How construction costs could affect your next project

Since the Great Recession ended, construction costs in Colorado have skyrocketed. The way property managers budget tenant improvement projects and building updates must be adjusted to take the rising costs into consideration.

“In 2014, the costs of construction caught up with this rapid increase in demand, and we saw costs increase somewhere between 15 and 20 percent,” said Doug Miller, director of business development and preconstruction at Alliance Construction Solutions. “The 30-year average is only 3 percent per year, so a 15 to 20 percent increase in costs in one year is huge.”

On a typical commercial project, a cost breakdown of the prime contract amount will reflect 25 to 30 percent for project materials, 45 to 50 percent for direct labor, and the balance goes to overhead administration costs and profit, said Terry Hordinski, Provident Construction chief operating officer.

With the largest percentage of the budget going to labor costs, the undersupply of skilled labor in Colorado makes the biggest impact on rising costs. Hordinski estimates that the cost of labor has gone up 10 to 15 percent per year for the past three years.

It’s important to understand what caused this shortage of labor in order to understand its current effects. A decade ago, the construction market was stable and expanding each year, with costs on the rise. That changed with the recession, which began in 2008 but lagged in the construction industry by about a year, said Miller.

“In 2009, the rubber really met the road, and we tumbled into the Great Recession,” said Hordinski. “That year and the next two years were painful, both for prime and subcontractors. All contractors started drastically cutting back their labor force, especially in the residential community, which directly affects the commercial community because you’re basically working out of the same pool of labor.”

The reduced construction market continued into 2012. “As a result, you had a tremendous amount of displaced workers, who went into other fields to find employment,” said Hordinski. “It is my personal opinion that somewhere between 30 and 40 percent of the construction workforce was displaced during that two-and-a-half year period.”

Those who remained employed saw their businesses cutting costs to stay afloat. Many businesses were unprepared to deal with the recession and therefore kept costs from rising for the following couple of years, said Scott W. Farrell, vice president, i2 Construction.

The costs were driven down to a point where virtually everyone was operating at or below cost for over multiple years, and this current pricing is just normalization to get back to a sustainable market condition were contractors and suppliers can successfully operate over time,” said Terry Hordinski, Provident Construction chief operating officer.

The same thing happened to the material suppliers, most of which were selling at or below cost for multiple years to stay in business, Hordinski said.

By 2013, the industry was back to where it was prerecession, said Farrell. “The issue that we started to deal with for the first time was the lack of labor force as they transitioned to the oil fields in North Dakota as well as large Davis Bacon projects within the market,” he said.

While the market struggled to find labor, which lost skilled tradesmen of all types, the demand for new projects escalated.

“The final result of the recession was shortage of skilled labor and unsustainable material costs, combined with pent-up demand because many customers were slow to invest in needed capital improvements while the macro market was so uncertain,” said Hordinski. “The market anomaly of costs going down for multiple years continued for over three years. So when the market finally got to a point where we started seeing growth, the contractors and suppliers first had to catch back up to where they were before the start of the recession.”

With the market doing well again, vendors and manufactures began to put a premium on their products and people. “They are making up for lost time,” said Farrell.

An example of this premium is the cost of concrete. Three years ago, Provident Construction paid in the low $80s for a yard of concrete, said Hordinski. After jumping almost 10 percent each year, prices were in the mid- to high-$80s in 2013, the mid-$90s in 2014, and now are over $100 a yard. “You can do that same analogy on a sheet of drywall, wire for an electrician, or any type of major commodity that you use in the construction industry,” he said.

This year, while the market remains strong and costs continue to rise, contractors are reporting a slight decrease in inflation.

“The most important concept that I hope you can communicate is that the costs the real estate community and property owners were seeing five years ago were numbers that were not sustainable,” Hordinski said. “The costs were driven down to a point where virtually everyone was operating at or below cost for over multiple years, and this current pricing is just normalization to get back to a sustainable market condition were contractors and suppliers can successfully operate over time.”

While a 3 percent increase to costs every year is the 30-year norm, it would be foolish to not assume a little higher inflation throughout the market for the next year or two, Miller said.

Advice for Property Managers

With that in mind, when budgeting for tenant improvement projects, property managers should budget as much as 15 to 20 percent more than they would have budgeted for the same project in 2013, said Miller.

“It is very difficult to make generalizations about interior construction costs, as every project is different in numerous ways, whether it be materials, schedule or even payment terms,” said Farrell. “In the past year, I would estimate that a space that we would have built out in May of 2014 for $45 per square foot would now cost between $55 and $60 per square foot.”

However, the biggest shift for property managers may be how they approach a project, rather than how they budget it. There is now an emphasis on an integrated process that brings the contractor into the discussion early, rather than completing a general bid process.

Prerecession, about 65 percent of Provident’s projects were secured in a straight negotiated fashion, 20 percent were negotiated as design-assist projects and 15 percent were hard bids. Today those numbers have been reversed, with 65 percent now design-assist projects and 20 percent are straight negotiated, Hordinski said.

“Contracting on a design-assist method has become a lot more popular,” he said. “The primary function for doing that is to control costs, so as the plans are developed we’re giving input and helping create a working budgets to keep a project financially on track. That has been a big change in the marketplace.”

A good contractor can be most helpful before a deal is finalized to provide real time numbers and advise as to availability of labor to complete a project, said Farrell.

Managers will get a better deal if they pick a contractor partner and develop the project’s scope and price together, rather than if the manager goes out and tries to get 10 different bids, Miller said. This is because the current market demands keep a lot of those companies from bidding for new projects. Miller estimates that a manager would be lucky to get bids from half to a quarter of the general contractors called. Most of Alliance’s current clients use this integrated approach rather than hard-bid approach, he said.

If the market was still in a recession, Miller would advise differently. When many businesses are just trying to keep the doors open and a manger solicits bids, he would probably get 11 out of 12 companies contacted to bid the project, Miller said.

Additionally, property managers should be aware of the increased time required to receive permits because of staffing issues in many municipalities as well as the significant amount of construction activity, said Farrell.

“Finally, I would note that labor truly needs to be treated like a long-lead item,” said Farrell. “You can no longer bid a project on Friday and expect them to be up and running the following week.”

Featured in the Colorado Real Estate Journal’s Property Management Quarterly August 5, 2015, issue.

Michelle Askeland is the quarterlies editor handling the Property Management Quarterly, Multifamily Properties Quarterly, Office Properties Quarterly and Retail Properties Quarterly publications for the Colorado Real Estate Journal. Prior to joining the CREJ, Michelle was the managing editor at RadioResource Media Group, where she helped publish a monthly domestic magazine and a quarterly international magazine…