The Costs of Construction

12 min read

Can we get them under control?  

“Construction costs are going up and the sources of funding going down,” declares Tim Leonhard, international director for JLL Capital Markets.

As construction costs continue their relentless upward track, affordable housing developers find themselves continually revising estimates and scrambling in search of additional sources of funding.

“We see it on every deal – we are getting upward adjustments in price,” says Jeff Lawrence, senior vice president of real estate finance for Walker and Dunlop.

Developers have struggled for years with a shortage of construction workers to build their projects, causing costly delays and overtime expenses. At times, the high cost of labor was compensated for by the high prices of the Low Income Housing Tax Credits (LIHTCs) they received. But with LIHTC prices lower and construction material prices higher, the equation is seriously out of balance.

“Development costs keep rising and incomes and the capital sources keep shrinking,” says Caleb Roope, CEO of the Pacific Companies.

The problem may get even worse this year as developers struggle with the impact of proposed cuts to federal funding programs they depend on and U.S. trade policies push the price of materials even higher.

“Every year, fewer and fewer projects work, and over time fewer and fewer units get produced,” says Roope. Higher costs mean “each unit is going to use more LIHTCs.”

Higher costs may also limit the kinds of projects that developers can produce.

“It puts pressure on every area of the capital stack, more pressure on what you can pay for land, more pressure on what you can charge for rents,” says Leonhard.

Material costs on the rise
The rise in construction costs does not seem to be peaking. Prices for materials have risen sharply so far this year and are likely to rise more. Contractors have not even passed many of these increases on to developers yet, according to the Bureau of Labor Statistics (BLS). “Contractors have been rightly cautious about telling developers it’s going to cost more,” says Ken Simonson, chief economist for the Associated General Contractors of America.

The Producer Price Index for materials for multifamily buildings rose 3.4 percent in May compared to the same month last year, according to the BLS. That same index fell 1.1 percent in 2015.

Developers in high-cost markets have been subjected to even larger cost increases. In the busier cities, hard construction costs have increased five to ten percent in the six months between the time a project received a tax credit award and the closing for financing.

“The surprise was how fast the costs moved and changed,” said Adam Oates, president of SunTrust Community Capital.

Federal policy is one of the factors driving up the cost. Trade officials are increasingly intolerant of foreign companies that dump products onto the U.S. market at prices lower than the cost of producing them.

“This Administration says they will get tough on foreign producers,” says Simonson.

The U.S. has recently added heavy anti-dumping duties to steel, which priced 13.8 percent higher in the past year. Copper and brass materials rose a similar amount.

“Drywall prices are also going up,” says USA Property Fund’s President and CEO Geoff Brown. The index for gypsum products (which includes wallboard) has risen 7.4 percent.

Lumber and plywood have risen 7.7 percent. The cost of wood may keep rising for years, as a trade war begins to heat up between the U.S. and Canada over lumber. (See Taken to the Woodshed ).

Even materials that had been relatively inexpensive are making the leap. Diesel fuel, used in many construction vehicles, fell 43.1 percent in 2014 and 26.9 percent in 2015, according to BLS data. In 2016, the price started rising. And in May of this year, the price jumped 23.3 percent compared to 12 months before.

Developers are fighting back by trying to lock in prices as soon as they can with their contractors and subcontractors.

“Some developers have considered warehousing materials,” says Walker and Dunlop’s Lawrence. However, finding warehouse space to store materials can also be expensive.

The labor shortage only gets worse
In markets like San Diego, the labor shortage is now so intense that contractors compete to hire workers.

“They are driving down the street and stealing employees, offering to pay more,” says Carol Galante, faculty director of the Terner Center for Housing Innovation at the University of California, Berkeley.

Two-thirds of contractors say they have difficulty finding workers, according to a survey by the Associated General Contractors of America (AGC). Every kind of construction job has been difficult to fill – especially carpenters, drywall hangers and framers.

The workforce of the construction industry never recovered from the Great Recession.

“In 2008 and 2009, a lot of contractors went out of business,” says Geoff Brown. With just 2.7 million workers, the workforce is over 20 percent smaller than it was in 2005 when it had 3.5 million workers, according to AGC.

Two years ago, the rising cost of labor and construction delays began to affect affordable developments. “We started going through our contingency budgets [to pay for labor],” says Brown.

The industry is likely to need 700,000 additional workers over the next ten years, according to the National Association of Home Builders. And it’s far from clear where those workers will come from.

Unlike the cost of materials, the expenses resulting from the labor shortage don’t necessarily show up as price inflation on the BLS data sheets. That’s because many of the highest-paid construction workers have reached retirement age. That forces many contractors to rely on younger, less experienced workers who earn less and are less productive, which means development takes longer and is more expensive, even though the average wage earned by a construction worker isn’t rising much.

Affordable housing developers have had to build extra time into their construction schedules to account for the less experienced workforce, and in construction, time is one of the most expensive commodities of all. But sometimes a subcontractor can’t provide enough workers or cancels altogether, and the delay upsets the complicated choreography of construction, forcing other contractors to reschedule – if indeed they are available.

To help avoid such surprises, many developers try to cultivate strong relationships with their work teams. “If you have good, long-term relationships with subcontractors, that helps,” says Brown.

The shortage of workers is exacerbated by the intense debate surrounding immigration. About a quarter of the people working in the construction trades were born outside the U.S. As immigration into the U.S. becomes more difficult, fewer individuals are entering the construction business.

In addition, fewer young people are entering the construction trades. “Older construction workers are retiring and we are not replacing them,” says Galante. “Construction is not considered a desirable job by people coming up.”

Finding funding
A reservation of LIHTCs may not be worth as much as it once was if President Donald Trump and the Republican-controlled Congress fulfill their desire to lower the overall tax rate on businesses, reducing the attractiveness of the credits.

