Living in a material world

As rising commodity prices and labor shortages push construction costs to 20-year highs, private equity firms are grappling with today's inflationary environment. By Paul Fruchbom

Though it is often said that real estate is a local business, recent trends may suggest otherwise. In an economy that is becoming increasingly globalized, perhaps it stands to reason that one of the world's most abundant assets, real estate, is becoming more susceptible to large-scale, macroeconomic factors. Interest rates, GDP growth, demographic trends, emerging economies—all of these can have a significant impact on local property markets. And in what has become increasingly clear over the past 12 months, so too can global commodity prices.

Since the beginning of 2005, the price of commodities such as petroleum and natural gas—which affect everything from the cost of PVC pipe to construction equipment to the transportation of cement—have risen by more than 50 percent due to heavy demand from Asia and supply disruptions in the Middle East and the Gulf Coast. Following the devastation of Hurricane Katrina, for example, traded oil futures hit an all-time high of more than $70 per barrel.

While prices have retreated from such peaks in recent months, the tense political situation in Iran is leading to jitters in the oil markets and many experts don't expect prices to subside anytime soon. In a recent teleconference, Ken Simonson, the chief economist of the Associated General Contractors (AGC) of America, noted: “People have the misimpression that the oil crisis is over.” A recent AGC economic summary pointed out that 20 percent of the Gulf Coast's production of natural gas remains shut down.

Costs for many other materials have skyrocketed as well. According to the US Bureau of Labor Statistics, overall costs for construction materials and components have risen by more than 16 percent in the past two years, significantly ahead of the broader producer price index and the highest growth spurt in the past decade (see chart).

Though price increases for certain materials have been due to temporary shocks, some of the underlying drivers are more long-term in nature: the surging Asian economies, a worldwide boom in real estate and tension in the Middle East. Simonson predicts that in 2006 prices for fuel, asphalt and plastics will increase by up to 20 percent while steel, wood and gypsum costs should remain commensurate with 2005 levels. At any rate, the current run-up in prices has been the most dramatic in recent memory.

“I've been in this business for 18 years,” says Paul Dougherty, co-founder of Perseus Realty Partners, a Washington, DC-based private equity real estate firm. “And I've never seen it this bad. A lot of the run-up in construction costs is due to the overseas factor and the demand from India and China.”

Dean Macfarlan, chief executive officer of Dallas-based Macfarlan Real Estate Investment Management, agrees. “I haven't seen [cost] increases like this since the early 1980s,” he says. “They're having a pretty significant impact.”

That impact has been a long time coming. High oil prices and a global real estate boom, after all, are not breaking news stories. Yet whereas in the past investors have been able to count on rising real estate prices to cover cost overruns or eroding profit margins, the situation has become dramatic enough—and the fear of a market softening palpable enough—that industry practitioners are starting to take notice.

“The run-up in end-user sales prices has mitigated a lot of the problem,” says Jon Halpern, managing director of New York-based Marathon Real Estate. “This is only coming to the forefront right now.”

The impact of material cost varies by market and property sector—it seems the conventional wisdom about real estate being local still holds true after all. Nevertheless, most private equity professionals believe that the impact of high construction costs will be the most severe in the frothiest markets, such as Miami and Las Vegas. Not only have investors in these cities had to contend with an abundance of capital and competitors, now they are also facing rising material costs and, perhaps more importantly, a dwindling supply of skilled labor.

“Commodities are just one part of the story,” Halpern says. “They're not the major driver. Most of the cost increases have been driven by a shortage of talented labor and, even more so, a shortage of quality contractors.”

Macfarlan agrees, noting that labor costs are one of the reasons his firm is focusing on geographic regions that have been less susceptible to a tight labor market. “We're investing in secondary and tertiary markets that are often overlooked,” he says. “Typically there is not as much cost pressure in these smaller markets—contractors are not as busy and prices are lower.”

