Why Construction Costs Are On The Rise 02/06/20

Why Construction Costs Are On the Rise

Post-Great Recession the U.S. construction industry has been rather dynamic. Employment, despite expanding by nearly 30% over the last ten years, has failed to surpass 2007’s peak levels. A steady commercial development pipeline, coupled with this shortage in skilled labor, is putting upward pressure on industry wages. Material prices continue to rise as well. Combined, these trends have led to rapidly increasing construction costs across commercial real estate markets in the U.S. While some indicators point to decelerating growth in the cost to build, industry experts anticipate modest gains to persist over the next year. Accordingly, expect this to impact all facets of commercial real estate development — including new construction and fit-outs for office product.

All-in Building Costs

Over the last 5-7 years, all-in building costs have been on a steady incline. Such consistent growth can be seen in the chart below, which looks at construction indices from two major players in the industry. While the scale is different for each of these data sources, the trajectory remains the same. Turner Construction’s Building Cost Index increased by about 25% since the beginning of 2013 and Engineering News Record’s National Building Cost Index climbed by more than 12% during the same period. Within the last year, Turner’s index increased by roughly 1.3% per quarter while growth in ENR’s index tapered off during the latter half of 2017.

Both sources site shortages of skilled labor as a major driver of these growth patterns, with recent natural disasters contributing to rising material costs as well.

Labor Costs

At a national level, construction employment has been on an upswing for several years, and skilled labor remains elusive. The following chart highlights just how tight the labor market is. The unemployment rate ended 2017 at 5.9%, which is more than 20 percentage points below the 2010 peak. While seasonality caused rates to tick up during the last few months of the year, by all indications construction employees have a clear upper hand in this market. These conditions are not expected to sway anytime soon.

As the demand for construction laborers continues to outstrip supply, wages have risen swiftly in recent years. According to data from the Bureau of Labor Statistics, average hourly earnings for this industry reached $29.31 in December of 2017 on a seasonally-adjusted basis. This represents at 3.1% expansion from year-ago levels.

Looking ahead, the labor market will remain constrained amidst the lack of skilled workers, stricter immigration policies, and weaker participation among younger age cohorts. Hourly wage growth should accelerate throughout 2018 as a result.

Material Costs

Hard costs account for a large share of development budgets. Several factors have led to the growing price of construction materials in the U.S. More recently; industry experts point to natural disasters impacting materials production as well as driving demand for new construction efforts. Looking at the Bureau of Labor Statistics’ Producer Price Index for construction materials, growth appears to have quickened over this past year; expanding by 4% from 2016-2017. This nearly doubles the growth seen during the previous year.

Material costs are anticipated to continue to rise through 2018 as well. In fact, prices have already surged during the first few months of the New Year. Uncertainty in the marketplace and recently imposed tariffs on foreign materials (25% on steel and 10% on aluminum) have begun to affect the bottom line. According to the National Real Estate Investor, sources in the construction sector saw a roughly 10% increase in the cost of steel following the announcement in early March of 2018. While this legislation excludes steel sourced from Mexico and Canada, costs are expected to climb further once these tariffs take effect.

Fit-Out Costs: Office

Rising construction costs not only affect ground up office developments but also, building out office space for new or existing tenants. Generally speaking, an office fit-out is a process of making interior space suitable for occupation. Although the type of space and complexity of the project will ultimately dictate pricing, hard costs (i.e., materials) account for more than half of a fit-out budget. A sharp increase in Tenant Improvement (TI) allowances is another indicator of growing costs. As leasing velocity downshifts during the latter stages of this current commercial real estate cycle and landlords begin to face stiffer competition for tenants, TI packages will likely become more generous. In the near term, expect material and labor costs to continue to rise — putting upward pressure on fit-out pricing in 2018.

Local Construction Costs: Boston

Boston remains one of the most expensive markets in the U.S. to build new construction and fit out offices. Citing data from JLL, Bisnow labels this market the sixth-most-expensive place to build in the U.S., with costs at a 12% premium over the national average. Similarly to national trends, the scarcity of labor and rising materials costs have been key drivers of increased pricing in Boston.

Add in high land values and growing demand for new residential and commercial space, and the cost to build has soared here. The cost of constructing a new office building locally, per Massachusetts developer Dacon Construction, has increased by close to 59% from 2012-2017. Fit-out costs have risen by 29% during the same five-year time frame. Construction cost guides from Walker Development, another local developer, paint a similar picture with general buildout costs jumping by approximately 30% over the last three years. The high-water mark for TI allowances in Boston reached $100/SF on select leases signed recently in existing Downtown office buildings, and packages have been well over $100/SF for long-term leases signed at newly constructed properties. Comparatively, allowances were topping out at $75-$85/SF for Downtown office space just 4-5 years ago. New technologies and creative solutions may help mitigate escalating construction costs in Boston, but developers should expect to pay more for development projects in the near term.

Final Thoughts

As 2018 progresses, the impact of the growing labor shortage and recent government legislation on the construction industry’s bottom line are key narratives to pay attention to.