HARD COSTS • REAL ESTATE • INVESTMENTS
This following is a guest post by Riley Coleman, CFA, Director of Acquisitions at Nitze-Stagen.
In real estate development, Hard Cost is the money spent on the physical construction of a project. In a development project, the Hard Cost line item is huge, typically 65-70% of the Total Development Cost. Some examples of standard Hard Costs include construction labor, lumber for framing, concrete for the foundation, a crane rental, electrical wiring, the list goes on and on. On a typical development project, the developer will hire a General Contractor (GC) to execute the construction phase of the project. The GC is responsible for coordinating and spending all the Hard Costs and is responsible for putting together a hard cost budget based on their expectations for what the project will cost to build. It’s typical for a developer to go “out to bid” to multiple contractors prior to construction and only decide on a GC after seeing the numerous proposed budgets. Once a GC is selected, then the paperwork gets started. There are multiple different types of construction contracts with different pros and cons depending on if you are a developer or a GC (Link). Let’s review the three most common below.
Under this contract, the GC is paid for all the costs of construction plus an agreed-upon amount for profit which can be fixed or a percentage of final cost. The profit is the “plus”. These contracts are often used when the full scope of a project hasn’t been fully defined and, thus, a GC is unable to accurately forecast all project costs. The GC is reimbursed by the project’s owner for all approved costs incurred which means that these contracts require detailed cost tracking and supervision from the developer. As this type of contract leaves the final cost of construction open-ended, it carries the most risk for developers and least amount of risk for the GC. Because of this, Nitze-Stagen doesn’t sign Cost-Plus contracts.
This contact is also known as a “Hard Bid” or “Lump Sum” contract. With a Stipulated Sum the General Contractor provides a hard cost budget that will be the cost of the project, not a penny more or penny less. This requires a clearly defined scope, with well-developed drawings as any “scope gap” can still result in change orders to the owner. The payment for this contract is on a percentage completion basis, which does not provide any transparency into the actual costs incurred. In the case where costs are lower than originally expected then the costs savings are kept by the GC. Alternatively, if the project costs are higher than originally expected and the scope remained the same then the Contractor must cover the cost. This contract type could provide incentives for a contractor to cut corners to decrease the cost and increase their profit. That fact, together with the lack of transparency and limited flexibility in terms of cost savings is why it’s not industry standard.
The industry standard construction contract is the Guaranteed Maximum Price (GMP) or “GMAX”. This contract is similar to the Stipulated Sum in that the GC provides a maximum price for the project. However, one key difference is that in many cases cost savings on the project are split between the developer and the GC. This dynamic adds to the flexibility of the project; if a project comes in under budget, then the developer can adjust their plans or spend the cost savings on some additional value-creating items. As well, the monthly reporting requirements for a GMP are stringent for the GC, typically including backup for every dollar spent during the billing period. Considering the savings split, this contract does well in aligning the incentives of both the developer and contractor. A lot of construction lenders will require a GMP due to their desired level of detail in tracking the project budget. At Nitze-Stagen we typically require a GMP contract for our projects.
Given the size of most Hard Cost budgets relative to the Total Development Budget, these contracts are extremely critical and must go through a rigorous review process by lenders and institutional investors.
Over the past three years, the US economy has experienced a historic run up of inflation across all parts of the economy. Levels of inflation, measured by the Consumer Price Index (CPI), haven’t been this elevated since the early 1980s. Covid-19 was the critical event causing a global supply chain shock and a substantial influx on liquidity from the federal government that triggered lower supply and higher demand, resulting in a rapid increase in costs and prices across all industries. After years of low inflation leading up to 2021, all industries in the economy felt the impacts of inflation and commercial real estate development was no exception.
As costs increased over the past three years the math related to development projects was going in the wrong direction. All things being equal, rising costs lowers the projected returns on any project. Previous editions of Nitze Stagen Real Commentary have touched on the metrics that a developer considers when deciding to start a construction project. As a reminder, the most important metric used, regardless of asset class, is Un-trended Yield on Cost (UYOC).
Within the denominator of the above fraction, and as mentioned above, the largest line item for any project is going to be Hard Costs. This means that the increases to the costs of material and labor over the past three years made ground-up development more difficult; higher costs result in lower projected returns which in turn makes raising the capital required (both debt and equity) to finance construction a challenge. Rising costs has put strong downward pressure on new supply, which is evidenced by the below chart showing how permit applications in Seattle fell dramatically as inflation picked up in 2021.
New Unit Applications 2018-2023:
Developers have been in a holding pattern waiting for one or two things: rents to increase or costs to drop. We’ve discussed in the previous “Houston We Have A Supply Problem” newsletter that we expect rents to increase in the years to come (Link). In terms of costs, the first chart above shows that CPI peaked in June 2022 and has been on a steady track down since then (Link). The key question is whether or not Hard Cost prices have behaved similarly.
