Cost fluctuation for raw materials is nothing new—it's a reality of our business," says Glenn Ferguson, president of Clark Realty Builders in Bethesda, Md. "Price increases simply make it more challenging to predict costs, particularly for longer-term projects. It seems like every year it's a different material's turn to shoot up in price."

It's not just in Ferguson's imagination. According to the Bureau of Labor Statistics, the Producer Price Index (PPI) for multi-unit residential inputs rose 7.9 percent from April 2004 to April 2005. That's compared to a 6.8 percent rise between April 2003 and April 2004 and a scant 0.5 percent for the same period from 2002 to 2003.

"If you tied up a deal two years ago, chances are the numbers don't work now," says John Eudy, executive vice president of Palo Alto, Calif.-based Essex Property Trust, a REIT with ownership interests in apartment communities on the West Coast. "And if you're tied up at today's prices, it's a hard time to make it work."

There are many reasons for the surge in construction costs and building materials prices. Interest rates are down. Housing demand is up. Trade policy is restricting cement and lumber imports. China is developing rapidly, and Iraq still needs rebuilding. All these factors collided last year, causing commodity supplies to crater and raw materials costs to skyrocket.

Running the Numbers
Running the Numbers

Such volatility creates a challenging budget and planning environment for multifamily builders, developers, subcontractors, and lenders. "Historically, materials costs were fairly predictable," notes Dan Walsh, managing director of KeyBank Real Estate's private equity group in Cleveland. But that hasn't been the case recently.

According to the 2004 PPI, the highest cost increases were for oriented strand board, or OSB, which rose 65.9 percent. For the first two months of 2005, the price rose by another 13.8 percent.

"There are fewer manufacturers of panel goods," says Paul Sowders, COO for Jacksonville, Fla.-based Summit Contractors, builders of 220 multifamily properties across the country. "They certainly are controlling the market. The latest hurricanes and horrible weather also increased demand."

Other materials experiencing double-digit price growth were steel (32.7 percent), copper and brass (30.6 percent), gypsum (15.2 percent), plywood (14.7 percent), and lumber (11.6 percent).

"Global competition for these construction inputs results in higher prices generally," explains Don Neff, president of La Jolla Pacific, a real estate consulting firm based in La Jolla, Calif. "The rapid industrial growth in China has taken up slack demand for concrete, steel, and petroleum products. As such, we are not likely to see moderating prices for these three inputs here in this country until a global recession sets in or more supply of those products becomes available."

Oil Connection Another factor in rising costs: oil and diesel fuel. According to the PPI, the costs for diesel jumped 58 percent between March 2004 and March 2005. People are paying for that at the pump, of course, but multifamily builders and contractors also are feeling the pinch.

"The fuel market will [wreak] havoc if it doesn't play out pretty soon," says Jeff Dickerson, vice president of construction for Opus West, an Irvine, Calif.-based provider of architecture, construction management, real estate development, and property management services. "It really affects everything." Diesel fuel powers construction trucks and off-road equipment. Oil is included in asphalt and roofing materials. And both contribute to the cost of any material that requires energy to heat, fabricate, or ship—plus the fuel surcharges on the myriad of deliveries to a construction site.

Cost-Saving Strategies So what are developers and builders doing to manage all these changing costs? Some get more aggressive with value-engineering, looking at every aspect of a project to find the best economies. Others retool the purchasing process to lock in volatile commodities early or pass the costs on to buyers and tenants.

But at the heart of it all is the budget. "You've got to have a decent contingency in your budget," Walsh says. "So be careful about your inflation assumptions. Drill down into your market to see if national economic trends play out in your area."

1. Look for Value.

Shaving costs off any project is tough anywhere. But it's even more difficult for developers working in urban infill situations, says Richard Gollis, founder and principal of The Concord Group, a real estate advisory firm in Newport Beach, Calif.

"Just staging the construction is more difficult and adds layers of costs," Gollis says. There's often remediation from prior uses, zoning changes and other challenges that add time and money to the project.

And then there's the structure itself. "High-density infill projects use more concrete and steel, so we've had to look for better ways to build the same product," explains Scott Choppin, managing partner of Urban Pacific Builders, a Long Beach, Calif.-based company. "When you can get the same density for less cost it's a slam dunk."

So, instead of doing a traditional podium design with a parking deck and units above, Urban Pacific selected a slab-on-grade option. This less complex construction style lowers materials spend while maintaining project density. (See "Keep It Simple," below.)

2. Use Your Purchasing Power.

Many developers buy early, securing savings in the supply chain by retooling the purchasing timeline. Moving out of sequence allows developers to procure certain materials early in the game if they expect prices to escalate, locking in a price.

