Construction costs not diminishing profits, for now

Mark Lodmill
Director, National Multifamily Valuation Group, CBRE, Denver

A persistent gripe in developer circles is the constant upward movement of construction costs. This has been a substantial brake on the fast-moving train of new construction within the Denver market. Steadily rising payroll and materials costs have prevented new deals from penciling, which has resulted in tightened purse strings of construction lenders. More and more proposed projects are being left without financing, forcing developers to drop sites they have under contract for acquisition. Don’t cry for the down-trodden developer, though, because there is more to this story ahead.

These rising costs have made cashing out of projects a lucrative prospect for builders who brought their projects to market. As costs have risen over the past eight years in the post-2009 doldrums, we have seen the per-unit cost metric change dramatically. The two tables reflect “all-in” costs of projects brought to market over the past 10 years. This all-in cost is inclusive of hard and soft costs, as well as land acquisition costs. This cost does not include a profit incentive. The data reflects the trends on over 50 completed or underway projects in the Denver metropolitan statistical area.

The dramatic shift shown in the charts has moved the typical all-in garden apartment construction costs from a level of $135,000 to $150,000 per unit at the start of the cycle to current projects in the $210,000 to $240,000 per unit range. More dramatically, we have seen elevator-style projects shift in cost from $180,000 to $210,000 per unit to current projects under way at costs north of $500,000 per unit. This leap in construction costs has changed the value per unit landscape of the market today.

As appraisers, we are armed with the principle of substitution; we state that a prudent buyer would pay no more than construction cost new today plus a profit incentive. However, the concept of “cost new today” is a moving target, steadily advancing with the market. Next, we ponder the more elusive topic of how much profit? The answer to this question is hard to extract. In our discussions with market participants, we often hear a range of 15 to 25 percent. But this will only be borne out in an active marketing process, with buyers pitted against one another to provide the highest price to the seller.

This leads to a second area of research: What profit have developers actually been achieving? As costs have inflated on the order of 10 percent per year over the last several years, we have costs today that are 20 to 30 percent higher than the costs actually locked in by the developer at the project’s origination. Adding this market movement to “cost new today” sweetens the pot for our developer friend mentioned earlier.

CBRE researched closed transactions of new properties in the last several years where construction costs were known. This data leads us into the pie-chart graphic. We aggregated the cost and sales data on several projects in the Denver market to report the level of profit actually achieved. The chart shows where the average sale price on a newly developed asset goes. The average sale price reflects 8 percent paid for the land, 48 percent of hard costs, 14 percent of soft costs and a healthy 30 percent slice of the sale price headed to the developer as profit. When viewed as a return on the lower “all-in” developer costs figure, this indicates a 43 percent rate of profit to the developer, well above the 15 to 25 percent return seen as typical in the market.

This substantial profit slice of the pie is reflective of a short-term market imbalance and not a “normal profit.” This atypical profit level has been the carrot to lead developers to our planning departments to discuss their project, with their eyes focused on the pot of gold at the end of the rainbow. However, additional cash flow pressures will further impact pricing due to increased rental concessions, higher vacancy, additional competition on rental rates, greater expense loads, higher tax assessments, etc. As more projects are brought to market under higher cost burdens, this pot of gold will shrink.

The moral to the overall story is that our developer friend has been quite well compensated for past work. The question as to the return to current projects will be answered with time.

Featured in November’s Multifamily Properties Quarterly.