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Building pressure

September 30, 2014

Shopping center developers are carefully eyeing construction costs, which have been creeping upward these past few years and have even spiked dramatically in certain locations. Some developers blame the rising cost of materials, while others point to a big jump in labor costs. Still others insist that the increases are not at a level that is worrisome.

“It’s a great time to be an owner of shopping centers — if you want to sell,” quipped Stephen Coslik, chairman of the Fort Worth, Texas–based Woodmont Co. “But it is a challenging time to be a developer; construction costs, which were rising at a pace of 15 percent annually for the last two years, are jumping very quickly: In a 90-day period this year, we saw a 40 percent increase in steel prices.” And rents may have risen but they have not kept pace with the cost of materials and land, Coslik says. “Years ago we used to try to build a 12 percent return on costs — now you work to get a 9 percent to 10 percent return.” And even that is tough, he asserts.

Meanwhile, in the Gulf South, cost woes typically involve labor more than -materials. “The primary materials for retail development are steel, asphalt and concrete, and while there have been continual upticks in pricing, I’ve not seen any big jumps recently,” said Townsend Underhill, senior vice president of development at Covington, La.–based Stirling Properties. The firm owns and manages some 20 million square feet of commercial real estate, including 15 million square feet of retail, across Louisiana, Mississippi and Alabama, and into the Florida Panhandle. Construction cost increases in the Gulf Coast are attributable mostly to labor, Underhill says, though he also says that he is unsure whether that problem is endemic to the U.S. as a whole. “The big issue is a rare phenomenon of general contractors outnumbering the subcontractors by two to one or three to one in the Gulf South,” he said. “This is an inverse relationship, and it is not healthy for the construction economy.”

It seems that certain subcontractors in the region have been tying themselves to two or three general contractors and declining to bid on any other jobs. “In most jobs the subs are not bidding against the ‘preferred’ subs for a particular general contractor so you are getting one, maybe two price quotes on each subcontractor job,” said Underhill. “There is such a glut of work and such a limited amount of skilled folks in the sub trades, we are ending up with very few bids. These guys don’t have to compete with each other for projects.” 

Tim Grogan, editor of the Engineering News-Record, which tracks construction expenses for the building trades, finds all this talk of fast-rising construction costs perplexing. The publication reports that unionized labor costs are rising by a moderate 2 percent to 4 percent annually. Materials costs did jump, but that was a few years ago, and those have since settled back to absorbable levels. “We might have hit double digits five years ago,” Grogan said. “Today everything is ranging around a 4 percent increase.” Grogan says he does not measure specific project types, such as shopping centers, that could make the cost very different. “Overall we have been seeing modest inflation rates for construction,” he said.

Historically, cement expenses rise roughly 4 percent annually, but in June cement was up by 5.6 percent year on year, according to the producer price index. Steel pricing had its own big movement a few years ago but has begun to cool. Structural steel did rise by 4.6 percent this year, but it was down by 2.9 percent last year and by 9.3 percent the year before that. And this is after having swelled by some 14 percent in 2011. Projections are that steel will rise by about 3 percent next year. Lumber spiked big when housing began to make a comeback, but then housing stalled. Lumber prices jumped by 15 percent last year and by 13 percent the year before. This year the projections see lumber heading upward at a roughly 6 percent pace. 

Another company that tabulates construction costs is New York City–based Turner Construction Co., and its second-quarter 2014 building cost index — which tracks the U.S. nonresidential building construction market — was up by 1.24 percent from first-quarter 2014 and by 4.31 percent from the second quarter of 2013. These increases occurred because labor costs in markets seeing boosts in construction add to the upward pressure, Turner says. The firm also reports that while raw materials remain flat, the cost of manufactured and engineered construction components continues to rise slightly. 

Geography makes a difference. -Cincinnati-based Phillips Edison & Co., which does not work the top urban centers, is seeing only moderate increases in construction costs. Phillips Edison owns assets outside the top 25 metros. “There is less activity in these markets, and construction costs are not going up exceptionally,” said CFO Devin Murphy. “From our perspective, it is not a concern. We have not seen a spike in construction costs, but we have seen increases. That’s due to supply and demand. Post-financial-crisis, when you were putting out bids for construction projects, there were very few, so you were getting 10 to 12 general contractors bidding. Now you’re getting three to four bids. Clearly, the general contractors are marking up costs slightly.”

Lead times on shopping center projects do vary, but rising costs have thus far been no problem, though the potential for difficulties is there. “Issues occur if costs significantly change in the six to 12 months between tenant rent agreements and the start of construction,” said Underhill. “Historically, that hasn’t been a risk for us. We haven’t seen construction pricing moving enough in the life cycle of a project. The fear right now is that [it] will happen.”

Stirling is putting together a very large, multiphase retail project in Lake Charles, La. “It will be 18 to 24 months before we break ground,” Underhill said. “In my initial pro forma, I put in a 10 percent annual bump in construction pricing from today’s dollars. That tells you how much we anticipate pricing to move. A 10 percent increase in construction dollars — that’s historic highs.”