"We're being more proactive," Choppin says. "We buy steel before we let the contract with the general contractor. We know the kind of material we need and buy it independently. That cuts out the mark-up and allows us to get a commodity at a fixed price."

Other developers award contracts out of sequence so contractors can nail down the priciest items first. "We try to make a concerted effort to get everything with steel or concrete awarded first, mitigating the risk by locking the price in," says John Fumosa, executive vice president and general manager of Hunter Roberts Construction Group's Philadelphia office. The newly formed construction firm focuses on commercial and residential projects, including multifamily, in the $10 million to $50 million range.

The downsides to early purchasing? The materials have to be stored, which costs money. And if prices go down, you've missed the savings.

3. Pass the Buck.

Perhaps the simplest way to deal with increased costs is to make them someone else's problem.

With demand for condominiums outstripping existing inventory, for-sale developers can expect buyers to absorb higher costs of construction.

"You can pass the increase in prices on to whatever degree you can in a good market," says Randy Rieger, owner and principal of Coconut Grove, Fla.-based Housing Trust Group, which invests in, develops, and manages affordable and market-rate residential housing in South Florida. "There are enough people wanting to buy to keep developers happy."

But not every market is that tight. "In the student or affordable housing communities, it's difficult to pass on costs because the rent base is fixed and these segments are in such a downturn," Reiger says. Costs can also be passed through to contractors. "We try to transfer the risk in all trades as quickly as possible," Fumosa explains. "That way, we're mitigating the risk by spreading it among 30 to 35 subs."

This is usually done via a guaranteed maximum price, or GMP, contract. "GMP contracts more frequently contain cost indexing for certain materials subject to volatile price fluctuation that allows the price to increase, notwithstanding the ?guaranteed maximum price'," explains Harold Lewis, a partner at Pathman Lewis, a law firm in Miami.

But in hot markets, this strategy is tougher to deploy because contractors don't have much incentive to work with a developer who's trying to be competitive on the buyout.

"Developers should, of course, attempt to eliminate or limit the use of indexing by the contractor and press the contractor to stand by his guaranteed maximum price as nearly as possible," Lewis counsels. "The problem with this approach is that the contractor will generally respond by increasing the guaranteed maximum price to a point that lowers the contractor's risk of price volatility."

Developers should bear in mind that they may need to absorb some or all of the pass-through of construction price increases from material shortages to avoid serious construction delays. And they should protect themselves in other ways. "Subs can't always absorb an increase in cost," Fumosa notes, "so we bond certain contractors if we think they're not capable of absorbing a cost increase."

Don't forget to brace yourself for a worst-case scenario. Lewis advises developers to include pre-sale and/or financing contingency clauses in their purchase contracts. That way, if the project can't get financing because of excessively low profits, the developer can cancel the sales contracts.

"In the present environment, a developer is in a rush to get substantial pre-sales in place and may not fully know what the cost of construction will be at the time that he is signing contracts," Lewis explains. "At the opposite end are the contractors who are taking as much time as possible to accurately run their numbers in light of the demand and volatility in supplies. The developer may be stuck with binding contracts at a lower square foot price than it needed to make sufficient profit and satisfy the lender."

4. Substitute.

Another way to keep costs in check is using alternative products. "Many of [our] projects take advantage of synthetic materials in the exterior application," explains Dave Angelini, purchasing director, for Clark Realty Builders in Bethesda, Md.

"These have given our customers exceptional value and quality," he continues. "Generally, these products are easy to work with, low maintenance, and fairly stable—plus, they meet one of Clark's key operating principles, which is to keep a high level of versatility and availability for our product lines."

5. Plan Ahead.

How long will price uncertainty last? Costs have shown signs of stabilizing in the last few months. From March until the end of 2005, construction materials prices are expected to increase less than 5 percent.

"I expect prices to remain volatile because there is so much more demand from developing countries for a variety of materials," notes Ken Simonson, chief economist for the Washington, D.C.-based Associated General Contractors of America. "But the volatility will be down as well as up, whereas last year it was mainly up. Mining, oil-drilling, steel making, and other activities are responding to higher prices, and demand has cooled in Europe, Japan, and some U.S. markets."

So most developers are staying conservative. "These days, we don't start a project unless the costs have been dialed in and locked," Essex's Eudy concludes. "Getting into a deal without fixed numbers is a still bad idea. We'd rather delay the project until the prices have settled down and commit later. Once you start, you can't stop it. You have to finish."

—Margot Carmichael Lester is a freelance writer in Carrboro, N.C.