The complex and fluctuating nature of the commercial real estate market can make it difficult to stay up to date on trends and changes in the industry, with even the smallest points changing market dynamics and influencing cost, risk, and expected returns. The cost of construction is one such factor, and it has recently seen a sharp increase.
So how does this impact CRE sponsors and firms? Read ahead to get the 411 on rising construction costs and what steps you can take to reduce the hit to your ROI.
Factors Driving Cost
There are two main factors driving construction cost inflation. In tandem, a shortage of skilled labor and the March 2018 implementation of tariffs on steel and aluminum have created a demand-driven cost escalation. According to Bisnow, construction cost increases are double the rate predicted by consumer price indexing and are now projected to average 6-8% in 2019. MGAC predicts that near the end of 2019 and heading into 2020 we may see demand slow and cost plateau, but current projects and upcoming deals will undoubtedly experience a spike in building cost. And unfortunately, in many cases developers will have to absorb these costs since bids for current projects were likely made months prior.
Skilled Labor Shortage
Since 2015 there has been a shortage of skilled laborers in the United States. A strong economy and low unemployment rates translate to difficulty attracting and retaining workers. Associated General Contractors of America reports industry-specific unemployment rates of 5.1% and an hourly pay increase of 3.9% heading into 2019. At the contractor level, sub-contractors have run the show by setting their own prices, and contractors have had to reluctantly agree or face project slow-downs. The shortage of skilled laborers raises CPI, which can limit potential returns.
Tariffs on Steel and Aluminum
The Trump Administration enacted tariffs on steel and aluminum in March 2018 that made waves within the construction industry. The tariffs, 25% on steel and 10% on aluminum, have led to supplier price-gauging in a bid to compensate for expected inflation and uncertainty. Without clear-cut expectations regarding price fluctuations and with an ever-climbing PPI, some contractors are building in a contractual steel contingency and refusing to begin new projects at a flat rate. Thus, the trickle-down effect of construction inflation reaches directly into your firm’s pocket.
These compounding factors have led to strained relationships, with contractors and sponsors both asserting that the additional expense should be absorbed by the other party. Trouble negotiating contracts and procuring materials can delay the building process, and shortage of skilled labor can cause additional lengthening of project timelines. Value-add and adaptive reuse projects may be experiencing a surge in popularity due in part to the cost of sourcing raw materials.
Proactive Steps You Can Take
It’s important to take construction inflation into consideration when budgeting, negotiating, and executing projects. Taking proactive steps will improve your overall ROI and help you insulate yourself from excessive expense. These trends may be unsettling, but there are several ways you can alleviate your cost burden.
Implement Bidding Contingency
One of the ways you can mitigate your own risk and insulate against construction cost inflation is to factor these costs into your bid structure. A fluctuation clause written specifically to address material cost will help limit your risk. It’s also wise to build excess into your budget in anticipation of cost, or to consider your top bid with possible steel or other supply contingencies in mind.
If at all possible, look into pre-purchase of raw materials, specifically structural steel, to lock in prices. This will limit risk and make it easier to predict ROI and calculate metrics. Flat-rate pricing narrows the possible ROI window to make total returns easier to predict.
Like all aspects of the CRE industry, change happens quickly. Construction cost is closing in on a flattening yield curve and will have to slow eventually. Global economics and policy changes can change the landscape of an industry overnight, so don’t let yourself fall behind. Expand your scope beyond the CRE industry so you can see the big picture and predict how changes outside the industry may impact what is happening within.
Offset the Cost
Look for areas of your business with opportunities to streamline operations and reduce cost. Forward-thinking firms are looking at potential ways to offset anticipated increases in construction cost, such as by implementing technology that can drive efficiencies and cost savings elsewhere in the company. A fully implemented digital strategy will save money, drive value over time, and reduce the amount of time spent on back office tasks, giving you more time to devote to addressing hurdles and keeping your business profitable.
What the Future May Hold
Don’t worry—there’s light at the end of the construction cost tunnel, and burgeoning cost is a sign of a robust economy. A skilled labor shortage may mean inflated prices, but low unemployment in any industry means more circulating capital. Don’t consider construction cost an obstacle. Instead, try to view it as an indicator of economic prosperity and overall market strength. The construction market is strong, but not infallible. While further increases are possible, it’s likely that the construction industry will stabilize and cost will plateau. Staying informed, leveraging technology, implementing bidding contingency, and pre-negotiating raw materials will help you mitigate risk and limit cost.
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