By Michael G. McGuinness
Improving economic conditions have led to an improvement in the NAIOP CRE Sentiment Index, indicating both overall optimism and several ongoing concerns. The Index for April 2021 is 54, significantly higher than the August/September 2020 reading of 45, which reflected a generally negative outlook for conditions. The current reading indicates respondents expect conditions for commercial real estate to improve over the next 12 months — in occupancy rates, rents, the availability of equity and debt and employment within their firms. On average, survey takers expect cap rates to remain unchanged.
However, respondents are now more pessimistic about construction costs than in any prior survey, and most expect construction labor costs to increase. This seems reflective of current labor and material shortages but may also indicate a consensus that demand for construction will grow over the next year (more on this below).
“We appear to be emerging from the pandemic, finally, with pent-up demand for goods and services and increasing reliance on delivery, which bodes well for the industrial and warehouse sector,” said Thomas J. Bisacquino, CEO and president of NAIOP. “Some mixed signals, and dramatic shortages in construction materials, remain indicative of ongoing market insecurity.”
Although respondents are broadly more optimistic, high standard deviations in survey results suggest continued uncertainty about the future. Varying degrees of optimism may also reflect a more challenging environment for some property types and geographic markets. As in the last survey, open-ended comments suggest a brighter outlook for industrial and multifamily, and continued difficulty for retail.
Of those surveyed, 57 percent expect to be most active in projects or transactions related to industrial properties over the next year. Multifamily was next at 20.9 percent, followed by office at 17.2 percent. Only 4.9 percent indicated they expect to be most active in retail. It was noted that Federal Reserve Chairman Jerome Powell is committed to holding interest rates low for the next two years.
Construction Cost Challenges
The contributing factors to rising construction costs are spelled out in “A Series of Unfortunate Events” by Ken Simonson, chief economist with the Associated General Contractors of America, in the summer 2021 issue of NAIOP’s Development Magazine. Despite as much as a threefold increase in the cost of materials over the last 12 months, contractor bid prices have only climbed 2.3 percent, as weak demand forced them to hold down prices even as their costs were soaring by 19 percent.
Lead times also increased this spring, with some suppliers of steel joists quoting delivery times stretching into late fall or early 2022. The crippling cold Texas experienced in February damaged facilities that produce the building blocks for plastic construction products such as PVC plumbing pipes and fittings, vinyl siding and vapor barriers and resins for acrylic paints, geotextiles and oriented strand board. That freeze also created more demand for PVC pipe to replace burst water pipes, resulting in nationwide project delays. Production problems at cement plants in Texas and California drove rationing in some Midwestern and western states just as demand was increasing for the spring building and paving season.
Shipping and rail delays on both coasts have left contractors scrambling for the appliances, fixtures, flooring and other imported products needed to finish projects. Just as some bottlenecks seemed about to ease, the six-day blockage of the Suez Canal in March added new reasons for delays.
Eventually these backlogs and price surges will abate, but experience tells us it can take as long as two years before contractors can pass through added costs. That may sound comforting to developers and owners, but it likely means many contractors could be driven out of business or certain market segments, leaving projects unfinished or far behind schedule.
According to the U.S. Bureau of Labor Statistics, from May 2020 to May 2021 material prices increased an astounding 146 percent for refined petroleum products such as diesel fuel and asphalt base, 114 percent for lumber, 107 percent for cold-rolled steel sheets that are used for metal studs and 39 percent for copper wire and cable. Still, savvy developers and owners are finding ways to mitigate these delays and extraordinary expenses.
Andy Halik, vice president at Chicago-based Skender, lays out steps to minimize risky economic variables and ensure the on-time and on-budget delivery of projects in “5 Solutions for Building Office Interiors Through Supply Shortages, Price Volatility.” With U.S. coronavirus cases plunging and knowledge workers craving the social component of the workplace, many companies are fully reopening their offices. Some used the lockdown to renovate or update workspaces, and some are now planning significant design changes to prepare for the next era of the office. Halik suggests five solutions, including:
- Blending the team early to foster collaboration between architect and contractor (in a design-build or design-assist delivery method) will accelerate schedules and prevent expensive, time-intensive redesign (stronger, earlier collaboration on these elements avoids do-overs later).
- Utilizing Lean construction, which focuses on efficiency and waste reduction and provides greater stability, reliability, efficiency and flexibility. A Lean builder can help navigate market conditions and material shortages and maximize ROI by conducting ongoing research, monitoring economic trends and providing counsel on lifetime costs, environmental impact, inflation and more. This process typically builds greater trust and ensures a continuous workflow.
- Expanding the material mix. This involves evaluating and analyzing substitute materials and systems to expand the menu of choices for all building components — foundations, superstructures, framing, interior building materials and more — early in the design phase to prevent any compromise on safety, quality, durability or functionality.
- Procuring materials earlier. Material prices are moving fast and furiously, causing daily uncertainty about how much a product could cost down the line. Working from real, data-driven expectations can aid in making material procurement decisions earlier, thereby mitigating unknown exposure to shortages resulting in cost savings, ensuring access to materials when needed.
- Establishing a strategic budget reserve and a reinvestment plan. Try to carry extra contingency and avoid building to your max budget upfront. Build a strategic buffer and, more importantly, a schedule of milestones for reassessing risk at the last responsible moment and gradually releasing reserved funds back into the project as risk diminishes. Converting surplus contingency adds real value and allows for adding project wish-list items, such as upgraded finish materials, appliances, technology and landscaping, that might entice employees back to the office.
Michael McGuinness is CEO of NAIOP New Jersey and has led the commercial real estate development association since 1997. NAIOP represents developers, owners, asset managers and investors of commercial, industrial and mixed-use properties, with 830 members in New Jersey and over 19,000 members throughout North America.