When Prices Rise, Will You Be Ready?

Prepare now for the coming escalation
by Mike Bolen, McCarthy Chairman and CEO

Commercial and institutional construction prices have come a long way since hitting their modern peak in 2007. A long way down, that is. They literally fell off a cliff during the recession, dropping 20 to 40 percent and lingering there far longer than anyone could have imagined. Today, it’s safe to say that component prices for commercial building have bottomed out, but nothing lasts forever. So when will prices start to rise again and, more importantly, how fast will they move?

You could peer into the proverbial crystal ball and hope for the best. Or more prudently, take guidance from one of the most reliable historical indicators: the retail new housing market. It’s typically the first to decline and first to recover. Commercial construction generally falls right in line behind it.

So how is the new housing market faring today? In September 2012, home builder confidence was at its highest level since 2006. That prompted Barry Rutenberg, the president of the National Association of Home Builders, to remark, “This fifth consecutive month of improvement in builder confidence provides further assurance that the housing market is moving in a positive direction.” But Rutenberg was also quick to say, “Against the improving demand for new homes, concerns are now rising about … the rising cost of building materials.”

Going hand in hand with rising component prices is another related challenge: the growing shortage of quality labor. Home builders everywhere are crying the blues because they can’t build homes fast enough to keep up with growing demand. According to a recent CNBC report, home builders simply can’t find enough qualified workers. The shortage is across the board, from framers to concrete workers to plumbers, roofers and painters.

The labor shortage increases cycle time, making labor costs go up. In markets with strong housing demand, labor prices have increased as much as 10 percent, according to Ted Wilson of Residential Strategies, a Texas-based marketing research and consulting firm focusing on the new home industry. Wilson recently conducted a survey of Dallas/Ft. Worth builders, and the results are revealing. “We lost over half of our production builder companies, and the subcontractors were enormously gutted as well. It’s not like these guys are waiting by the phone. It’s been six years.” So where did all the talent go? In a word, elsewhere.

When the recession hit, many skilled professionals left construction to find work in other industries. (Those who aren’t committed to building won’t be coming back.) Plus, many subcontractors simply had to close their doors. To top it off, there’s the issue of retirement: Vietnam-era craftsmen are beginning to leave the industry and take decades of quality experience with them. You’d hope a new generation would be ready to take their place, but the fact is many young and talented people today would rather work in high technology than with their hands.

Rising prices and labor shortages may be contained in the housing market for now, but there’s no question that the challenges home builders face today will be at the doorstep of commercial builders soon enough. So how can prudent owners manage the coming escalation?

First, Build Your Budget the Right Way
If you’re planning to build in the future, be sure not to budget based on today’s prices or worse, historical data from early in the recession. In 2014, a “widget” will very likely cost considerably more than it does today. If you budget at 2012 prices, you could be setting yourself up for an unpleasant surprise down the road. That’s why it’s so critical to align your budget with the anticipated delivery date and account for possible cost increases.

Above all, make sure you can accommodate your project’s basic needs should escalation occur – this can be achieved during the design by having your core design that meets your needs and additions and/or deductions that can quickly be tapped into to align the final project scope with that of escalation. That way, you won’t have to return to your board of directors for additional funding or trim corners on your project. We’ve seen recent examples of owners who had assumed prices would stay low – at deep recession levels – only to find that they had risen significantly when it was time to buy. The result: These owners had to take their projects back to the drawing board, with significant loss of sunk cost and time.

What if planned-for escalation isn’t in full force when you’re ready to build? Then you will have some welcome options if you have created a list of options. You’ll have the funds not only for your project’s basic needs, but also for additional items on your “wish list.” So you can choose to invest in some or all of those items or simply save the money.

On all projects going forward, we recommend building a prudent level of escalation into the pro formas. Again, it’s not a matter of if prices will increase, but when.

The New Rule of Thumb (Sorry There Isn’t One)
How can owners budget today for the components they’ll need to buy a year or two from now? During past cycles, the task was far easier and the outcome more predictable. Three percent was a standard rule of thumb for projecting annual escalation. But in today’s economy, there are no old rules that work. This time, it really is different. Unprecedented times call for smarter thinking. So the most accurate escalation projections will be based on a deep understanding of local market conditions, including the local cost of commodities and availability of quality labor.

The truth is pricing (and owners) hate uncertainty. While there’s never been a crystal ball for knowing exactly what prices will be in the future, there is a sensible approach to managing through that uncertainty. It starts by having clarity of information (e.g., knowledge of local workforce availability and pricing for strategic components such as steel). A seasoned builder with hands-on, local-market expertise will have that information and be able to create an informed bid package. Then it’s a matter of comparing comprehensive bid packages among seasoned, qualified competitors.

Combining clarity of information with qualified competition should yield the best current price. That’s welcome news in any economic environment.

Looking Ahead
Home builders everywhere are clearly starting to feel the effects of price increases and a diminished workforce that can’t keep pace with building demand. Commercial and institutional escalation can’t be far behind. Neither is the strain on the diminished commercial workforce, as every builder’s schedule starts to get full again, putting even more pressure on prices.

These challenges are historically inevitable, and they’re way overdue. So if you’re going to build soon, don’t ignore them. Be sure to plan wisely by giving yourself options.

About the Author
Mike Bolen is Chairman and Chief Executive Officer of McCarthy. With over 30 years of experience in the construction industry, Mike joined McCarthy in 1978 as a carpenter, moving his way up through the company to assume the role as CEO in 1999. He earned a bachelor of science in general engineering from the United States Air Force Academy in Colorado Springs, Colo., and completed his graduate degree in guidance and counseling at the University of Northern Colorado in Greeley, while on active duty.