In his more than two decades in the real estate business, Bob Faith, CEO of Charleston, S.C.–based Greystar Real Estate Partners, has ridden three different real estate cycles. In that time, he’s learned some valuable lessons. Most notably: When you’re developing apartments, timing is everything.
“Historically, if you look at your margins on projects as you go through [each] cycle, the highest margins are on the earliest deals,” says Faith, a Harvard MBA, who diligently studies past cycles for hints of future behavior. “As you get deeper into the cycle, margins get thinner and thinner as competition grows.”
Obviously, Faith saw margins wide enough to justify development in 2012. Greystar started 5,360 units, placing it No. 1 on multifamily executive’s Top 50 Builders list (see May 2013, page 51). But in 2013, Faith plans to pull in the reins a bit—estimating about 4,700 starts. “I think 2012 will be the high point,” he says.
Steep Increases
Why pull back when you’re at the top? As Faith indicates, margins simply aren’t where they were a couple of years ago. With more people starting apartment developments, costs are rising. And, in some cases, they’re spiking dramatically.
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These cost increases are coming from a variety of places and are forcing developers and contractors to re-evaluate their deals. Right now, Faith and many of his counterparts have mechanisms in place to buffer the effects of rising costs. But if costs don’t stabilize or don’t decrease, many of those same people may start slowing down their construction engines as quickly as they revved them back up.
A quick glance at the producer price index (PPI) from Arlington, Va.–based Associated General Contractors of America (AGC) illustrates just how much building products for garden-style properties, in particular, continue to rise as the cycle heats up. As of March 2013, gypsum products had risen 4.4 percent since January 2013 and 17.8 percent since February 2012. In the same time frame, lumber and plywood rose 2.3 percent and 15.8 percent, respectively.
For many developers and general contractors, woozy from the brain damage of constantly readjusting deals, AGC’s numbers feel conservative. Faith says he’s seen costs (especially for wood-frame projects) increase 15 percent to 25 percent over the past 18 months.
Patrick Trask, regional director at Atlanta-based Wood Partners (which built 5,082 units in 2012), says lumber has risen a percentage point per month, pushing up costs 20 percent since the downturn. Charles “Chip” Bay, senior managing director of the Mid-Atlantic region for Dallas-based Mill Creek Residential Trust, which built 5,001 units in 2012, estimates a 5 percent to 7 percent increase in construction costs over the past year, with lumber rising 40 percent to 45 percent and drywall going up more than 30 percent.
Contractors, as well, are feeling the pain. “Across the board, we’re seeing costs that are 20 to 30 percent more than a year ago,” says Marc Padgett, a principal with Summit Contracting Group, a Jacksonville, Fla.–based general contractor.
There are several reasons for these increases, one of which is beyond simple supply and demand, as Thomson Reuters reported in March 2013. The news service noted that contractors, lumberyards, and homeowners had filed suits alleging a price-fixing conspiracy against a number of building product manufacturers.
Other explanations have more to do with basic economics. When the economy fell off a cliff and construction halted in 2008 and 2009, both gypsum and lumber manufacturers shuttered their facilities. “The pipeline has been depleted for all of these construction projects,” says Kenneth D. Simonson, chief economist at AGC. “I do expect to hear of a lot more facilities opening in the next few years [however].”
Buying lumber products isn’t the only challenge; finding framers to install them is an equally pressing issue for developers and contractors. Just as manufacturers shut down plants and mills when the recession hit, framers retired, went to other industries, and, in many cases, returned to their home country (see “Labor Pains,” page 29).
Suddenly, there’s a labor squeeze. “You used to be able to get as many framers as you wanted,” Padgett says. “With one phone call, you got 100 guys. Now, you have to make 50 calls to get 25 guys.”
Framers aren’t the only trade whose costs are rising. “Many multifamily subs went out of business during the recession,” says John Rooney, project director at Doster Construction Co., a GC in Birmingham, Ala. “This has led to fewer subs bidding on more jobs.”
And with 299,000 starts slated for this year and another 317,000 in 2014, according to the National Association of Home Builders, good multifamily contractors will be able to pick and choose the jobs they want. If single-family starts continue to increase on top of that, the price squeeze for labor and materials will only tighten.
“Until the demand [for contractors and materials] is absorbed, things won’t change,” says Kent Plemons, a vice president with Addison, Texas–based Pinnacle, which started 2,400 units in 2012.
Ultimately, the biggest component in development is land. Since the initial flood of bank-owned, entitled land hit during the recession, the market for dirt has hardened. But Mill Creek’s Bay sees things easing up. “Land recovered significantly in multifamily,” Bay says. “There are a lot more people in the business, and we haven’t seen a reduction in the price pressure, but I think that’s starting to come to an end.”
Containing Costs
Surging construction costs seem to affect different developers in different ways. Faith says prices haven’t forced him to abandon any deals. “That would be a pretty dramatic set of circumstances for that to happen,” he says. “There’s an awful lot of the pricing that you should know, going in, to a high level of certainty.”
That’s not the case everywhere, though. Padgett says he was working on a student housing deal in Murfreesboro, Tenn., when the developer came back to him and said the plan had outgrown its original budget because of construction costs. “He already had a relatively skinny deal anyway,” Padgett says. “Developers can only squeeze so much before a deal doesn’t work.”
If the deal does work, there are things developers can do to contain costs. For Faith, the key to cost control is simple—knowledge and repetition. Greystar usually relies on its own construction teams and has an urban garden product that Faith estimates the company has replicated 15 to 18 times over the past 12 to 18 months. “That repeatability and experience take a lot of the variability out of pricing,” Faith says.
But even with that certainty, things change. Trask says Wood Partners typically estimates some type of inflation over the period it’s pursuing a project, usually a quarter to a half percent a month, to cover rising costs. As it fine-tunes the design, Wood eases off the contingency.
Theoretically, it’s possible for developers to buy materials ahead of time, but they’d have to pay storage costs. Trask says it’s also harder for private developers like Wood, because it does every deal as a single-purpose entity. “We don’t have the money for that project until we close with an equity partner and a lender,” he says.
Instead of buying materials beforehand, Cleveland-based Forest City Ratner Cos. (FCRC) is trying something that could provide a template for developers who want to contain costs in the future: modular construction. At its Atlantic Yards B2 Modular project in Brooklyn, N.Y., Parsippany, N.J.–based Skanska and FCRC created FC + Skanska Modular to build 930 modular components off site and attach them to each other (and to the building’s steel frame) on site. Skanska says it’s estimated the modular construction will result in 70 percent to 90 percent less waste than traditional construction.
Like a number of developers, Mill Creek tries to have its contracts in place when it closes on a deal so that its pricing is locked in. Although the subcontractor or supplier is responsible for price variability in this scenario, it can lead to other issues.
“When prices are moving by 15 to 25 percent, that makes a scary environment for a sub,” Faith says. “It has led to several situations where we had to sit down with subs. You’re not going to get anywhere by forcing somebody into bankruptcy over a contract they can’t do.”
In a rising-cost environment, ultimately the safest way to deal with uncertainty is to remember the basics: Build contingencies, trust your underwriting, and, if the deal doesn’t work, don’t do it.
“It all comes down to project feasibility,” Faith says. “What you see in the later part of the cycle is that deals get priced to perfection, meaning the margins are so thin that everything has to go perfectly or else it’s not going to turn out well.”
Ultimately, the best way to combat rising construction costs is to beat the cycle. MFE
