The painful reality for any construction project these days is that it will cost more and take longer to get done. However, development teams and owners are sharpening pencils to value-engineer projects and find solutions to move projects forward.

Construction costs have been exceeding even the rapidly rising rate of inflation. The Producer Price Index for inputs on nonresidential construction in the U.S. reached 16.9% in June, nearly double the 9.1% rate of inflation. High construction costs have been a chronic problem over the past two years. Compared to April 2020, bid prices on new nonresidential construction are up 23%, and key materials like steel mill products have spiked 124% and lumber 61%, according to the Associated General Contractors of America.

“When we reprice development projects in the pipeline, they’re up 15 to 30%,” said Trademark CEO Terry Montesi. “Obviously, that is going to have a material impact on planning and whether real estate development happens, what city participation needs to be and what rents need to be to make a project work.”

Some retail projects are simply not feasible in current market conditions. Montesi recently heard of one national retailer that had seen its costs rise from between $400,000 and $500,000 per store to $700,000. The retailer has decided to put its national expansion on hold to figure out whether it can redesign stores to lower costs. “The same thing is going to happen on ground-up retail projects,” said Montesi. The high construction costs likely will translate to existing retail space that becomes more valuable due to occupancy and rent pressure, he added.

“Rising costs have really been extreme, and it’s only been the last couple of months that we’ve seen any relief at all,” said AGC chief economist Ken Simonson. For 20 consecutive months prior to June, the PPI had been running at more than 20%. Price increases for specific materials continue to vary widely. For example, the PPI for steel mill products for June shows a year-over-year cost increase of 22.4% and a 19.6% jump for gypsum building materials. Construction also is feeling the labor shortage pinch. According to the AGC, there continues to be a record number of job openings in construction: 466,000 as of May.

Long Lead Times

Project completion dates are stretching out due to supply chain disruption and long lead times for needed materials. Delays are costly for property owners, developers and retailers. For some retailers, opening before the holiday shopping season is critical, as that period can amount to a majority of their annual sales. “Speed is important in a capital-intensive business, and time is as much the issue as the cost,” said Shopoff Realty Investments president and CEO William Shopoff.

Construction managers and project superintendents have to spend significantly more time with general contractors to stay on top of purchasing to avoid delays, he noted. “It feels like it is getting better, but delays are still very much in play,” he said. For one tenant improvement project, Shopoff Realty is waiting for air handler units that are not expected to be available until March. Normally, that equipment is available on demand or within 30 to 60 days.

Delays can impact the entire development pipeline. If it takes three months longer to finish one project, that often means waiting three more months to start the next, noted Shopoff. “I can do multiple projects at the same time, but there isn’t unlimited capital to start new projects all at once,” he said.

In many cases, construction projects take 20 to 25% longer to complete. “You’re operating in an environment now where everything has to go right to keep a project on schedule,” said Grant Gary, president of brokerage services and a principal at The Woodmont Co. “If you run into even one issue or anomaly, the schedule is pushing out, and there are a lot of different issues out there that have the ability to impact scheduling,” he said.

Moving Projects Forward

The big question developers are grappling with is whether projects still pencil out, as rising interest rates only add to expenses. Retail faces the added challenge that it hasn’t seen the same accelerated rent growth as multifamily and industrial. According to Gary, it’s almost a necessity to have some type of public-private partnership with the city or county to bridge the cost gap and make projects viable today.

“You really have to get creative in understanding what the options are,” said Gary. Public-private solutions include tax increment financing and sales tax rebate agreements, upfront grants and waivers on fees. In some cases, cities or counties even take some form of ownership in a project. Woodmont recently acquired a 90,000-square-foot former Sears in Garden City, Kansas, that has been vacant for a number of years. The company plans to redevelop the building to accommodate new retail tenants and is discussing some type of collaboration with the city to offset building costs and benefit the local community.

“Without major city participation, it is difficult to get the numbers to work on a ground-up retail deal with rents where they are and with construction costs having accelerated,” agreed Montesi. Trademark is working on one project for which the city is pre-approving TIF so that at closing, the company already will have some dollars committed and advanced against a future TIF. “The municipalities and the tenants are going to have to bear some of the cost of increasing interest rates and inflation on construction materials and labor,” he said. Developers also are focusing more on mixed-use, in which they can lean more on rents in other uses, such as apartments, to offset higher costs and build needed retail and restaurant space.

Developers Take Proactive Approach

Rising costs, staffing and supply chain issues have highlighted the need to engage proactively with contractors and designers to stay on top of purchasing and the need to be flexible in making decisions on finishes. When construction projects go out for pricing, the first step increasingly has become to value-engineer what is on the plan, noted Haynes Group project executive Jeff Benevides. Project managers from the Haynes Group sit down with designers and owners to figure out where the team can cut costs or find alternative materials without compromising the overall design of the project.

One creative way the Haynes Group is taking on renovation projects is separating the job into phases. It’s working on one store renovation that needs a new, 20-ton rooftop HVAC unit, but delivery isn’t expected until the end of February. To get the store open on schedule, it’s making do with the existing unit and, when the new unit arrives, will swap out the old unit during the store’s off-hours. “Phasing projects and reusing materials like electrical switch gears are some of the things we’re doing to get stores up and running sooner,” said Benevides.

Development teams also are ordering materials early to avoid delays, ordering in bulk and storing extra materials, and choosing materials and equipment that are less expensive and/or more readily available. Developers don’t want to disrupt the long-term value of a building, but they can’t fully absorb the cost increases or pass them on to tenants, so it does require being smarter about value-engineering projects, added Shopoff.

Slowing Economy Could Bring Relief

Rising interest rates are likely to slow demand for new single-family home construction. Additionally, a recession or slower economic growth also could slow demand more broadly and alleviate some of the supply and demand pressures in the construction industry. However, developers do not expect any significant relief until 2023, and they remain conservative when forecasting costs and schedules on new projects. “From what we’re seeing, the next six to eight months is going to be pretty much the same as what we’re seeing now, if not a little bit worse,” said Benevides. “The backlog just continues to mount up.”

He also sees two schools of thought emerging on new retail development. One is to pause until costs and supply chain disruption settles, hopefully with some improvement in 2023. The other is to move forward with development, which could result in a project that’s ahead of the curve and in a good competitive position in the market. “We have had some projects that have been pushed out to 2023, mainly to allow time to source materials and make sure they have everything in hand when they do break ground so that there are no delays,” he said.

On a positive note, there are some signs pricing is more stable than the weekly or even daily extreme price jumps of 2020 and 2021. The pricing on some materials, including lumber and steel, have come down from peak levels. “Material costs appear to be moderating and trending in the right direction, but every now and then, something unexpected spikes,” noted Shopoff. “A year from now, I think challenges will be far less than what we’re having, and probably by the end of next year, we will have rebalanced most of the supply chain. But all of that is with a giant caveat: If we continue to have COVID outbreaks around the world, [the] supply chain continues to get disrupted.”