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WHY HAVE APARTMENT CONSTRUCTION COSTS CONTINUED TO RISE?

September 8, 2018, Author: Mark Graffagnino

Over the past 25 years in the Multifamily space, I’ve seen a lot of changes.  One constant change, which had been fairly predictable, has been construction costs; they historically rise and fall with the market, while overall trending upward slightly with inflation.  But recently, about the past three years or so, construction costs have kept rising even as the pace of apartment starts has slowed.

As most know, after the crash in 2008, apartment development basically stopped cold, as lenders restricted apartment financing. Projects that had been started and were underway got completed, but very little new development projects came out of the ground.  The post ’08 years are when many (myself included) got into rehabbing of apartments.  My market has predominantly been the state of Georgia, especially the metro Atlanta region.

Construction costs during that time were very low.  The supply of subcontract labor was much greater than the demand.  Many subs took on rehab work in order to stay in business, as it was the only type of apartment work available at the time.  Many subs took projects at close to their cost, in order to keep their employees on payroll.  There were also a ton of layoffs, which created more supply, as former employees of large subcontractors got entrepreneurial and were now bidding projects as subcontractors. We also had commercial subcontractors “stepping down” to bid on multifamily projects, and single family subs “stepping up” to multifamily.  Because of this oversaturation of the subcontractor market, many either moved to other states (Texas was popular), returned to Mexico, or just got out of the business altogether.

When the real estate recovery began, apartment development and construction led the way.  Condos, commercial and single family construction all lagged the apartment sector.  Construction costs were low as supply of subcontractors outpaced demand.  My first apartment development project after the crash was a 2010 Class A garden style deal that had a total construction cost of right at $65,000 per unit. Yes, the good old days.  But they didn’t last long, banks were lending, apartments were coming out of the ground, and subcontractor demand and pricing rose with this increase in apartment development.  It wasn’t too long before the demand for subcontractors was greater than the supply, and as the phrase goes “the worm turned”.

Sub pricing was increasing constantly.  Bids that were given were not being honored mere weeks after they were received, because pricing was rising so fast.  It was not uncommon to have a subcontractor come back to his GC in the middle of a project to renegotiate a higher price, sometimes more than once.  The renegotiation was not because the sub was losing money, it was because Contractor X down the street had offered him $0.05 more per square foot, and if he couldn’t renegotiate then he would pull his crews off the job and go work for Contractor X.

I also know of subcontractors that came back out of the crash too fast, and took on too much work, as development ramped up.  They scaled from doing maybe a couple of small renovation projects to 10-20 large new construction projects, contracted for work at what they thought was the right price, only to have their crews pull the same “pay me more or I go work for so-and-so” routine, over and over again.  The sheer volume of work they had on the books made it impossible to constantly renegotiate, difficult to manage, and they crumbled under the weight of the work that was not profitable and/or not getting done in a timely fashion.

The unusual thing was that the large growth you’d expect of the subcontractor labor base, due to the hot apartment development market, didn’t happen.  And I believe that is the major reason why construction costs have continued to escalate.  I think too many subs got burned in the crash and are still sitting out. The number of subcontractors who are bidding work has not kept up with demand, and honestly, the number of GOOD subcontractors is well below optimum level.  So the good subcontractors are in a “name your price” kind of market.  From a recent article in National Real Estate Investor:

 “Meanwhile, it has become even more difficult to find workers to build apartment projects. Contractors have been forced to make do with smaller work crews and inexperienced workers, making it more difficult to complete construction on time and on budget. A surge in the construction of rental apartments has created a fierce competition for workers, similar to the bidding wars that take place for development sites. More than two-thirds of contractors report difficulty in hiring craft workers, according to an Aug. 20 survey from AGC. Carpenters are particularly hard to find. Electricians and bricklayers are also very scarce.”

If I had a dollar for every general contractor over the past few years that told an apartment owner that the price escalation was a temporary thing that would correct itself in the next six months or so….well, I wouldn’t be rich, but I could take my wife out to a nice dinner.

In my opinion, it’s going to take either either of two things to bring construction costs back in line:

  1. A market correction that significantly reels in apartment development, or
  2. A collusion type effort by apartment developers to say “enough”.

Number one above is going to happen, it’s just a matter of when.  But I don’t think number two will happen until number one happens first. Reason is, apartment developers are still able to sell their deals to institutional investors at top of the market prices.  Merchant type developers are still making their development fees.  Even developers planning to build, hold and operate are selling because the sales prices are so high.  Several times I’ve had an apartment developer client who was in some kind of dispute with their GC as construction was finishing up.  Disputes like liquidated damages, the buyout number suddenly evaporating on the final draw (one of my favorites), audit results that the GC disputed, etc.  But then the deal goes under contract to a buyer at a higher price than they proforma’d, and the owner takes a much more “relaxed” stance with the GC on any disputes.  A high sales price (as well as time) heals all wounds.

Anyway, that’s my two cents.  As always, feedback, conversation and disagreement are always appreciated in the comments below.