Equipment rental poised for greater growth in 2014 and beyond
Editor’s note: The latest update to the ARA Rental Market Monitor™, an online subscription service available to American Rental Association (ARA) members, forecasts an 8.0 percent increase in North American equipment rental revenues in 2014 to reach $41 billion, including the U.S. and Canada. In an exclusive interview with Rental Management, Scott Hazelton, a senior partner with IHS Global Insight, the economic forecasting firm that compiles data and analyses for the ARA Rental Market Monitor for ARA and Rental Management, discussed why the industry is positioned to outperform the general economy in the coming years. An edited version of that conversation follows.
RM: How would you compare the performance of the equipment rental industry in 2013 to the rest of the economy? Why is rental performing so much better?
Scott Hazelton: The economic recovery is proceeding, just at a slow pace, as there remains a great deal of uncertainty both domestically and globally. In particular, Congress and the White House failed to resolve tax issues at the end of 2012, leading to postponed hiring and investment decisions until companies knew the after-tax cost of employees and equipment. The process has been repeated this year with a government shutdown that resolved little other than an agreement to continue discussions. Internationally, Brazil and India have underperformed, and Europe remains stagnant in terms of growth.
Rental has managed to perform better than the economy for several reasons. First, the economy is growing while businesses are cautious on long-term commitments. If a firm needs to expand capacity to accommodate any growth, rental is a way to get the necessary equipment without incurring a large expense or medium-term loan. Secondly, rental is well-positioned in growth industries. Construction is reviving, particularly residential, but commercial and industrial structural investment also is coming along. Energy sector growth has slowed, but the sector remains strong and well-positioned for future growth. Rental of industrial equipment also has been boosted by better performance in the automotive and transportation equipment industries.
RM: Equipment rental revenue growth started strong in 2012, but slowed in the third quarter with expectations that things would pick up in the fourth quarter and beyond. Why did this pattern repeat itself in 2013 and will we see the same in 2014?
Hazelton: The outlook for rental revenue growth was largely driven by the outlook for the economy. The assumption in 2012 was that the election would resolve fiscal issues and that there would be upward momentum at year-end, given increased certainty. In fact, quite the reverse happened as we had budgetary gridlock. The belief was that a resolution of the tax code in early 2013 would then allow this year to move upward in the second half. However, we ended up with government gridlock over the debt ceiling and health care implementation. The view for 2014 is similar to that originally called for in 2013 with growth improving over the course of the year, although it is a gradual rise.
RM: A year ago, the ARA Rental Market Monitor™ forecast called for growth to accelerate in 2014 and 2015. Do you have the same expectations now? Why?
Hazelton: Yes, the expectations are largely the same. The housing recovery is continuing and this drives about 15 percent of the economy. Mortgage rates have risen and slowed the new housing market somewhat, but the fact that mortgage rates are rising is in itself proof that the market is recovering — these are demand-driven increases, not the result of Federal Reserve policy, which remains expansionary. Also important to note is that home prices are increasing, which fuels further real estate development, but also improves consumer confidence. As long as job growth continues, even at its moderate pace, household formation will improve and homebuilding will expand.
A number of nonresidential structures benefit from housing, notably retail, but also health care, education and some local infrastructure to support water, sewer and roads. There is often a lag of 12 to 18 months between a residential recovery and renewed commercial growth. Indeed, the American Institute of Architects billings index — the indication that companies are hiring architects and therefore planning new building — has moved into the expansionary range. Moderate new hiring is on a pace to have jobs in 2015 equal their level prior to the economic peak. This suggests that vacant office and industrial space will be absorbed, creating the incentive for new construction.
With improved consumer confidence — and consumers account for about two thirds of the American economy — we will have the demand to have a sustained expansion.
RM: Are the expectations for 2014 different for Canada?
Hazelton: Growth rates in Canada are more subdued than for the U.S. Part of that is the now familiar base effect story — if the recession was not as deep, the expansion is not as robust. However, Canada also has implemented policies to limit the impact of a potential housing bubble. Canada’s weak residential market mitigates against other construction growth. In addition, Canada still has a large natural resource component to its economy and commodity prices are relatively flat. We do expect some modest upward potential in oil prices — the oil sands will continue to be profitable — but it is difficult to see any major expansion given a rather tame price outlook.
RM: In the U.S., residential investment is expected to show strong double-digit growth in 2014 and 2015. Why do you expect this to happen and how will this impact the equipment rental industry?
Hazelton: Housing demand is a function of household formation and the ability of households to afford new accommodations. The U.S. economy should form about 1.2 million households per year. At the trough of the recession, we were forming households at less than half that rate. The recovery is now strong enough that we are nearing a normal formation rate. They key assumption is that employment growth continues and we begin to absorb the pent-up demand of unformed households from prior years. Those individuals remain out there and will eventually need housing.
A 1.2 million household formation rate suggests a 1.5 million home construction rate, given the need to replace dilapidated units and the demand for second homes. To the extent that household formation exceeds 1.2 million, we will need to build incrementally more homes. That drives a forecast of housing starts at a 1.6 million unit rate or better for 2015 and 2016, at least.
It is important to note two other phenomena. First, new households tend to be renters or condo owners. Secondly, we are seeing a lower labor force participation rate, partly in response to the retirement of the leading edge of the Baby Boomer generation. The rising number of retirees also is likely to open up the larger existing homes that they already own while demanding proportionately smaller homes or condominiums.
The larger proportion of multi-family housing will increase equipment rental more than the same number of single family homes. The general tool segment does well in either scenario, but the construction equipment segment does better with larger projects. Also, as indicated above, there is a knock-on effect on other building types from a residential recovery. This can be especially prevalent locally as there is growth in property tax levies to support public construction and infrastructure expansion.
