Surging Construction Costs: Implications for Commercial Real Estate

Over the past two years, residential construction spending has skyrocketed while commercial construction spending, including most “non-residential” property, declined (Figure 3). This comes as most commercial sectors, such as office, retail, and hotels, have reported more muted absorption levels, while those of industrial, multifamily, and life sciences have remained robust. At the same time, demand for all forms of residential for-sale housing has remained very strong, as there continues to be a shortage of high-quality and affordable housing in many parts of the country, as more and more live in a broader mix of living arrangements and locations amidst favorable demographic tailwinds.

​FIGURE 3: RESIDENTIAL & COMMERCIAL CONSTRUCTION ​SPENDING, 2002-2021^​12

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IMPACT ON THE CRE INDUSTRY

Overall, higher construction prices have mainly impacted the overall CRE industry in four ways, which may continue in the near future.

• Tighter margins on new development and renovations;
• Project budget overruns and delays; according to a recent survey by the International Data Corporation (IDC), 78% CRE owners were over budget on construction projects and were an average of 70 days late on projects;¹³
• More moderate development pipelines, largely excluding multifamily and industrial; and,
• More room for rent growth and appreciation at existing properties due to higher replacement costs.

However, the anticipated effect on Clarion Partners’ target overweight sectors varies considerably based on current supply and demand dynamics.

​Industrial:​ With vacancy near all-time lows and absorption at record highs, industrial demand has remained extraordinarily robust over recent years and throughout the pandemic.

Residential​: With the recent strengthening of home property values, single-family home builders also have a greater ability to pass on the increasing financial burden to buyers through higher purchase prices. On the other hand, stick-built low-rise and garden-style multifamily have been more impacted by the recent spike in lumber prices, while high-rise multifamily was less affected, as lumber is less of a key building material for this format. While the recent decline of lumber prices is welcoming new development, overall construction costs for multifamily remain elevated.

PROPOSED INFRASTRUCTURE SPENDING

In the years ahead, there may not be a signifcant correction in the recent run-up in construction prices if supply chain disruptions remain and the infrastructure spending legislation is approved. The Biden administration’s massive infrastructure plan is likely to have a major impact on construction costs over the outlined five-to-eight-year spending period, impacting both material and labor costs nationwide. The planned $1.2 trillion “Bipartisan Infrastructure Framework” is expected to make large-scale investments in clean air, water, and transit infrastructure.¹⁴ The program will direct billions of dollars towards major clean energy and transportation initiatives, universal broadband infrastructure, cleanup of legacy pollution, and environmental remediation programs.

Other considerations or potential risks that may impact the construction supply/demand outlook include: new COVID variants, tariff/trade policy, the pace of Chinese economic growth, and new construction technologies that may achieve greater economies of scale in production.

OUTLOOK: CONSTRUCTION COST PRESSURES LIKELY TO STABILIZE BUT STILL REMAIN ELEVATED

Looking forward, construction costs may moderate as production and supply chain disruptions ease. Historically, commodity prices have been volatile with large swings. For example, lumber spot prices rose almost threefold to a record of $1,670 per thousand board feet in May 2021; however, prices have plummeted in recent months to below $600 per thousand board feet as sawmills ramped up production and some suppliers began to sell their lumber inventory (Figure 4). Nonetheless, as of Q3 2021, pricing for many key construction materials remained elevated, as global production and supply levels had not universally improved.¹⁵ For example, prices remain well above prior peaks for steel and aluminum.

FIGURE 4: LUMBER, STEEL, & ALUMINUM SPOT PRICE

Source: Nasdaq, Clarion Partners Investment Research, October 2021. Note: Spot price 

data on a daily frequency through 10/13/2021 and steel is based on cold rolled coil steel. 

Units are: lumber = $/BFT ($ per board foot), aluminum = $ per ounce, and steel = $ per ton.​

​​CONCLUSION

The unprecedented surge in construction costs is having  a significant impact on both new and existing CRE. Higher commodity prices, supply chain disruptions, a shortage of desirable development sites, and a tight labor market can make development and renovation projects more expensive and cause substantial delays. On the positive side, owners of existing properties should have a greater ability to maintain and increase rents amidst rising replacement costs and a manageable supply pipeline, which may further boost asset appreciation going forward.

Nonetheless, there is likely to be ongoing and tremendous demand for institutional-quality or “Class A" space, while there is still widespread functional obsolescence across the CRE investable universe, which will justify new development. ​​Given higher building costs in the near-term, Clarion Partners recommends targeting property sectors with the highest demand (e.g. rental housing, logistics property, and life sciences facilities) and markets/submarkets with the most acute supply constraints, where landlords have the leverage to grow rents.​​

​​​​​​Alexandria, Virginia​​