At Nitze-Stagen, we prioritize bringing a GC onto the project as early as possible to help ensure constructability of the projects we design. The benefits that come from doing so are numerous. Their perspective allows the project team to identify efficiencies that can reduce costs while providing real-time pricing feedback to confirm the design is staying within budget. We have found that the more work we do up front in this regard, the more we can avoid value-engineering at a future date which will result in less savings and costly redesign fees. Lastly, GCs early engagement on a project allows Nitze-Stagen to track Hard Cost data over time more effectively than just following a CPI chart. For purposes of this newsletter, let’s look at an example Nitze-Stagen project that has received numerous GMP budget updates during the design process over the past few years.
The below table shows three separate pricing exercises completed on the same project from late 2021 to early 2023. Each “% Change” amount represents the change in budget from the budget immediately preceding. For example, Structure/Envelope line item below increased by 12% from Q4 2021 to Q3 2022 and it was flat with 0% growth from Q3 2022 to Q1 2023.
Example Project Budget Changes Q4 2021- Q1 2023:
As you can see, there was a significant increase of 14% in the Hard Cost budget from Q4 2021 to Q3 2022. This jump is consistent with the dramatic spike in CPI that you can see in Chart #1. The two largest Cost Categories by amount in the above budget are Structure/Envelope and Mechanical Electrical Plumbing and Fire Suppression (MEPF).
Structure/Envelope costs consists of the concrete, metals, woods and plastics among other things that are required for the physical structure of the building. MEPF costs include the plumbing, HVAC ventilation, and all the required electrical wiring. Simply, the two largest cost categories of the budget are materials and equipment that were directly affected by the inflationary pulse through the economy. That is why we saw a 12% increase in both Cost Categories from Q4 2021 to Q3 2022.
So, what has happened since Q1 2023? The CPI chart above shows a softening in inflation. Has that been seen in Hard Cost pricing estimates for this project? See the below table which includes the latest pricing exercise from Q4 2023 (just a few months ago):
The Hard Cost budget for this example project went down by 5 % over the course of 2023. The largest line item, Structure/Envelope decreased by an impressive 26% over the course of 12 months. As mentioned above, that line item consists of many materials and commodities used to build the physical structure of the building. As we’ve seen across the economy, commodity prices have been dropping steadily since early 2022, and these drops in prices are now making their way through the supply chain. This is a macro trend that can been seen in the Bloomberg Commodity Index, shown below, which is now at the lowest level it’s been since 2021.
Bloomberg Commodity Index:
As well, the National Association of Home Builders (NAHB), reported that the price of materials required for homebuilders (lumber, concrete, steel) plummeted during 2023 after significant increases in the years prior.
Something interesting to note is that the Structure/Envelope Cost Category decreased while the MEPF Category stayed practically the same. As mentioned above, MEPF contains the cost of plumbing and electrical which includes material such steel, plastics, and aluminum. Given the above trends, we would expect that the MEPF Cost Category will follow a similar path to Structure/Envelope over the next several quarters.
While falling commodity and materials prices have an impact on the Hard Cost budget, there is another important aspect of the Budget that is much harder to track: the subcontractor’s profit. When a General Contractor puts together a Hard Cost budget, they first canvass their network of subcontractors to get estimates for their work. Subcontractors perform most of the physical work on a given site as very little of a project scope is performed by General Contractor employees. The pricing estimates received from the subcontractors will include the cost of the materials and labor but also, and very importantly, it includes their profit (you can think of it as their mark-up). When the demand for subcontractors is high, their profit margins will increase as developers will pay up to compete for the best subcontractors. This was a dynamic that has played out over the past 4 years as the number of construction projects exploded to all-time highs. Below you’ll see a repeat chart from previous newsletters which shows how in 2020-2022 demand for subcontractors peaked as projects were started. However, the combined increase in project cost of the materials along with the labor reached a tipping point in 2023 where development projects were no longer feasible and new supply fell off a cliff.
With the pipeline of multi-family projects drying up, the demand for subcontractors is doing the same. In Nitze-Stagen’s opinion, this dynamic is equally relevant to commodity prices dropping when looking at the change in Hard Cost pricing over the past 12 months. Subcontractors are being forced to trim their profits margins to win jobs – the negotiating leverage is shifting to developers. This is a trend that is expected to continue through 2025 as investors remain on the sidelines for development projects, which will lead to diminished demand for subcontractors.
The question will be, how far do the cost of materials and labor need to drop before development becomes increasingly attractive? We believe there is still more room but will be monitoring the situation closely.
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