Rising Construction Costs
Nationally, construction costs have increased by more than 100% over the last 20 years — a trend that will likely continue — introducing a new layer of complexity to development, capital improvement investments, and landlord tenant lease negotiations.
Markets are struggling to meet the demand for labor across many industries, including construction; the supply of skilled construction labor simply cannot keep pace with the rapid increase in residential and commercial activity. Regulations are impacting build cost structures, introducing an element of unpredictability that further impacts project pricing.
Tenants are leveraging technology to enhance the workplace, adding significantly to build-out costs relative to those of just a decade ago.
Despite the historic rise in construction pricing, the Southeast’s relatively favorable cost environment and strong growth and demand trends place it in an envious position relative to higher-cost markets.
At this stage of the commercial real estate cycle, construction costs are rising faster than rents, further emphasizing the importance of long-term occupier and investment strategies that can withstand softening economic conditions.
While there is no universal strategy on how owners and occupiers are adapting to rising costs, new trends are emerging:
• Tenants are often renewing inplace leases instead of relocating and incurring additional build-out, moving and other expenses.
• Landlords are deploying capital wisely, balancing the cost of interior construction with the build-out needs of tenants to preserve the long-term value of their assets.
• Developers (and lenders) are proceeding with caution, only greenlighting high-build-quality projects located in prime locations with leasing pre-commitments in place.
Why Construction Costs are Rising
It took approximately 60 years, from 1940 to 1998, for the national RSMeans Construction Cost Index to climb from 0 to 100, but only 20 more years to climb from 100 to 200, doubling the index’s measure in one-fifth of the time. At no other point in America’s history have construction costs accelerated so aggressively. Consequently, the outlay required to build from the ground up or complete a tenant fit-out is at an all-time high, presenting new challenges to owners and occupiers of commercial real estate.
While the strategies used to minimize these cost impacts vary (many of which are discussed in this CBRE report, excerpted from the Southeast Construction Costs report, www.cbre.com/research), ultimately, the cost burden is an issue both occupiers and owners must assess, negotiate, and resolve to keep markets moving efficiently. The commercial real estate cycle is at a stage where new development is peaking across many property types. In addition, historically low unemployment is impacting the available supply of construction labor. As a result, the cost to hire and retain construction workers has increased, which also impacts costs, due to project delays. Compounding the cost challenge is the growing expense of building materials. Prices for steel, gypsum and glass have increased rapidly over the past few years, though certain material costs have leveled off recently. Further clouding the issue is the ongoing trade negotiations with countries supplying construction materials to the U.S. While the full effects of policy changes on trade are unknown, there could be additional upward pressure on pricing.
Given the longer-term, cyclical trend of cost appreciation, builders are “sharpening their pencils” and carefully considering the timing of construction materials purchases. Regulation is another major driver of cost, and adds complexity to the build process. As local, state, and federal building standards evolve, developers need to use more expensive materials and possess higher skill sets to execute projects in compliance with ever more complex building codes.
The time, labor and materials required to meet these new standards can add significant costs to a project, approaching as much as one-third of the total cost in the case of a new multifamily development. While cost factors can be segmented into distinct categories such as materials and labor, cyclical drivers of change (e.g. the densification of space, the rise of flexible space arrangements, and the increasingly prominent role of technology within offices), are placing historically significant emphasis on layout, design, and finishes, further inflating costs.
Both residential and commercial real estate markets were hit hard by the Great Recession, prompting workers to leave the construction trade in favor of job opportunities in other fields. Consequently, industry employment fell to a cyclical low in 2010, at a time when property fundamentals and construction levels were beginning to recover. Fast forward to today, and labor markets are struggling to meet the demand for labor across many industries, including construction.
The supply of skilled construction labor simply cannot keep pace with the rapid increase in residential and commercial activity. Atlanta is a good illustration of this trend. It is the second fastest-growing construction job market among the largest U.S. metros over the last five years, with a growth rate approaching 37%. However, Atlanta also has the highest rate of rent growth in the U.S. (14.2%) for prime office properties over 12 months ending Q1 2019. While this aggressive rent growth reflects tightening market fundamentals, it’s also due to the higher labor costs of constructing new space.
With construction activity peaking, builders are welcoming the recent pause in price increases of the four primary construction materials: iron and steel, gypsum, glass, and concrete block and brick. Notably, the rapid increases in the cost of structural steel in 2018 slowed through the first half of 2019.
Also, a slowing of demand in the U.S. housing market led to falling lumber prices. But the broader trend of rising material prices has overshadowed the temporary halt in appreciation, challenging developers to source and secure materials in line with budgets. Except for iron and steel, costs for primary construction materials have risen aggressively since 2011, with all four notching significant spikes since 2016. The rise in gypsum cost has been particularly rapid since 2011. Hard costs such as materials are typically inflexible, so developers often shift savings strategies to soft cost components such as labor and the timing of other non-critical improvements. However, the lack of slack in labor markets is making such shifts very difficult.
Despite the rapid increase in hard costs, overallconstruction costs in the Southeast have remained closely tied to the national average since the late 1990s. The rise in the region’s index score over the last five years is only slightly higher than the national average. And while the cost of materials challenges developers, the Southeast’s lower overall cost of doing business relative to other areas of the country provides some relief, albeit limited.
