By Andrew Hanzl
When considering taking on a commercial real estate development project there are two key questions to determining the profitability…what does it cost to build and what can you sell it for? Although both questions can be difficult to answer, lately it has been especially difficult to nail down what a project will cost due to rising construction costs.
In 2018, construction material prices increased almost 10% from the previous year, with key materials rising even more dramatically: the cost for crude petroleum rose by 49%, iron and steel went up 14%, and softwood lumber jumped 23% from the year before. A large factor in the increase in material costs is international trade considerations. Tariffs affected the price of steel, aluminum, and lumber, dramatically impacting U.S. construction companies. Furthermore, a 2018 tariff of 10% on $200 billion worth of Chinese imports magnified the problem of rising construction materials. In addition to the cost of materials increasing, wages have skyrocketed for construction workers, a clear a signal of labor shortages. It was estimated that during the last recession that 600,000-construction related job were lost, and as the economy has continued to recover a vast number of these jobs have remained unfilled. Making matters worse millennials entering the work-force are not as interested in pursuing construction related jobs as generations of the past. A recent report of construction companies concluded that 79% of construction companies are short staffed and looking to hire more employees this year.
Now that you get a sense for why and by how much construction costs have changed recently, let me take a second to describe the available construction contracts and how they might or might not mitigate some of the risk associated with rising construction costs.
The first type of contract is called a cost-plus contract, which is a type of contract where the general contractor is paid for all construction related expenses plus an agreed upon profit. Under the basic cost-plus contract, the developer has tremendous exposure because they are responsible for assuming all the risk of project costs increasing substantially. This is especially important to note in the current environment when construction costs are rising in a dramatic fashion. However, there is a variation of a cost-plus contract called a Guaranteed Maximum Price (“GMP”) contract that establishes a maximum price or ceiling on the developer’s bill. Under a GMP contract, significant cost overruns (over the maximum price) get eaten by the general contractor making it a prudent option for a developer. In fact, most lenders are going to require a GMP contract from a reputable general contractor to feel comfortable making a cost-plus construction loan.
The other primary type of contract is a lump sum contract where the developer agrees to a fixed price that will be paid for all the construction work. A lump sum contract places all the risk of cost overruns on the general contractor. Given they are taking more risk, the general contractor is going to price in more room for error meaning potentially more profit to them and less to the developer. Lump sum contracts can only be utilized when a developer has detailed and complete construction drawings and specifications, allowing the general contractor to properly estimate the cost of labor and materials. Lump sum contracts can be inflexible for changes that might occur along the way, might lead to inferior materials/craftsmanship to save money, or lead to major disputes if the project goes way over the anticipated costs.
Picking the right general contractor as well as signing the right construction contract is a major decision in the development process. To increase the odds of success it pays to do the proper research, due diligence, and read the fine print to make sure your project is a profitable endeavor.
If you would like more information about construction contracts or would like assistance securing financing for a development deal, please contact Andrew Hanzl at [email protected].
The Author, Andrew Hanzl, is a Senior Analyst in the Dallas Office of Metropolitan Capital Advisors.