In May 2003, CIM Group Inc. finalized plans to build The Market in Los Angeles. The 360,000-square-foot mixed-use project was budgeted at $50.4 million and construction was set to begin in October 2004.

Instead, The Market swelled to a $110 million, 400,000-square-foot project, with seven stories rather than six, and groundbreaking was postponed until this February. Why? Because, while the project was on the drawing boards, runaway inflation in the cost of building materials made the original plan unprofitable. During 2004, the cost of steel mill products rose 46.5 percent, according to the Bureau of Labor Statistics. With a worldwide shortage, the price of concrete rose 10 percent. Gypsum board was up 21 percent. And items such as wiring, copper and brass, and plywood all saw double-digit increases.

To justify the escalating price, CIM added a seventh floor to the project, maintaining the overall number of residential units, but making them bigger in order to retain the 56,000-square-foot retail component, which includes a 50,000-square-foot Ralph's. The opening was pushed back from spring of 2005 to December of 2006. And instead of rental apartments, CIM opted for condos to get an immediate payback, says Shaul Kuba, CIM principal. But raising the retail rent was not an option in the competitive Southern California market.

CIM's story reflects a bigger industry problem: Prices for construction materials are increasing so quickly and by so much that developers have had to alter their processes and, in extreme cases, redesign their projects. Some are fast-tracking their deals to get them going, ahead of further price increases that are expected later this year and beyond. And contractors are inserting clauses into contracts requiring developers to pay for price increases that occur during construction. “As this continues, contractors are going to be more stringent about negotiating those clauses,” says Randy Flick, senior vice president and head of development of Equity One Inc.

At the same time, developers are not using rising prices as an excuse to cut back construction. Subsequently, the continued flow of new projects combined with the quest of owners to find more properties to buy will exert additional upward pressure on pricing at a time when costs have already risen astronomically. And this is all happening when developers are unable to jack up rents sufficiently to produce the revenue to cover the increase in expenses.

Picking up Speed

Smart developers are pushing architects and engineers to accelerate the design process, says Barry LePatner, a partner at LePatner & Associates, a New York-based law firm specializing in construction consulting. “In a market where construction costs are going up, you want to get to the point where people ordering steel can lock the price in today,” he says.

Continental Real Estate Cos. and Equity One Inc. are among the developers who have taken steps to get ahead of the price spiral. “We're trying to speed up the process,” says Todd Alexander, president of Continental Building Systems, which is a division of Continental Real Estate. If the company knows it wants to pursue a project, it is trying to move on it today rather than planning a start six months down the road. “We're trying to improve the timing at the front end and make commitments earlier.”

How hard developers are hit depends on the type of construction — steel costs more than concrete. But overall, the cost of construction went up 10 percent from 2003 to 2004 according to Marcus & Millichap Brokerage Services. That's three times the inflation rate for the U.S. economy and the highest annual growth rate in construction costs since the 1970s. But there's a difference between then and now: The entire economy was experiencing double-digit inflation, so developers could pass on the costs to tenants, who hiked prices to consumers, says Ken Simonson, the chief economist with the Associated General Contractors of America. “Then, we had inflation pretty much across the board,” he says. “The fact that it is so concentrated in construction is putting quite a squeeze on contractors, property owners and retailers.” Today, tenants and landlords must find ways to cut costs since they can't recover their expenses from the consumer.

Why the disproportionate inflation in construction materials in the U.S.? The answer lies in China, where the economy is growing at 8 percent annually and which is on a building binge that is siphoning materials from all over the globe, including the U.S. By some estimates, the country is taking in 20 percent of the world's steel supply, including about one-eighth of U.S. exports.

For some U.S. cities, surging demand for steel is a blessing. Steel plants that had been shuttered in places like Cleveland and Pittsburgh are now back in operation.

Getting the Band Back Together

But the downside of the shortages and price increases also have regional implications. For example, as a result of the extensive rebuilding in the aftermath of four hurricanes that swept through Florida last summer, cement and concrete are so scarce that developers can only get shipments every other week. Pre-cast blocks are also hard to come by. What this means is that they've got to carefully manage the construction process and make sure they get all their pouring done in the window when they can get the materials. Prices for both poured concrete and pre-cast blocks are up between 80 percent and 90 percent from a year ago in Florida. And there is a similar crunch on roofing materials.

In order to take on the rising costs, many developers are trying to shorten the up-front work — such as getting the final drawings completed — to push up the time frame for ordering materials. They are also trying to bring the general contractor into the planning phase earlier to identify modifications that can lessen the impact of higher material prices and reduce the number of change orders during construction. “There's a lot of value in bringing the team together earlier in the process,” says Brett Hutchens, president and CEO of Casto Lifestyle Properties. Indeed, Hutchens likes to bring in contractors when the budget is being determined. “It's better to have a contractor provide input into the pro forma numbers when you're making a decision on whether to do the deal or not,” he explains. “They have a better crystal ball as to what material prices are going to be.”

But there are limits to how much a developer can do to speed up a project without taking on additional risks, says Equity One's Flick. “Sometimes it takes so long to get permitted, that you may be tempted to go out on a limb and get the steel ahead of time,” he says. “But if there are changes as a result of the permitting process, you may get burned doing that.”

