Commercial construction costs will increase on average by 6% to 8% in 2007 — two to four times faster than inflation — despite a slowing economy, according to Kenneth Simonson, chief economist for the Associated General Contractors of America (AGC).

Driving those increases are international demand for materials, limited domestic supplies and high energy prices. Labor costs will grow more slowly, 5% to 6% over the course of 2007, but still well ahead of last year's 2.5% core inflation rate, which excludes food and energy.

But wait a minute. The plunging housing market should lower demand both for materials and labor, right? Shouldn't a less constrained supply be reflected in prices for commercial construction?

Well, yes. But that's already included in Simonson's forecast. Had single-family construction this year barreled along as before, commercial construction costs might be increasing 10% annually, as they did in 2004. In other words, deflation of the housing market is taking the edge off the severe price growth of the past three years, but prices keep rising.

Slowed housing activity is bringing price relief for some products used in commercial construction, including copper, plastics, plywood and gypsum, used in wallboard. Gypsum prices climbed 20% annually from 2003 into 2006, fell slightly in December, and at year's end were only up 5.4% over year-ago prices.

Milled copper and brass, which spiked up 30% annually in 2004 and 2005, climbed another 44% last year, but a 1.6% price drop from November to December suggests slower increases ahead. “We will still have to expect price increases in 2007, but hopefully they won't be as dramatic as in recent years,” Simonson says.

Apples and oranges

Most of the materials (and the labor sets that go with those products) that are expected to experience slower price growth going forward are used in residential and non-residential construction, including sheetrock, fiberboard, plumbing and wiring.

A lack of substantial overlap between residential and commercial construction, however, means prices will climb unabated for many building materials. The same is true of labor; few homebuilding skills are transferable to the construction site of an office building, hospital or mall. “You can't take a framing carpenter and put him in a tower crane,” Simonson says.

In 2004, demand by developing economies, like China, contributed to a 49% spike in the price of steel. Today, China has stepped up manufacturing and now exports about as much steel as it imports. As a result, steel prices dropped 4.3% in the fourth quarter and were only 11.6% higher than year-ago prices at the end of the year.

Concrete, on the other hand, is expensive to transport and is usually purchased near a job site. Concrete demand for buildings, roads and sewers has grown in recent years, while U.S. cement production is little changed from a decade ago.

At the same time energy prices, which climbed 4.5% in December, have increased the price of concrete and other materials, and raised the cost to mine and transport the aggregates that are mixed with cement to form concrete. Concrete prices climbed 10.1% in 2005 and 7.9% in 2006.

Prepare for increases

What does the AGC's forecast mean for developers and investors? For one, expect further price spikes and shortages on materials this year, as well as bottlenecks and high transportation costs in getting those supplies to the job site.

Given a choice, contractors will prefer to deal with developers that include materials price-adjustment clauses in their contracts and will be reluctant to work with government agencies and developers that insist on fixed budgets.

Frequent commodity shortages are a sign that the U.S. economy is operating at capacity, says Craig Thomas, research director at CBRE Torto Wheaton Research. Once builders begin to calculate anticipated price spikes into their contracts, inflation kicks in, potentially ushering in the end of the economic expansion.

Hopefully some of the smart money will help to alleviate this serious situation in 2007 with development — not of office buildings or retail centers, but with cement plants, copper mills, and the infrastructure this nation needs to thrive and grow.

Matt Hudgins is an Austin-based reporter who writes regularly on economic issues and governmental affairs. He can be reached at mhudgins@sbcglobal.net