of entering a recession by the end of the year at just under 50%, and by midyear 2021 at almost 70%.
However, the design and construction sector of the economy should fare relatively well regardless of whether the emerging slowdown in the economy results in a recession or the proverbial “soft landing” that economic policy makers strive for. Even with the relatively weak recovery coming out of the last recession, the economy has been able to absorb the new building activity that has resulted. New construction has been added to our stock of buildings at a rate of 1.3 billion square feet on average each year since 1980, according to Dodge Data and Analytics, but there hasn’t been that level of construction activity in any year over the past decade. As a result, there isn’t the typical oversupply of buildings that traditionally has exacerbated a construction downturn. Vacancy rates for office buildings and availability rates for rental space are below their average levels of the past 20 years, and occupancy rates at hotels are above their average of the past two decades. This suggests that the real estate sector, and therefore the construction industry, is better prepared to cope with an economic downturn should one emerge.
Monitoring Business Conditions
There are good reasons to believe that even if a recession were to emerge over the next 18 months, it will be relatively mild by historical standards, and that construction is not likely to be one of the sectors of our economy that will bear the brunt of a downturn. Still, there is every reason for architecture firm leaders to remain vigilant. On average, architecture firms currently have over six months of project backlogs, meaning that even if no new project work came in, the current staff would be fully covered for more than six months. This level is about as high as backlogs have been over the past decade, and theoretically should give firm leaders plenty of time to adjust in the event of a slowdown.
However, as many firms learned during the Great Recession, project backlogs can be an elusive indicator. A project that a firm has included in its estimate of backlogs could be significantly delayed or put on hold with little or no notice from the client. Other projects may be significantly redesigned or scaled back, while others may be canceled if development assumptions or business conditions were to change. A survey of architecture firms conducted this past October found that over half of them had at least one project that fell into one of these categories that year, with an average of more than 15% of their project revenue being impacted by these at-risk projects. Project backlogs can therefore evaporate very quickly.
When economic conditions become more volatile, it’s useful to monitor measures of business conditions closely to try to anticipate unwelcome surprises. Indicators monitored should include several categories of potential disrupters:
- Indicators of national economic conditions, such as GDP, interest rates, stock market trends, employment trends and the unemployment rate, and consumer confidence scores will help gauge the general arc of the economy.
- Design and construction market indicators, such as AIA’s Architecture Billings Index, construction spending levels, construction contract awards, the AIA Consensus Construction Forecast, backlogs at construction companies, vacancy rates and rents for key building types, building materials costs, and labor rates help monitor the general direction of the construction industry, as well as the health of different sectors.
- Conditions in market areas served by a firm, such as the health of industries in its service area, the performance of current or perspective clients, the outlook of contractors in markets served, and business conditions of other design firms in its area. These measures help to provide a broader perspective of the business ecosystem. For example, if the residential market is weakening in its area, that generally suggests that the commercial/industrial (and eventually the institutional sectors) will follow suit.
- Detailed indicators of business conditions of a firm may include staff chargeability rates; overhead rates; quality of new project leads; the potential for current projects to become stalled, significantly redesigned, or canceled; and the probability of project win rates, cash reserves and credit lines, and cash flow situation. While broader billings and backlog trends give a general sense of financial health at a firm, getting a feel for potential problems over the coming months and quarters helps to provide “an early warning of bigger issues on the horizon.”
Developing a Plan
While there are numerous variations, there effectively are only two strategies for dealing with a business downturn: increasing revenue or reducing costs. Most effective business plans consist of a combination of the two. However, often the key to success is having sufficient business intelligence to pursue a strategy as soon as problems begin to emerge.
Revenue strategies can involve traditional diversification efforts to serve new construction sectors (e.g. diversifying into designing distribution centers) or new geographical areas. But it typically is extremely difficult for a firm to develop expertise in a new specialty on short notice. A more realistic approach is to expand firm offerings, particularly to existing clients. Longer-range facilities planning, sustainability and resiliency initiatives, and energy management strategies may be attractive services to clients, even if they have no current need for additional space. Also, developing strategic partnerships to supplement existing firm specialties may be beneficial for opening up new project opportunities when conditions become more competitive.
Managing expenditures is often viewed as an option of last resort, and therefore generally not planned in advance. However, having a series of possibilities in place to deal with a range of scenarios can save a lot of time and agony if cutting expenses is deemed necessary. Generally, it is useful to have a series of cost-cutting options planned out—for example, specific strategies to reduce firm expenditures by 10%, 15%, or 25%. Often, cost-cutting strategies are put off too long, with plans hastily hatched after more opportune choices are no longer viable.
Business cycles are a fact of life for architecture firms. On one hand, it is fortunate that it has been almost a decade since most architecture firms have seen a downturn of any magnitude, since these are typically extremely painful events. On the other hand, since it has been such a long time since firm managers have had to implement downturn policies, the “muscle memory” for dealing with them may be a bit hazy. Also, a large share of employees began their career after the last recession. Having never experienced a downturn in their professional life, they may be resistant to the sacrifices that are asked of them. That makes it all the more important that firm leaders monitor the situation closely, have the required information at their fingertips, and put strategies in place that can be implemented decisively should the need arise.
