With Rising Construction Costs, Is Real Estate Still a Good Investment?

Topic:  • By David Scherer • June 24, 2021 Views

Soaring building material prices have made multifamily construction costs and timelines rise. Commodity prices for lumber and copper hit 10-year peaks in May 2021; steel, concrete and gypsum products are rising at a record pace; and supply chain delays are drawing out project timelines. It’s made pricing multifamily housing thorny for private real estate managers, and left investors wondering if it’s still a good investment.

No one knows when high commodity prices will ease, but there are substantial reasons for private real estate investors not to stay on the sidelines. Even with price volatility, multifamily housing fundamentals remain strong and create a high expected return on investment. To understand the impact of rising commodity prices and the long-term prospects for multifamily real estate, investors need to look at the three inputs that are most important to the success of any development deal:

  1. Rent Growth. Actual and projected rent growth correlate directly with net operating income (NOI), or the cash flow an investor can pull out of a property. Since January 2021, effective rents have gone up remarkably—25% in a four-month span.
  2. Cap Rates. Capitalization rates, the first year NOI as a percent of purchase price, are falling. At a constant NOI, cap rates go lower as property values go higher.
  3. Construction Costs. The May 2021 peak for lumber, $1,711 per board foot, was four times higher year over year. On a 200- to 250-unit project, the cost of lumber, concrete, steel and other commodities are driving up the cost of a $40 million to $50 million deal by $3 million to $5 million, or 5% to 8%.

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How Rent and Price Growth Moderate Construction Costs

While rising construction costs seem like a financial hurdle at first blush, the reality is that rents and cap rates more than make up the difference. First, rising rents show there’s continued demand for multifamily housing. Origin’s Monroe Aberdeen Place property in Chicago illustrates the turnaround. In 2020, the new construction multifamily asset was 88% to 90% occupied and the rent roll was static. In 2021, occupancy is 98% with no rent concessions, and rental rates are rising.

Second, cap rates are even lower than in 2020. The pandemic has created uncertainty in hotels, office buildings and other property types, shifting the capital markets into multifamily housing and industrial projects. Readily available financing is bidding up valuations for these property types. At a constant NOI, as prices rise, cap rates fall. A $1 million property with a $100,000 NOI has a 10% cap rate; buy the same property at $2 million and the cap rate is 5%.

Steady rent growth and low cap rates are not only positive, but also powerful together. If the rent roll is expected to grow, as is now the case, the property should command an even higher future valuation. The capitalization rate serves as the multiple on earnings.

Solving for Profit: Making Two Parts of the Equation Work

Investors don’t have to win all parts of the equation to make multifamily investing work right now. Right now, and for the foreseeable future, two out of three positives make building multifamily housing a “go.” Of course, a private real estate investor can wait for construction costs to go down. But with multifamily development margins at historical highs–on the order of 35%—it will be hard to find better risk-adjusted returns right now.

When costs finally do go down, the other inputs may change as well. Reduced demand may depress rent growth. The uncertainty in turn can also push cap rates higher and further limit the profit potential.

The perfect scenario—the lowest input costs, future rent growth and lower cap rates—would have been to build throughout the pandemic. In fact, Origin has been developing multifamily housing throughout the pandemic in multiple cities. Higher commodity prices won’t affect returns if other variables make up the difference.

What a Volatile Input Means for Pricing

Commodity prices are volatile, though, which makes projections difficult. However, there are ways to mitigate the risk. On the Chicago Mercantile Exchange, lumber is a downward sloping market right now, with cheaper prices for each successively longer futures contract. This indicated an efficient market because while no one knows the future, everybody has the same information at the same time.

The solution is to use a conservative pricing strategy that looks at future lumber and steel costs and allocates more money for such events. In addition to a 5% contingency for construction (say $2.5 million), Origin will assume $1 million for rising construction costs to see if the deal can withstand the volatility. If a deal with $3.5 million in contingencies covers the cost of capital, and still pencils out at a 35% profit, it’s worth doing.

A large margin for contingencies can have three possible outcomes:

  1. The outlay is higher, eating up the whole contingency, and the profit margin is still 35%.
  2. Costs can drop, and the project gets savings from the initial underwriting that adds to returns.
  3. Expenses are exactly as modeled without touching the contingency fund. All $3.5 million falls to the bottom line.

There are other ways to think about this price modeling. One is that a unit that costs $200,000 to build and sells for $270,000 has a 35% profit. Another is the untrended return on costs—that is, the profit assuming no rent increase. If the untrended return is 5.5% and the capitalization rate is 4%, the percentage spread between 4% and 5.5% is a 37.5% margin.

Price volatility has predictably stirred concerns about inflation. Conservative underwriting assumes higher cost inputs but no change in price outputs. In reality, inflation triggers growth in rents as well as expenses. The higher top line is powerful compensation.

Why It’s Key to Act Quickly

With private real estate providing more than enough capital, competition is keen for good development sites and good partners. Pension funds, endowments, family offices and real estate funds all want to be cut in on desirable real estate deals. When a prime property is available, there’s lots of competitors vying to assemble financing and make an offer. It’s hard right now to find good deals—and when you find them, act.

In such an environment, Origin’s relationships and track record make all the difference. We’re experienced investors in growth markets, we constantly monitor market indicators and we tap into our networks in local markets to get access to off-market deals. Financing flexibility gives us many ways to make a deal work, even in an environment of rising costs, and to deliver investment options for private real estate investors to meet income and growth objectives.

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Posted By

David Scherer
Co-CEO

David Scherer formed Origin Investments in 2007, along with Co-CEO Michael Episcope. He has more than 25 years of experience in real estate investing, finance and asset management.