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Tax Credit Advisor: The Celebration Continues; Construction Costs Likely to Stay Lower This Year

May 01, 2010

By Mike Schlegel, President, Bozzuto Construction Company

“Where are cap rates headed?” That question echoes off the walls at just about every real estate industry cocktail hour. These days, however, I’m hearing a different question reverberate amidst the clinking glasses: “What lies ahead for construction pricing?”

The truth is, with multifamily housing project deliveries at a 10-year low, many contractors and subcontractors are lowering their prices to secure a share of the relatively
small amount of work moving forward. I am consistently asked three construction pricing related questions:

(1) How much have construction prices dropped, and why?; (2) How much lower will they go?; and, (3) How long will construction be “on sale”?

How much have construction prices dropped? Why?

It is probably easiest to first analyze how far multifamily rental housing construction costs have dropped since their peak in 2006. The table below illustrates the change in pricing per unit between 2006 and the latter part of 2009, for projects built in the Baltimore/Washington metropolitan area. The figures represent the final contract cost amounts per unit, including site work, parking, general conditions, and fees.

Since no two projects are the same, these figures cannot precisely reflect each and every development. But these percentage changes are probably in the ballpark for most markets nationwide, give or take a few points. Most of the decrease in construction costs has occurred in the past 18 months. This is a very significant change in a very short period, especially given that construction costs normally track inflation loosely.

Most believe that these large recent construction cost savings simply came from contractors and subcontractors cutting their margins. While all of us in the multifamily industry have sharpened our pencils, the fact is that cuts in contractor and subcontractor margins are not large enough to fully account for the large recent reductions. So what’s the full picture?

Most large contractors operate on a pre-tax net margin of 1%-2.5%, subcontractors, 5%-10%, often based on size. (Interestingly, larger subcontractors tend to have lower margins.) But even if contractors reduced their net margins to 1% and subcontractors to 3%, the sum of these savings would only account for approximately one third of the total cost reductions between 2006 and 2009.

The remaining savings has come from reductions in costs for materials and, to a greater extent, labor. Pricing of materials tends to be somewhat rational (notwithstanding the current rise in lumber and drywall prices); manufacturers factor in their actual costs for labor, raw materials, delivery, energy, etc.

With the construction industry’s unemployment rate nearly 30%, labor costs are a bit less rational. Many individuals are willing to take a construction job at almost any rate; they have minimal “overhead.” Minimum wage is the only floor for labor costs. And non-factory labor accounts for nearly 50% of construction costs.

How much lower will construction costs go?

Some fear that construction costs are about to rise. For the most part, this is not the case.

True, prices for some materials – lumber, copper, diesel fuel – have increased in recent months, some rather dramatically, prompting some economists to cry out that inflation is imminent. Yet while prices have risen for certain materials, we have not seen an increase in overall construction costs. For example, our own company saw even lower prices in two recent subcontractor bids that we received. In fact, our subcontractors tell us that what little backlog they have will run out this spring and summer – they have few new prospects on the horizon.

While I do not expect to see multifamily construction costs fall much more, I would not be surprised by a further drop of 2%-3% in 2010. Sure, there will be spot inflation in certain trades or materials, but these will likely be offset by reductions in other areas.

One positive product of a recession is that everyone learns to produce much more for less. This greater efficiency will last into the next boom market.

How long will construction be “on sale”?

Multifamily projects often take 12-24 months to build. In addition, the construction industry always lags the rest of the economy when entering and emerging from a recession (single-family home building excluded).

Thus, I predict that 2010 will be worse than 2009 for most contractors and subcontractors.

There is very little demand for their services now, and the gestation period to get a project started is lengthy. Conventional debt and equity projects are virtually non-existent. And even if the financial markets return to normalcy soon, it can take six months or more to underwrite, permit, and close a conventional multi-family deal. Additionally, HUD’s backlog for Section 221(d)(4) loans is now around nine months.

In summary, there is plenty of excess capacity in today’s construction industry. Unemployment is well north of 25%; plenty of workers are sitting idle at home. And many factories are operating at half capacity.

This sarcophagus of excess capacity will need to be significantly absorbed before we see any noteworthy inflationary pressure in the construction industry. Therefore, I expect that the “sale” on construction will continue through 2010 and into 2011….which means that tomorrow is a great time to start that new project.

Mike Schlegel is President of Bozzuto Construction Company, based in Greenbelt, Md. Established in 1988, the company has constructed and renovated more than twenty million square feet of mixed-use and multifamily residential projects valued in excess of $2.2 billion. The firm’s portfolio includes urban infill, high-rise, mid-rise, senior living, affordable housing, and garden-style apartments, along with retail, theatre, student housing, and site infrastructure construction/ renovations. Bozzuto Construction’s expertise is in project planning, cost estimating/bidding, general contracting, and construction management. Schlegel can be contacted at, 301-220-0100.