The proposed federal budget would also eliminate other government funding programs, like HOME Funds and Community Development Block Grants.

Some affordable housing developers are trying to build protection against rising costs and disappearing funding programs by combining usage of a variety of tax credits on their projects, hoping a mix of LIHTCs and Historic Rehabilitation Tax Credits will provide extra subsidy as construction costs rise.

“We are able to generate that much more resources,” says Ross Freeman, president of the Pioneer Group, which often combines State and Federal Housing Tax Credits with Historic Tax Credits to finance its developments.

Many of Pioneer’s projects are located in places that, under LIHTC rules, allow the developments to generate more LIHTCs. “We get the ‘basis boost’ for developing in ‘qualified census tracts,’” he explains.

Other developers mix affordable housing with market-rate apartments to benefit from the strong demand for rental housing.

USA Property Fund develops mixed-income projects financed with tax-exempt bonds in which 80 percent of the apartments rent at market rates and 20 percent are affordable to low-income households. However, even these properties struggle with a higher cost of land, labor and materials.

“It’s still a challenge to make the pro-forma estimates work for a new construction bond deal,” comments Brown.

Some local and state governments offer soft financing to help make up for rising construction costs. For example, Florida has replenished its Housing Trust Fund so that state officials can provide soft financing through its State Apartment Incentive Loan Program, known as “SAIL.”

Developers also often include a large construction contingency budget for their projects. LIHTC syndicators now often require ten percent, adding to funding pressures.

The high cost of housing policy
Ironically (and unfortunately) the programs that help pay to build affordable housing also often add millions to the cost of construction.

In many states, developers now must promise to include a long list of expensive features in their affordable housing projects to win a reservation of LIHTCs.

“All those policy objectives cost money,” says Roope.

For example, Maryland officials offer an extra point in the competition for LIHTCs to developments with coat closets. In Maryland’s intense competition, that one-point incentive is effectively a requirement.

But not every apartment can easily accommodate a coat closet. Enterprise Homes is currently renovating a community of townhouses that are only 20 feet wide and 26 feet deep.

Other state requirements can add more unnecessary costs. For example, a public housing property may have a proven history of staying fully-occupied. However, a developer who renovates the property with LIHTCs will still have to provide a complete market study.

“Why do we have to spend $6,000, $8,000 on a market study if we have a waiting list?” said Chickie Grayson, president and CEO of Enterprise Homes, Inc.

Energy efficiency is now often a threshold criteria to be considered for funding. Developing affordable housing that meets green building standards for energy efficiency and air quality is simply more expensive than meeting the minimum standards required by local building codes, often adding two-and-a-half to five percent to the cost of construction.

“An ever-increasing sentiment towards energy-efficient buildings, which is not cheap to do, is the most costly change that we have seen in our industry in the last five years – maybe ten,” adds Leonhard.

However, some affordable housing developers turn these expensive requirements to their advantage. A growing number of lenders are willing to make larger loans to developments that include features like higher-quality windows or improved insulation that will lead to lower utility bills.

“Energy efficiency can be cheaper,” says Chris Estes, president and CEO of the National Housing Conference.

Local building codes and zoning rules also add to the cost of development. “The biggest one is parking requirements,” says Galante. Many local governments require two parking spaces per apartment, even though the development may be near mass transit.

“We can’t afford to pay $40,000 to $50,000 per parking stalls. We are housing people, not cars,” she says.

Value engineering
Affordable housing developers are on a perpetual search to find new ideas that may help them cut the cost of construction.

Some developers attempt to save money by value engineering their projects. That often includes reusing the architectural drawing from development to development. These communities can look so much alike that Inland Development used photographs of its completed Copper Peak Apartments property in Longmont, CO, as a rendering to show what its Copper Valley development, now under construction in Puyallup, WA, will look like.

Yet it’s getting harder to reuse architectural plans as development becomes more common on infill sites, which are often oddly shaped, thus requiring a new plan for each building.

“This is the time when you cannot think of your business as usual,” says Galante.

For example, tall wood buildings made from laminated lumber projects may help developers avoid the rising cost of steel.

Buying and renovating existing buildings is looking more attractive to many developers. Single-family rental houses may provide an opportunity for scattered-site portfolios of renovated affordable rental units.

Other developers are investing in modular construction, largely built in factories and trucked to construction sites and 30 to 50 percent faster than conventional construction, according to Full Stack Modular, based in Brooklyn, NY.

Pioneer is considering trying modular construction for a series of potential affordable housing developments in Dallas, all on publicly-owned sites, such as parking lots in densely-developed areas.

Modular construction may also help solve the shortage of labor as more workers might be willing to work in a factory than outside on a construction site. Work in a factory is also more regular and does not require as much heavy physical labor.

“It may open up the workforce,” says Galante. “I visited a factory where 40 percent of the workforce was women.”

With a federal government more focused on matters that many say are counterproductive to affordable housing and state housing agencies stretching for criteria to differentiate among submitted projects, developers are going to have to look for more new ways to veer from what has been accepted as business as usual. Going forward, it is likely the unusual that will become usual.

Story Contacts:
Jeff Lawrence, Senior Vice President of Real Estate Finance, Walker and Dunlop

Caleb Roope, CEO, Pacific Companies

Tim Leonhard, International Director, JLL Capital Markets

Ken Simonson, Chief Economist, Associated General Contractors of America

Adam Oates, President, SunTrust Community Capital

Geoff Brown, President and CEO, USA Property Fund

Carol Galante, Faculty Director, Terner Center for Housing Innovation at the University of California, Berkeley

Ross Freeman, President, Pioneer Group

Chris Estes, President and CEO, National Housing Conference