RM: Also, the forecast for construction in 2014 and 2015 shows residential construction growing at 15.6 percent and then 16.9 percent. Commercial construction is expected to grow 6.9 percent in 2014 and then explode to grow 24.1 percent in 2015. Why?
Hazelton: As we’ve discussed, residential expansions all by themselves create demand for local shopping, banks, restaurants and more. If the developments are large enough, they also impinge on local services and require investment in health care and education structures.
In addition, by the middle of 2015, we expect the unemployment rate to fall below 6.5 percent and for the economy to hit a new peak level of employment. This suggests the need for more space to accommodate net new employment, particularly in the office segment.
The industrial picture also looks better. Rising employment creates additional demand for goods and services, and rising home prices reinforce this trend. As importantly, an economy running at closer to full employment will support income gains larger than we have seen in recent years, so there will be increased production of key goods, such as autos, home appliances and machinery. By 2015, we expect economic recovery in Europe and better growth in emerging markets, which improves the market for U.S. exports.
RM: How does the North American energy boom benefit the equipment rental industry?
Hazelton: There has been a benefit to rental already from the energy boom — you can see it with a visit to any drilling site and in rental revenue numbers that have remained quite strong in an otherwise weak environment. Low natural gas prices have curtailed new exploration plans, but natural gas prices are once again on the rise, so we expect renewed growth in drilling.
So far, we have seen rental benefit mostly on the upstream side — drilling and extraction. However, we will next be seeing expansion on the midstream side. We need to build processing facilities for the gas to make it consumer-ready, and we need to get gas and oil to their markets — which are at some distance from where they are sourced. This suggests pipelines for natural gas and rail for oil. Given the nature of this type of construction, it is likely to be more equipment-intensive and provide even more opportunity for rental. The demand for steel, tank cars and other industrial components also will be good news for industrial equipment rental in manufacturing.
In addition, we only are beginning to see impacts on the downstream side — the processing of the gas into other chemical feedstocks and the potential to export our natural gas. Export would create the need for compression plants and port facilities for storing and loading. The processing of the raw materials will require investment in new chemical production facilities. Ultimately, the availability of lower cost feedstocks will boost the production of any U.S. product with a high petroleum component as we potentially become a lower cost producer of these goods.
RM: The projections for U.S. rental industry investment in equipment also show the expectation of growth in 2014, but a significant increase in 2015. What do you see happening in 2015 to cause this greater investment in equipment?
Hazelton: A rental company needs to buy equipment to meet demand. The expectation is that not only is there an increase in growth in 2015, but that this new level will be sustained for two or more years. Given the useful life of a rental machine, this suggests that not only will demand materialize for new equipment, but it will last sufficiently long to offer a profit on investment in that new equipment. Even with the increase in investment in 2015, the ratio of investment to revenue remains within historical bounds. Of course, growth cannot continue forever. We expect the level of rental activity to remain high in 2016 and beyond, but the growth to tail off. As such, the demand for new equipment should tail off as well as the existing stock will be relatively new and capable of meeting demand.
RM: How does the current climate for credit and financing equipment impact equipment rental?
Hazelton: According to the Federal Reserve Loan Officers Survey, credit is getting more available. This index indicates only whether credit is getting tighter or looser, not an absolute level, so credit could still be harder to obtain than in 2007, for example, and anecdotal evidence suggests that is the case. However, even with tightening in the broad commercial and industrial loan category, credit remains extremely tight in the narrow field of real estate development. As such, the contractors making the decision to rent or buy are among those seeing the toughest credit environment in the country. The good news for rental is that even if individual developers regain their confidence to want to buy their own equipment, affordability could be a problem for many of them for an extended period of time — until bankers feel as good about real estate prospects as the developers do.
RM: In general, the U.S. construction and industrial equipment rental growth by region is very positive, with all regions showing at least a 6 percent compound annual growth rate with the Pacific and Mountain regions showing more than a 10 percent compound
annual growth rate from 2013-2017. What is helping all regions show such growth over the five-year forecast period?
Hazelton: Historically, recessions hit different parts of the country to different degrees. In the early 1990s, the East and West coasts were hit harder than the Midwest as we had a financial- and real estate-induced recession. The more typical inventory correction recession tends to hit the manufacturing intensive Midwest harder. The Great Recession hit everybody, so the base effect means that everyone gets some strong growth coming out of the hole.
The key is to find the regions recovering for the “right” reasons. In parts of Florida and Nevada, for example, the growth comes from digging out of the biggest holes. In Texas, North Dakota and other energy-producing states, the growth comes from net new demand. States with well-diversified economies, such as Colorado, also have better-than-average potential.
RM: What economic factors should equipment rental stores watch closely in 2014 and 2015 to help them plan better for success?
Hazelton: On a macro level, job growth will be the important factor. This drives income growth, household formation and capacity absorption — all keys to the construction forecast. Recoveries are not smooth slopes — there are fits and starts — but it pays to watch the trend and any changes to the slope, which is the speed of the trend.
In conjunction with using the ARA Rental Market Monitor state and local forecasts for equipment rental industry revenues, another resource is probably the local paper or Chamber of Commerce. Knowing such things as who is doing well, who is looking at what land and who is hiring are all important clues as to who will be demanding equipment in the near future.
Business conditions also are a function of local, state and federal policy. There are localities and states looking at restricting fracking, for example. Federal action on tax reform, health care law implementation and other top issues will impact businesses. The ARA is very good at keeping its members aware of legislative affairs. In this case, it is not just enough to be aware, but to also be prepared to act to inform and influence the debate.