One of the most frequent questions we get in the current environment is when construction prices will decrease. It’s an important issue to consider, given the impact of these costs on project–level returns and in replacement cost analyses that establish asset valuations. Steep price increases at the start of the pandemic have ebbed somewhat, but deteriorating credit conditions for construction loans and a 41% decrease in new multifamily construction starts might make you think pricing is declining significantly. While material prices have contracted slightly, the labor component continues to grow steadily.
The truth is that the fickle forces determining construction prices go far beyond private rental housing demand. That can make them very difficult to predict and even more difficult to realize evenly across every project in a developer’s portfolio.
As my colleague Bill Stewart has concluded, we are not expecting labor costs to decline significantly even if demand slows. Additionally, we’ve looked at what has happened to construction material pricing during times of recessions. Historically, there have been limited declines in material pricing—notably, down about 9% during the Global Financial Crisis—but it tends to remain flat over a two-to-three-year post-recession horizon.
Producer Price Index by Commodity: Construction Materials
Source: U.S. Bureau of Labor Statistics
Today, we are looking at some of the leading indicators, including commonly used indices and government data, to help understand the dynamics in the construction market:
Commodity futures prices: the most common futures prices we track are those of steel, concrete and lumber, all of which form the structural systems of rental units. We also track copper, the most used commodity in electrical systems.
Oil prices: The price of oil (we track WTI, or West Texas Intermediate) is core to the construction market. Many petroleum–based products are used in our buildings, including insulation, sealants and paint products. And oil is a key input in transportation costs to get goods and equipment to the project site and fuel the equipment used to construct our projects.
Import price index: The Import/Export Price Index (MXP–Selected Building Materials) measures prices paid for building materials that are imported to the United States. The majority of the light fixtures, cabinets and other finished elements in our projects are manufactured overseas.
AIA/Deltek Architecture Billings Index (ABI): This leading indicator projects future demand of construction services by tracking the demand for architectural services, a key part of any development project. How it works: Any reading above 50 means more billings than the prior period, and anything below 50 means fewer billings than the prior period.
U.S. Census Bureau Construction Spending Data: This data breaks down all domestic construction between type of construction and private versus public spending. This is lagging economic data, but it’s a powerful tool to see where construction demand is flowing. While new multifamily and single-family construction makes up 25% to 35% of all construction spending in the United States, most of our subcontractors can find work in other forms of new construction.
The chart below summarizes recent the three-, six- and 12-month changes in the indices mentioned above.
Key Index and Indicator Changes
Source: NYSE American Steel Index, Federal Reserve Bank of St. Louis, Nasdaq, MarketWatch, U.S. Bureau of Labor Statistics, American Institute of Architects
Anecdotally, we are seeing construction pricing as flat to slightly negative on most projects, an observation generally reflected in the leading indicators listed above. As Origin’s managing director of investment management, Marc Turner, noted in a recent webinar on our Income Plus Fund, we have seen the bargaining power of owners increase when negotiating new work with general contractors. We attribute this to the slowdown in demand for multifamily projects and the normalization of supply chains, both of which create a more predictable pricing environment. If these trends continue, we are optimistic that contractor margins may be squeezed, resulting in lower overall prices for owners and developers.
Plenty of construction work is still going on, especially with a significant increase in public-sector work, but any shock to supply chains could reverse trends in material prices and neutralize any margin savings to owners. A prolonged slowdown in new housing demand means contractors will focus on other sectors. And from an investment point of view, any anticipated future decreases in cost must be carefully weighed alongside changes in rent growth, which could have an even bigger impact on returns.