Anecdotal evidence seems to support his claim. Halpern says that Marathon's projects in Miami and New York are seeing cost increases of 20 percent to 30 percent, while a Marathon hotel development in San Antonio has experienced around half that amount. In Montreal, where labor has been more readily available, Halpern says that costs are coming in under budget. He also points out that location is just one factor; equally important, as always, is a private equity real estate firm's choice of operating partner.

“In a volatile market, working with anyone other than a superfinancially stable contractor could be suicide,” says Halpern.

In addition to the geographic impact, construction costs are having an influence on various property sectors. For example, certain residential condo developments with fixed sales prices and variable cost structures, have become a four-letter word for private equity real estate firms and lending sources. By contrast, niche sectors such as luxury hospitality and nursing homes are gaining in popularity. This is partially due to firms seeking higher levels of risk and return, but is also influenced by rising material costs—margins are generally high enough to withstand large increases in the underlying cost structure.

The fallout may also be more subtle in nature. Higher gas prices, Macfarlan believes, will have a detrimental impact on people's driving and travel habits, encouraging the development of entertainment and retail venues in heavily populated areas. “I think you'll see continued interest in mixed-use developments and urban redevelopment,” he says.

While the influence of today's inflationary market has been pervasive, GPs point out that it doesn't have to be devastating. Through the use of higher contingencies, creative deal structuring and efficient uses of labor, private equity real estate firms are learning to adapt.

One of the biggest changes that some private equity real estate firms have made is increasing the size of their contingencies, or allowance for cost overruns in their projections. Macfarlan points out that a normal contingency is approximately five to six percent of building costs; in today's environment, however, he believes eight to 10 percent is more appropriate.

Perseus Realty's Dougherty agrees. “Your guaranteed maximum price contract from a general contractor is probably only good for a week or so,” he says. “We've been putting in much higher contingencies— 10 percent on both hard and soft costs—and constantly updating our projections.”

Another way in which investors are reacting to higher costs is by structuring deals such that the contractor bears a higher percentage of the risk of cost overruns. Halpern points to Marathon's $280 million hotel development in San Antonio. Though the firm is working with an experienced hotel contractor, Marathon wanted to reduce their risk given the size of the project. They negotiated a contract with the developer that included a turn-key fixed price at a specific delivery date. “We had to pay a bit of a premium for this,” Halpern says. “But the obligation is on them.”

In terms of rising labor costs, Halpern describes, once again, how the choice of an operating partner can be a key factor. During the remodeling of a residential complex in St. Petersburg, Florida, for example, the developer, a company with regional operations was able to pull construction crews in from different parts of the country.“We had to house the crews,” says Halpern. “But the costs were still lower than if we had to bid into that market.”

Yet while labor costs have been one of the biggest cost drivers, Dougherty, for one, believes they may ease soon, particularly if some markets soften and the current backlog of projects dries up. Contractors who once thought their slate was full may find that they have a lot of extra time on their hands.

“I think you're going to see a huge fallout in condos around the country,” says Dougherty. “Many projects will not go forward and as the condo market slows down, labor costs will be less of an issue. That's been the biggest problem. It's been the subcontractors, not the GCs.”

While rising construction costs have been a large negative for many private equity real estate firms, potential benefits have existed as well. As new development becomes more expensive, the value of existing buildings has been steadily increasing. And as owners of real estate, opportunity funds are certainly profiting from the run-up in values.

“For existing product, the replacement cost bar is getting raised,” Halpern says. “In itself, it doesn't cause one to pay more for properties, but it is a valuation barrier. It creates more room for upward values on exiting properties.”

Others believe that the current inflationary environment may bring some level of rationality back into the real estate market. In a recent Fortune article, Colony Capital head Tom Barrack pointed to rising material prices as the potential pinprick in the US real estate bubble.

Though Macfarlan doesn't believe that rising construction costs are a bigger threat than rising interest rates or underlying job growth, he does think it could lead to a correction—and that would be okay.

“In a way, this is going to be healthy,” he says. “It may lead to a correction in the real estate market, which would be much better than a crisis. If people respond appropriately, all of this is a good thing.”