And, for many projects, it's not practical to look for substitute materials to cut costs. “It's difficult to find alternative methods,” Alexander of Continental says. “With retail, the shapes you're trying to create have to be steel. There's really no way to work around it.”

Pure retail is perhaps the most difficult environment for developers now, because they can't get tenants to pay higher rents to cover the costs of steel. Developers of multifamily projects, on the other hand, can raise rents or condo prices to consumers. As a result, building-materials inflation is emerging as another factor in creating more mixed-use projects. “Most of our projects have a residential component where you can absorb the price increases by raising the per-square-foot cost per unit,” says Hutchens. “On the retail side, though, that doesn't translate. Those rents are based on sales projections and those just don't change.”

Other tactics include finding finishes that are cheaper but look nice. Retailers are also keeping their showrooms upscale, but cutting corners in the back ends of stores.

And as a last option, developers are trying to salvage steel where possible.

“The one impact that we have seen is on the demolition,” Alexander says. “There are a lot more salvage operations going on.”

While landlords may have little wiggle room on base rents, they do have other ways of reducing the impact of rising materials costs. For example, some developers are reducing tenant improvement allowances and, in some cases, eliminating them completely.

Mary Lou Fiala, president of Regency Centers Corp., says her company is no longer giving allowances to toy, athletic shoe or video rental stores. She says that's partly because these sectors have all been under stress. But the reductions also help offset rising material prices.

“Landlords are pushing for higher rent or lower work-letter agreements in the leases where the landlord gives money for build-out to a tenant,” LePatner says. “If everything is going up, the deal may not be as sweet as it might have been.”

There's another hidden cost in materials inflation: As replacement costs rise, so do insurance premiums, which are based on those replacement costs. Average replacement costs have risen 11 percent, according to Willis Group Holding Ltd., a London-based insurance broker. Later this year, some owners may be surprised to find that their buildings are actually under-insured and will get hit with bigger bills.

As developers look at rising construction costs, it becomes more attractive to them to buy rather than build. That places additional upward pressure on prices — at a time when cap rates are already hitting historic lows seemingly on a weekly basis.

One measure of how serious the situation is getting is the reluctance of the two largest mall companies, Simon Property Group and General Growth Properties, to talk about it. Both declined to discuss the impacts of rising material costs, other than to acknowledge it is something the companies are constantly addressing.

You might expect the soaring costs to choke off the construction pipeline — but you would be wrong: Developers are expected to deliver 27 million square feet of neighborhood and community center space and 3.8 million square feet of regional mall space this year, according to Marcus & Millichap. That's up from 25 million square feet of neighborhood and community center space in 2004 and just shy of last year's 4 million square feet of regional mall space. In 2003, according to the brokerage firm, 23 million square feet of neighborhood and community center space came onto the market and 3 million square feet of regional mall space was added.

Developers are not backing off new projects. On the contrary, they are trying to get projects in motion now in order to avoid paying higher prices six months or a year from now, Hutchens says, especially since there is no sign of the fundamentals that have created the problem changing. China's building boom is continuing. And construction activity in the U.S. isn't slowing either.

“In most markets, retail along with residential, hotel, entertainment, etc., construction is up in every one of those sectors,” LePatner says.

So, material costs will be an enduring problem. No one has said that they have had to walk away from a deal because the cost of materials made the project unfeasible. But because there is little that can be done to counteract rising costs, that day may well come. In the meantime, developers will have to continue to bear the brunt of inflation in material costs.

Incredible Rising Budgets

While some techniques can lead to cost reductions, they don't totally offset the rising cost of materials, so the developers have to pass it on to tenants or else just bear the costs themselves.

  • In San Francisco, the price tag on Westfield Group's and Forest City Enterprises' joint redevelopment of San Francisco Centre and 835 Market Street has risen from $380 million to $410 million, at least partly due to material costs.

  • Developer Kamehameha Schools will pay $84 million for the renovation of the 293,000-square-foot Royal Hawaiian Shopping Center, instead of the original $55 million estimate.

  • In Sacramento, cost overruns halted construction of a mixed-use residential and retail project. The developer, Sotiris Kolokotronis, needed a $4.75 million loan from the city to restart construction. The cost of the project jumped from $31.8 million when it was approved in 2001 to $37.5 million.

Precious Materials

Inflation in the price of construction materials has now spread beyond steel, impacting everything from gypsum to lumber and plastic.

PRODUCER PRICES INDEXES
Product Name % Change from Jan 04 to Jan 05
Steel Mill Products
46.50%
Copper and Brass Mill Shapes 22.10
Gypsum Products 21.00
Fabricated Structural Metal Products 17.50
Fabricated Ferrous Wire Products 17.00
Aluminum Mill Shapes 14.60
Softwood Lumber 10.30
Cement 9.50
Concrete Products 9.30
Plastic Construction Products 7.60
Plywood 7.20
Millwork 5.90
Hardwood Lumber 1.80
Source: Bureau of Labor Statistics