Regarding the impact of changing U.S. tariff and policies, the situation remains fluid, challenging contractors to make intelligent purchasing decisions. As of this writing, the impact on pricing for materials has been minimal, but estimators warn significant cost increases could hurt the profitability of future projects. Thus far, contractors are implementing strategies such as holding off on purchases for better pricing certainty, and working with suppliers to closely monitor prices. They are also looking for project- and budget specific opportunities to minimize pricing impacts. While trade negotiations have yet to impact construction pricing significantly, market participants should keep an eye on the dynamics of market rents and changing construction costs.
The breakdown of costs due to the impact of regulation is not well documented. However, research suggests the impact of regulations can comprise up to 32% of a project’s total cost, according to a joint study by the National Association of Home Builders (NAHB) and the National Multifamily Housing Council (NMHC).
Regulation affects every sector of the real estate industry outlining build requirements that ultimately increase both labor and materials costs. In general, market participants report an increase in regulation during this economic cycle, particularly in areas such as indoor air quality, fire and safety, and energy efficiency. Materials used during construction — like insulation systems, paints and structural components such as windows — must meet certain regulatory standards. Additionally, contractors must identify and hire the skill sets necessary for installation that complies with the more rigorous codes, which can add on more costs.
The joint study by the NAHB and the NMHC provides some observations on how regulation impacts multifamily construction: Although local governments generally have authority for approving development and adopting building codes, state and federal governments are becoming more involved in the process.
Cost increases from changes to building codes over the past 10 years were encountered 98% of the time by developers, and accounted for more than 7% of total development costs. When the cost of multifamily development rises, it translates to higher rents and reduces the affordability of rental housing.
Landlords are delicately balancing the cost of interior construction with the build-out needs of tenants. The higher end cost for Class A office tenant improvements in the Southeast is in the $150- to $250-per-sq.-ft. range, while the lower-end goes from $60 to $90 per square foot, all-in. The days of “turnkey” build-out are long gone, as the cost to prepare a move-in-ready space necessitates contribution — sometimes significant — from the tenant. The efficient use and management of tenant improvement funds are paramount, given the cost of the physical build-out, and technology associated with modern space design.
Here are just a few ways that landlords are adapting:
• Spending tenant space improvement dollars wisely, with a focus on stable, long-term credit occupants.
• Deploying fewer capital improvement dollars by delaying or scaling back planned projects.
• Building out vacant speculative space to proactively manage construction costs.
• Grasping the nuances of tenant build-out requirements to remain cost-effective.
• Gauging the cost of tenant improvements rolled into a tenant’s lease obligation to minimize the impact on asset valuation.
Tenants approaching a lease expiration are in a difficult situation, as favorable economic conditions and a tightening office market pressure rents upwards. Over the last five years, rents have risen by an average of more than 22% across the larger Southeast markets, with Nashville and Charlotte effectively in the 30% range. From both a space build-out and rent perspective, there are few remedies to rising costs.
The ongoing strategy has been for tenants to “ride out” existing lower-cost lease terms; then, before lease expiration, negotiate a renewal to remain in place. Renewing, despite the known increased rent, can save the additive costs of a new tenant build-out, moving, and the change management process. Consequently, there is some evidence that landlords are decreasing tenant improvement packages for renewing tenants due to the high costs of moving. If moving does become a competitive option, tenants sometimes sacrifice concessions such as free rent for landlord-amortized tenant improvement dollars to offset the cost of a space build-out. As a result, the tenant negotiation process is increasingly nuanced.
Developers in the current economic cycle have had to assess whether achievable market rents justify the cost of new construction. As Figure 7 illustrates, the asking rent for Three Alliance Center, a recently developed trophy tower in Atlanta’s Buckhead submarket, was substantially higher than the asking rents for either One or Two Alliance Center.
While these higher asking rents are reflective of market fundamentals during each time period, the greatest rent driver for Two and Three Alliance Center was the higher cost of building construction at the time. Despite the challenge of leasing new Class A space above the psychologically significant $40-per-sq.-ft. mark, the leasing team for Three Alliance Center was able to break through prior market rent barriers. Once occupancy reached a stabilized level, this afforded the developer, Tishman Speyer, the opportunity to realize a record price of $535 per sq. ft. upon sale.
This achievement ushered in a new era for metro Atlanta, one which established a model for other developers to follow for future office construction. In doing so, asking rents for new and trophy Class A product in Atlanta are now in the $40- to $50-per-sq.-ft. range. Similar trends are occurring in markets throughout the Southeast and across the country.
As construction costs rise, commensurate rents must be achieved to justify the exit strategy, and to wit, the risk of building at all. Consequently, both the cost and risk associated with building speculative space is greater, causing market participants to focus on high-value projects in the best locations.
New Class A office developments in the Southeast can have a rent premium of anywhere from $5 to $15 per sq. ft. triple net over existing buildings. Other than charging higher rents, there is little a developer can do to mitigate the actual construction cost of the project without sacrificing quality.
Developers are also working to mitigate risk through the next down cycle, because any new office building breaking ground today could deliver in a slowing economy. Thus, the capital stack and the term of debt financing are in focus. Developers will need much longer loan terms to provide enough time for lease-up if the economy slows at the point of construction completion. In this scenario, developers are focusing on designing and building the very best asset in the market, so that it will benefit from a “flight to quality” decision by occupiers. Hence the need for a longer debt term and lease-up timing to attract select tenants who will pay a higher rent, even in a recessionary period.
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