Sep 7 2006
Construction costs continue spiraling because of rising energy costs and material shortages. For example, during the past three years asphalt increased nearly 50%, concrete more than 25%, steel over 75%, and diesel fuel more than doubled. It's safe to say that overall construction costs have risen more than 20% on a combined basis.
Developers are adapting quickly. Tactics include project redesign, scheduled delays and even cancellations. Common redesign elements may mean removal of underground parking or more spartan tenant improvements. Scheduled delays are more risky tactics allowing developers to "wait and see" whether prices will drop. Of course, cancellations are the most drastic measures. In other words, developers must manage the expectations of sellers, equity investors, lenders, tenants and suppliers during such a volatile time.
On the real estate capital side of the development budget, some land and investors owners are realigning pricing expectations. Examples include contributing the land into the deal as an equity component in the hopes of appreciating cash flow upon project completion. Still, others are paying more equity and accepting lower overall returns in anticipation of appreciation (Returns on cost may be as low as 7%).
Good news on some cost components. In particular, construction and permanent financing costs are favorable. Interest rates remain near historic lows. Furthermore, the cost of fixed-rate, permanent debt based on forward-delivery timetables is extremely competitive. Developers can capture forward-delivery pricing as low as two basis points a month, translating to about a quarter point higher rate to secure financing 18 months out. In contrast, such pricing was more than double within the past couple of years.
Construction loan pricing for most institutional-grade projects in excess of $20 million range is as low as 130 basis points over 30-day LIBOR. Permanent financing based on funding as far out as 24 months is available starting at 125 basis points over comparable-term treasuries.
Nat Zvislo, research director for the Real Estate Capital Institute, suggests that "while construction costs are rising, ultimately those costs will translate to higher rents. Existing project-pricing will also benefit from better spreads between replacement costs and new development."