Time to put the shovel down? So far this year, we have abandoned three projects due to staggering construction cost estimates
His number came 100% more than the cost of our last store, and the matter is no longer in pencil.
By John E. McNellis, director of real estate developer McNellis Partners, for WOLF STREET:
A great entrepreneur in San Francisco told me the other night that he half wished for another recession. Why? Because his contractors – the guys doing the work – are so overwhelmed with work that they’ve become unbearable: either they don’t answer the phone or they hand in stratospheric bids.
His submarines may indeed fatten their profit margins, labor may cost a bit more, but the real problem with construction is soaring material prices. Another builder said its costs had risen 15-20% in the past 12 months, pointing to a 50% spike in asphalt prices due to the Russian oil fiasco.
As troubling as the prices is the shortage of critical materials. Just one example: Switchgear, the equipment that transforms raw electricity from power lines into that which can be used by project tenants, is only made by three companies in America. Two are reporting a 12-month delivery delay and the third is not taking new orders. Thus, a developer is faced with a choice for Sophie: she can either order her equipment 6 months before submitting her final plans for the city’s approval (and light a candle), or see her project opening delayed until a year.
Rises in construction costs are not new, they have persisted since we emerged from the Great Recession. And material shortages have been around ever since Covid slithered out of Wuhan. What is new is the other side of the coin: the uncertain values of real estate.
You can live with cost increases and delays if your profitability is assured, but today a profit is anything but guaranteed. Where house prices will be by the end of the year is pure speculation. Couple soaring construction costs with interest rates and inflation rising like hot air balloons, and one might conclude that now is a good time to put the shovel away.
I asked one of the Bay Area’s biggest residential developers if his company was hitting the pause button on its new developments. “No,” he answered. “Our projects take 5 to 6 years from start to finish. So the ones we’re starting construction on now benefit from cheap land that we bought years ago. And the brand new ones won’t go live until the end of the recession we’re heading into.
This can work great for million dollar projects, but for those of us who are double A’s, i.e. with project horizons of 12-24 months, it’s a another story. Here’s one: Earlier this year, we signed a lease with one of our favorite supermarket chains to build a new store. I had blithely assumed it would cost about 25-50% more than the last one we built for this grocer. Belatedly, we had a reliable contractor who gave us the price. His figure was 100% more than the cost of our last store, the deal was no longer in pencil and we had to break the lease.
So far this year, we’ve dropped three projects due to sky-high cost estimates. We’ve sold a small residential project to a more optimistic builder than us, are in initial talks to sell or possibly build another, and have mothballed a third. On the commercial level, we have chosen to sell rather than develop a self-storage project. We find that retail – our longtime specialty – only works with fast food land leases.
I recently likened our development company to farmers, which means that we continue our projects despite the economic monsoons and droughts that we inevitably encounter because we have confidence in the favorable long-term business climate. It’s true, but if we stick to this metaphor, there comes a time to rotate crops, to leave the fields fallow. The new construction could well be the ground to rest for the next two years.
Veteran developers will tell you to build in good times (because you can’t find existing properties for a decent price) and buy finished buildings when, like today, they are so often cheaper than the replacement cost. Not a bad rule of thumb. By John E. McNellis, author of Succeed in real estate: start as a developer.
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