As global markets start to reopen and covid restrictions begin to widely ease, fluid pricing and supply chains have created negative repercussions within the private real estate market.
Construction demand has been outpacing supply during the coronavirus pandemic, as supply chains have been impacted by health concerns, bottlenecks, labor challenges and material shortages, according to the Commodity Volatility – Impacts on CRE & Construction report by Chicago-based real estate services firm Cushman & Wakefield. At the same time, construction demand has soared, with Q1 2021 total private construction activity up 7.5 percent year-on-year and expecting to hit 20 percent-plus for the rest of the year, according to the report.
One new source of anticipated construction demand is the Biden administration’s proposed $2 trillion infrastructure plan, of which $213 billion is set to be invested in housing. Emergency monetary policy has “distorted the natural supply/demand dynamics in the economy, which is impacting both real estate prices and construction costs,” says Steve Cornet, head of US research and strategy for BlackRock Real Assets, the real assets arm of the New York-based asset manager.
Actions taken by central banks to lower interest rates have resulted in lower mortgage rates, Cornet adds, which have increased homebuying activity and consequently heightened demand for construction materials.
“Home prices have risen higher partially because of demand, but also due to commodity prices, which have been pushed significantly higher,” he continues. “The cost of building a new single-family home has risen by $36,000 due to lumber prices since April 2020. We are seeing a similar situation in the commercial real estate markets.”
Build versus buy
Lumber, along with copper and steel, have seen substantial price increases in the past year. Production has ramped up at existing mills to keep up with an increase in single-family and multifamily construction starts during the pandemic. Lumber producer prices are expected to grow by 28 percent in 2021 and 7 percent in 2022, before levelling out in the middle of the decade, according to the Cushman & Wakefield report.
Commodity price increases previously were “absorbed” by general contractors because of the dearth of projects during the pandemic, according to the report by Cushman & Wakefield. Now that the economy is reopening and more construction work is available, contractors are passing along these cost increases directly to clients, which is impacting both occupiers and investors.
These supply challenges and rising commodity costs in a competitive market have affected decision making around building versus buying assets. “The residential sector held up well in the downturn, which means pricing has become increasingly competitive to buy ready-built good quality stock and you are bidding in a very crowded playing field,” says Sabina Kalyan, global chief economist and global head of real assets research at Los Angeles-based real estate investment manager CBRE Global Investors. “About a year ago, we would have said if you have high conviction around a particular market or a sector, it might be better value to build it rather than buy it.”
The uncertainty surrounding construction costs, however, has caused many to consider whether this build-it-yourself approach is in fact economically beneficial, particularly in January and February of this year, when prices were rising sometimes by as much as 30 percent in a week, Kalyan explains.
Whether to build or buy differs regionally as covid continues to have varying impacts across the world, she adds: “We are not seeing a synchronous situation this year. Countries are opening up at different points and there are differing approaches to flexibility, which is really hampering supply chains.”
The impact of rising costs
Nonetheless, pricing spikes in commodities have already affected the feasibility of certain real estate investments. “Many of those development projects that were once on the market might not happen now, particularly where land prices were high and returns were already squeezed,” says José Luis Pellicer, head of investment strategy and research at M&G Real Estate, the property arm of the London-based investment manager.
“Once construction costs increase, this eats into returns and makes certain projects unviable. Higher costs could have implications for some value-add strategies with heavy capex programs, although less so for core strategies or capex-light value-add strategies.”
Pellicer says logistics is a sector where projects could be in jeopardy due to these higher costs: “Very low development yields coupled with higher construction costs can put a new project at risk unless the developer assumes further yield compression or more rental growth or even decides to incorporate additional floorspace, if feasible and permitted by planning regulations.”
These higher costs could help to prevent oversupply, however, according to Pellicer. “Development in certain sectors is increasing sharply and a rise in construction costs might help to keep some of this development in check over the next couple of years.”
As global real estate markets begin to slowly reopen, the build versus buy dilemma will continue to unfold. Real estate managers and investors will be compelled to look at the use of alternative materials and other means to ensure their real estate investments remain viable amid a costlier building environment.