Construction Cost Concerns Demand A Variety Of Solutions

The rising cost of construction is an ongoing challenge, and one that may just bring new development to a halt even if the economy continues in a positive direction.

Speakers at Bisnow's Silicon Valley Construction & Development Forecast event last week had differing opinions on just how dire the construction cost situation is — offering up different ways their firms are working to address those challenges. For some, the outlook is bleak until something gives, particularly when it comes to labor costs.

Construction costs have been rising about 1% a month over the last year, Lowney Architecture Chief Operations Officer Anthony Cataldo said.

Insight Realty and Acquity Realty co-founder Dennis Randall said construction costs are rising by 10% to 12% a year while rents are going up about 3% a year in multifamily and 4% to 5% for office.

"Your costs are going to overcome your ability to justify a project, and that's exactly where we are," he said. "We're at the point where projects are going to stop. I'm not predicting any doom and gloom for the economy, but we're absolutely going to have a reset in the real estate development, construction industry to get our costs in line."

Randall said he already knows of half a dozen or more projects that are going to be shelved due to rising labor costs — and rent increases are just not keeping up with cost increases.

"It's not just the increases we have to date," he said. "It's the increases we don't even know about yet."

There was agreement on the event's construction panel that early conversations between the owner, architect and contractors makes a difference in both having a better sense of pricing in real time as well as moving a project along as quickly as possible.

"I don't see how a lot of construction costs can continue to rise the way they have and projects still be feasible," Cataldo said. "Some of the technologies will allow us to bridge some of that as costs continue to increase."

New technology could help speed a project to market faster and reduce errors and costs. That could include modular construction or the use of building information modeling, he said.

Randall mentioned a new type of concrete that will reduce the cost of a foundation by $1M.

While modular requires a pipeline of product to be cost-effective, Swinerton has had success with cross-laminated timber, Project Executive Preston Hoopes said. CLT is 30% faster to market and offers about a 4% savings on construction costs.

Another key is controlling the supply chain, he said. The cost of labor is going to keep going up, but there are opportunities to bring down costs by cutting out the middleman and contracting directly with manufacturers for building materials, Hoopes said. Some new technology is making that simpler to do.

Swinerton is also lining up its own work groups for drywall, concrete and demolition to control markup and offer fair pricing to its clients.

"We're in a unique bubble in the Bay Area," Hoopes said. "We're all bullish on the economy. The real estate bubble in the Bay Area — something's got to give — and I think we're starting to see that at this point."

As the market moves in cycles, those in the industry have to adjust, said Hunter Properties' Deke Hunter, who spoke on the development update panel. While some of the returns on costs are a little tighter than expected, it is about managing the costs as anticipated.

"It's trying to manage to certainty. It's OK if costs are going up if you know it," he said.

For spec office development where the lease is signed after the project is done, it comes in at market rent and is able to absorb construction costs, Jay Paul Co. Director of Acquisitions and Capital Markets Kristin Molano said. Where the challenge arises is more with pre-lease deals.

If a tenant signs a pre-lease and then construction takes a few years, the lease terms don't always line up with the project cost.

"The returns get thinner because the lease was signed so long ago that it's not at the market rent anymore," she said.

One solution in this type of market, Hunter said, is negotiating pre-leases using an index that ties the rent in some way to the construction costs.

Even as developers, architects and construction firms are looking at ways to best plan for and address cost increases, city officials are also looking at ways to keep costs down and keep development going.

Right now is the best of times for development in Silicon Valley, but construction is already starting to slow significantly, San Jose Deputy Director of Economic Development Chris Burton said. The city of San Jose is weighing how fees charged to developers affect construction costs and trying to improve parts of the process so projects can move along faster, taking advantage of current prices for materials and labor before they increase further.

"Especially in the commercial space, we have lower rents, that's a lower return as construction cost goes up," Burton said. "Going into the next year, we're seeing probably a significant slowdown. We're doing everything we can on the city side to try to address that."