Rising Construction Costs Depressing Land Values, Slowing D.C.'s Development Wave

The continued rise in construction costs has made D.C.'s ongoing projects more expensive, and developers say the next wave of new projects will be hit the hardest. 

Development deals that are in the planning stages, from pre-acquisition to design to entitlements, are becoming significantly harder to pencil out, and D.C.-area developers expect this will lead to a regionwide slowdown in new construction.  

Skanska, which has multiple D.C. developments in the works and operates its own construction division, estimates construction costs have been rising by 4% to 4.4% annually.

"We've seen the escalation in construction costs be a lot higher than originally projected," Skanska Executive Vice President Mark Carroll said. 

The construction cost increases will likely worsen with the increased tariffs on Chinese imports that President Donald Trump announced last month, several commercial real estate leaders agreed. In addition to rising costs of materials, the shortage of construction workers is exacerbating the problem with rising labor costs.  

The rising costs did not stop Skanska from delivering its new office buildings in Capitol Riverfront and Foggy Bottom, as Carroll said it was able to lock in its costs three or four years ago before breaking ground. But Carroll said he has seen significant cost escalation over the last year and does not expect it to slow down, likely impacting the next wave of developments planned in the region. 

In Tysons, Skanska has been moving through the design process for a 350-unit apartment building on a piece of CityLine Partners' Scotts Run development site it acquired last year. Carroll said costs have risen quickly during Skanska's design planning and it was forced to make changes. To help offset the cost increases, he said Skanska reconfigured the parking layout, consolidated entrances and designed more efficient floor plates. 

"The way it's affected us has been stepping back during the design process and making design modifications to adjust the pricing," Carroll said. 

Carroll said cost increases have had an even greater impact on potential projects for which Skanska is seeking to buy land. As it is forced to account for higher construction costs when underwriting development deals, he said Skanska has had a challenging time making the math work for new projects. 

"We've looked at a number of them and haven't been able to get to the land value that meets the seller's expectations," Carroll said. "It has made it tougher to make land acquisitions work."

CBRE Vice Chairman David Webb, a leading finance broker, said the combination of rising costs and stagnant rents have impacted land values across the region. 

"It makes it harder to get top dollar for land not just because of the cost increases, but because of the fear of more increases with tariffs and the labor shortage," Webb said. "If costs are going up and rents aren't going up, the land has to go down."

Carr Properties Chief Development Officer Austen Holderness said the company was able to lock in construction prices for its massive Midtown Center project — the redevelopment of the Washington Post's headquarters at 15th and L streets downtown — before the worst of the cost increases.

But he said he saw significant escalation between the time of Midtown Center's 2016 groundbreaking and last year's start of construction on its high-rise Bethesda project, a redevelopment of the Apex Building, and the increases have not slowed down since. 

"If I could get Midtown's pricing again, that would be great. I don't think that market exists anymore for construction pricing," Holderness said. "We build in some pretty heavy contingencies within our projects for cost inflation and overages, and we used up all of that on Apex and then probably a little bit more." 

Construction cost increases could be offset if the market could achieve large enough rent increases, but that has not been the case in D.C. Average asking rents for office space in the D.C. region increased 1.7% over the 12 months ending March 31, according to Newmark Knight Frank, a slower pace than most estimates of construction cost escalations. 

This dynamic is likely to slow the pace of new office construction going forward, Holderness said. 

"If there's not real rent growth, I think it will limit the amount of construction downtown, at least on the office side," Holderness said. "Everybody's feeling the pain right now on the construction increases in a soft market, so I think everybody's trying to figure out what to do next."

On the residential side, Class-A apartment rents in D.C. experienced 2.5% rent growth during the year ending March 31, according to Delta Associates' Q1 report. Mill Creek Residential Executive Managing Director Sean Caldwell said he has seen annual construction cost increases around 4.5%. Caldwell said this has forced Mill Creek to change the way it thinks about pursuing new projects. 

"It has really been a challenge for us," Caldwell said. "What that has forced us all to do is that your map becomes smaller — the areas where you can make the rational decision to make development work, your map gets smaller."

In areas where new development deals don't pencil, Caldwell said it makes more sense to look at multifamily acquisitions, because limited new supply could allow existing properties to raise rents. 

Stonebridge principal Doug Firstenberg said cost increases didn't force his firm to make design changes on its Avocet Tower high-rise project in Bethesda, which broke ground last month, but he thinks the next wave of projects may not be so lucky. 

"Avocet ended up in a place that was fine and we didn't have to make compromises whatsoever in terms of quality of finishes and amenities," Firstenberg said. "But to replicate that project for a start a year from now, I would be concerned whether the economics would pencil out if these increases keep happening."

Firstenberg said rents have not been growing enough in the office or residential markets to offset the construction cost increases, and he said margins for developers are getting slimmer. 

"I start to wonder: Are people really going to do it for that much a reduced return on cost?" Firstenberg said. "I think there are going to be issues with some longer-term viability on some projects."

The Meridian Group Chief Investment Officer Gary Block also expects the next wave of development to feel a significant impact from cost increases.

"Construction costs are making new construction and extensive renovations more expensive and more difficult to pencil," Block said. "I think it will have a chilling effect on new construction."