His figure came in at 100% more than our last store cost, and the deal is no longer set.
Written by John E. McNelis, Director, Real Estate Development Corporation McNeills PartnersFor Wolf Street:
A major contractor in San Francisco told me last night that he’s half wishing there was another recession. why? Because the subcontractors – the guys who actually do this work – are so overwhelmed with jobs that they are becoming unbearable: they either don’t answer their phones or bid in the stratosphere.
His subs may already be increasing their profit margins, and labor may cost a bit more, but the real pain of construction is the higher prices for materials. Another construction worker said his costs had risen by 15-20 percent in the past 12 months, citing a 50 percent rise in asphalt prices due to the failure of Russian oil.
Of such concern as pricing is the shortage of basic materials. Just one example: Switchgear – equipment that converts raw electricity in power lines into one that can be used by project tenants – is only manufactured by three companies in America. Two reported a 12-month delay in delivery, and the third is not receiving new orders. Thus, a software developer faces Sophie’s Choice: She can either order her key set 6 months before she submits her final plans for city approval (and light a candle), or delay the opening of her project for up to a year.
The rising cost of construction is nothing new, it has continued since we emerged from the Great Recession. And there has been a shortage of materials since the outbreak of COVID-19 from Wuhan. New is smearing the other side of the coin: uncertain real estate values.
You can live with cost increases and delays if your profitability is guaranteed, but profit today is not at all guaranteed. As real estate prices by the end of the year will only be guesswork. Pair runaway construction costs with rising interest rates and inflation like hot air balloons, and one might conclude it’s a good time to throw away the shovel.
I asked one of the largest residential developers in the Bay Area if his company is hitting the pause button on its new projects. He replied, “No.” Our projects take 5-6 years from start to finish. So those we started building on now are taking advantage of the cheap land we bought years ago. And the new products won’t be released online until any recession we might be headed toward has cleared up.”
This might work well for billion dollar projects, but for those of us in the Double-A ball, i.e. with a project time horizon of 12 to 24 months, it’s a different story. Here’s one: At the beginning of the year, we had a lease signed with one of our favorite supermarket chains to build a new store. I assumed it would cost about 25-50 percent more than the last one we built for this grocer. In hindsight, we got a reliable contractor price for us. His figure came in at 100 percent more than the cost of our last store, the deal was no longer set, and we had to terminate the lease.
So far this year, we’ve dropped three projects due to the staggering cost estimates. We sold a small housing project to builders more optimistic than us, and are in preliminary discussions to sell or possibly another joint venture, and put a third project on hold. On the business side, we chose to sell rather than develop a self-storage project. We’ve found that retail – our long-standing specialty – only works with fast food land leases.
I recently likened our development company to farmers, which means that we are moving forward with our projects despite the economic monsoons and drought we inevitably face because we are confident in the right business climate for the long term. True enough, but holding on to that metaphor, it’s time to rotate the crops, to allow the fields to rest. New construction may be the basis for rest for the next couple of years.
Veteran developers will tell you to build in the good times (because you can’t find current properties at affordable prices) and buy prefabs when, like today, they are cheaper than replacement cost. Not a bad rule of thumb. Written by John E. McNelis, author of Getting Started in Real Estate: Getting Started as a Developer.
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