Is everyone just getting desensitized over the continued rise in construction costs? Despite a reported low overall inflation environment, it seems construction costs keep rising at extraordinary rates year after year. The continued cost increases exacerbate challenges for the housing market. Unless you are a NIMBY (Not In My Back Yard) neighbor, you likely are challenged in some way by rising construction costs.
It is becoming more common for final construction costs to blow apart construction budgets and kill development deals. We’ve recently seen it ourselves pricing an apartment development project. No surprise, the numbers that have come back from our general contractor are higher than original estimates. (We’re working through the process. Stay tuned!)
What really shocked me is what I realized when I sat back and looked at the bigger picture — the magnitude of the price increase on hard costs compared to an almost identical project from five years ago. Looking at a similar mid-rise multifamily project, with a similar design, similar parking, similar size and both located in similar location. Five years later the hard cost is now almost 50% higher. Think about any other product out there, such as a piece of furniture, car, phone, TV, computer or bicycle. Would you pay 50% more for the same product with the same specs as you did five years ago? Of course, the answer is no. Many consumer products are actually cheaper now per the same specs than they were five years ago. My car is now five years old and I could get new model for almost the same price that I paid five years ago.
So why have there been these significant cost increases in construction? One reason often citied is a shortage of skilled labor, but let’s dig in further. Construction seems to have seen very little productivity innovation compared to many other industries. According to a 2018 report by JLL, over the previous 25 years, nearly every industry doubled their productivity rate, whereas construction has not. Think about how different automobile assembly plants look today compared to many years ago. Now think about how your nearby construction site looks compared to many years ago.
Yes, there has been innovation in computer-aided design and construction management software, but the innovation in construction itself seems to still be in its infancy. For example, can you show me to date where there has been real cost reduction from modular manufacturing or standardization? How about machine learning for building assembly? Historically, the multi-trillion dollar construction sector has been slow to adopt new technologies. (I wonder if this industry hasn’t innovated like many other industries because of lack of sex-appeal compared to other industries that have been disrupted. What do you think?) So, what do we do in the real estate business? We pay too much for construction and try to pass it on to our customers, the renters.
Until recently, there has been little pressure on construction and development firms to change the way they work because rents and property values kept rising. But 2018 was the first year that significant venture capital money was raised for “ConTech” (aka Construction Technology) ventures. I was recently part of some fascinating discussions with the principals of the biggest Silicon Valley ConTech firm that is trying to transform the construction industry. But, to date, there are no savings to our projects in Atlanta despite their penetration into our market of construction and design firms.
In a rising market, passing along high cost increases to renters can work… until it eventually doesn’t work. Are we now at that point in time? Even if you can make the numbers work on your individual project, the effect of rising construction costs on the overall population is troubling. Despite all the cranes you might see in certain sub-markets, in general, there is a shortage of rental housing. Vacancy rates are at a decades low, pushing rents up faster than incomes, especially middle-income households. According to a recent study by Harvard University’s Joint Center for Housing Studies, both the number and share of the cost-burdened are again on the rise. For example, 27% of households earning $45,000-$75,000 are considered cost burdened – defined as spending more than 30% of income on housing.
The vast majority of new rental stock is focused on the high-end, Class A units. It’s simple math. It’s generally not financially feasible to create a Class B product due to the high cost of construction and lower rent relationship. The availability of government funding for affordable housing is also very limited and cumbersome to obtain. I think the housing challenge requires a different approach than just throwing more money into it. I think it requires taking more money out of it and that will require breaking the old way of doing things. We need to figure out how to disrupt an old industry.
I hope my friends in the construction industry will still acknowledge me after reading my thoughts. It’s not personal, just math. What do you think? And how are you handling high construction costs? What innovations are you seeing in the construction sector that will drive cost reduction? I look forward to your feedback and insights.