Construction Costs Build Up

 

Increase in Construction Cost Index evident in reduced finishes, smaller office size, more wait-and-see

 

The Twin Cities-based ABC Company planned to build a 30,000-sq.-ft. build-to-suit office building in 2004. The projected price tag was $2,301,300, which included the 12-foot, clear-height shell, tenant improvement costs and some variables, such as site work, utilities and permits. (The price excluded the land.)

 

The ABC Company postponed the project and decided to pursue it again in 2006. However, company officials were in for a shock.

 

Due to the escalating cost of construction materials—from skyrocketing steel and asphalt prices to the rising cost of carpet—the 2006 price tag for this same office building jumped to $2,684,100—a 16% increase from 2004. Two of the key components of any project are the shell building and the tenant improvement (TI) costs, which contribute to this project's 16% increase. The price of the shell alone jumped 15.1%, while tenant improvement costs increased 15.6%.

 

This example illustrates just how volatile construction costs are, says Bruce Palmer, senior vice president - Construction Services for United Properties.

 

"Developers and contractors have been living with double-digit inflation in construction materials for the past several years," Palmer says. To demonstrate fluctuations in pricing, United Properties' Construction Services developed the "Construction Cost Index," which has been tracking construction costs for a single-story, 30,000-sq.-ft. shell office building as well as retail and industrial shells during the past two years (see accompanying articles).

 

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In some cases, the rising construction costs, Palmer says, can influence everything from a project's size to forcing some companies to scale back on the use of certain materials.

 

"We're seeing a reduction in the scope of work for some projects," Palmer says. "For example, to stay within budget some office spaces are not as grandiose as in past years. Some reception area finishes are being scaled back, and companies are being more conservative."

 

Palmer also sees fewer high-end finishes in retail projects. "Retailers are trying to make finishes nice, but they're not 'wowing' you," he says. "They're slightly downgrading the level of finishes—even in some department stores—to bring costs down. This is all related to construction costs and rising land and soft costs."

 

 

Why Higher Construction Costs?

Many factors have driven up the price of construction, including the global demand for materials. U.S. contractors today are competing with contractors in developing countries, like China.

 

In addition, natural disasters like Hurricane Katrina drove up the cost of construction materials. As the massive rebuilding continues, material costs could increase further. Also, as local contractors travel south to help with the rebuilding, it could result in a shortage of skilled labor locally, which would also mean higher construction prices.

 

"To date, labor has increased about 5% annually over the past two years for a 10% increase since 2004," Palmer says.

 

Which construction material costs are rising? The price of copper, used for electrical wiring and some plumbing, increased 36.9% in the past nine months, Palmer notes. "Copper is very expensive and in high demand," he says, adding that copper has been stolen from job sites because of its value, and some contractors are now locking it up.

 

Petroleum-based products—including everything from asphalt (made from the substance left after gasoline is refined from oil) and roofing materials to carpet and wall covering—have seen prices increase due to recent low petroleum supplies.

 

"Asphalt prices are up 43.1% in the past nine months," Palmer says. "Carpet prices rose 16% from 2004." In addition, the high cost of diesel increased the cost of trucking construction supplies, and contractors have been paying more to run their bulldozers, generators and backhoes. The recent drop in oil and natural gas prices should eventually trickle down to fewer cost increases in petroleum-based materials and may even mean decreases if petroleum prices continue to drop.

 

"We’ll continue to track costs with our Construction Cost Index and see where they head in 2007 and beyond," Palmer says.

 

 

Other Material Costs Also Skyrocketing

In addition to petroleum-based materials, the price of steel rose 13.6% during the past nine months. Drywall increased 21.2%, and concrete is up 5.5%.

 

The bottom line is construction costs are putting pressure on contractors and developers. Office tenants that received aggressive leasing deals because of softer market conditions will now have to absorb some of the increased construction and tenant improvement costs in order for projects to move forward. 

 

John McCarthy, United Properties vice president – Office Brokerage, agrees. "Two years ago when we started seeing rising construction costs, the Twin Cities office market was soft," he says. "So although these costs were real, the landlords absorbed the additional costs in an effort to fill their buildings and position them for sale."

 

As the market continues to tighten, landlords will pass these additional costs on to tenants in the form of higher rent.

 

Additional Impacts of Higher Costs

Rising construction and build-out costs are also increasing the number of office lease renewals. "We’re seeing a slowdown of companies willing to fund new projects, and many are staying as long as they can in their current space situation," says Tom Smith, United Properties’ vice president - Construction Services. "That also has a lot to do with the economy, as some companies are moving forward cautiously." Many office tenants are experiencing "sticker shock" as they price new space.

 

Companies that do relocate are feeling the impact of higher tenant improvement costs.

 

"A company moving into an existing space may make due with what’s there to keep lease rates down," Palmer says. "We’re seeing fewer major build-outs. Average tenant improvement costs in office space are going up about 5-6% a year."

 

More companies are also eliminating spacious corner offices and squeezing employees into tighter spaces—and that too affects construction.

 

"Companies used to figure 200 or 300 square feet per employee; that number is down to 150 feet or less," Palmer says. "With technology, companies don’t need as much space for file cabinets and other equipment—everything is digitized. The amount of space employees occupy is being reduced; however, that increases the building's parking requirements."

 

Parking is a major issue, and some cities are requiring more parking for office buildings, McCarthy says. "Previously, tenants 'requested' more parking; today they are 'demanding' it and incorporating it in the lease. Employers are putting more employees in the same amount of space and holding down the impact of rising costs."

 

United Properties will continue to track the Construction Cost Index to provide a consistent measurement tool to illustrate the fluctuating costs of construction. Watch the January 2007 complete Outlook Market report for the annual update on these costs. For more information about this Index, contact Bruce Palmer, senior vice president-Construction Services at 952-831-1000.