AMA – When Building Costs Are High
Welcome to the Real Estate Expresso Podcast. Your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce. Today is another AMA episode – that’s ‘Ask Me Anything’. I’m here to answer your questions. If you have a question you think will interest a broad audience, send it in. I’ll answer it live on the air. Send your questions to [email protected]. That’s [email protected].
Today’s question comes from Immanuel who asks, ‘How should new investors approach the development of multi-family properties when construction costs are high, but demand for rentals is steady?’ Well, Immanuel, this is indeed a great question.
There are several levers that we pay close attention to when costing a potential project. When we say ‘construction costs are high’, this is a little vague. The viability of a construction project is based on three main variables: market rents, construction costs, and capital costs. It’s the intersection of these three that determine if a project is viable or not. Developers often get into trouble if they rely on simple back-of-the-envelope math to make decisions.
Material prices might be high in some aspects of construction but low in others. For example, there had been warnings for some time that certain electrical equipment were in short supply, and that items like utility transformers and circuit breaker panels were in short supply with long lead times and exorbitant prices. That’s no longer the case, though we do see volatilities in mechanical equipment pricing due to international trade disruptions. It requires a detailed look at the entire bill of materials for a project to determine if you’re going to have a problem or not, and there’s no doubt that the current trade war is upending global dynamics and supply chains.
In some cases, we can mitigate this by looking at other countries where the supply of materials is good and pricing is reasonable. Secondly, labor costs play a significant role, and this is primarily influenced by local conditions. It’s affected by factors like supply and demand, and public works projects happening at the same time as your project.
If you’re going to be competing for labor with major projects, you’re likely going to end up paying more and probably get inferior quality as a result. So, it’s not enough just to use commodity numbers for labor. Your contractor needs to engage with their trade partners in order to understand their loading. It might be that you can bring trade partners from another city and save a lot. For example, Toronto has seen a sharp downturn in construction activity, so there are major subcontractors willing to send a whole team to another city for several months to complete a project. We’re hearing similar things in Charlotte, North Carolina.
The alternative is that these people are sitting at home watching Netflix or seeking work elsewhere. Large multifamily projects require subcontractors who bring the necessary skills and resources to a project in order to maintain a schedule. Understanding labor loading in your local market is therefore a crucial element.
The third element of construction costs is influenced by interest rates. Even if material costs are dropping, rising interest rates could offset the drop in materials. The last variable, which is more difficult to quantify, are possible changes to local building codes which drive an increase in construction costs. For example, some building codes now require additional insulation which can add a significant amount. New energy codes also require higher efficiency mechanical equipment like heat pumps and air conditioners.
We often see local conditions driving costs in ways that are not intuitive. For example, we have urban design constraints in some communities that elevate costs. In Grand Junction, Colorado, the city is requiring concrete masonry, which is adding a lot to the cost of an industrial building.
In another jurisdiction, we have a city requiring wood siding on all buildings, and they won’t accept anything else. They even insist on certain colors, forcing us to use a non-standard color palette instead of a less pricey standard one. In one jurisdiction, we have a building inspector that wants weekly reports and another where they’re happy to speak with us in six months. The point I’m trying to make is that these situations are hyper-local. While general knowledge is transferrable from one market to another, local nuances take precedence.
When it comes to the other variables, rents are hyper-local as well. Sometimes an average market rent paints one picture, but if you segment the market appropriately, you might reach a different conclusion. For instance, about 11 years ago, we were developing in Philadelphia. We had completed a small building that had all three-bedroom apartments. We ended up with a tenant who rented a three-bedroom unit for just one person. This single feedback told us there was an excess of three and four-bedroom units in the area and a massive shortage of one and two-bedroom ones.
From then on, we only built ones and twos and stopped building larger units. What this shows is that you need a detailed and complete analysis of the entire project. The days when you could do quick back-of-the-envelope math and use that to justify approving a project are over now. There are simply too many moving parts.
I want to thank you, Emmanuel, for a fabulous question, and to all the listeners at home, have an awesome rest of your day. Go and make some great things happen! We’ll talk to you again tomorrow.
Stay connected and discover more about my work in real estate by visiting and following me on various platforms:
Real Estate Espresso Podcast:
- 🎧 Spotify: The Real Estate Espresso Podcast
- 🌐 Website: www.victorjm.com
- 💼 LinkedIn: Victor Menasce
- 📺 YouTube: The Real Estate Espresso Podcast
- 📘 Facebook: www.facebook.com/realestateespresso
- 📧 Email: [email protected]
Y Street Capital:
- 🌐 Website: www.ystreetcapital.com
- 📘 Facebook: www.facebook.com/YStreetCapital
- 📸 Instagram: @ystreetcapital
