CRE N Illinois

Construct sooner, faster, better to avoid inflation’s impact

How might inflation impact the costs of your construction project? Two guest writers from Leopardo Companies examine the issue in this column.

Leopardo Construction

Guest post by Pierre Cowart and Rory Tihinen, Leopardo Companies

The pace of inflation has a big impact on the cost of commercial construction. Given the current low-inflation environment along with historically low interest rates, companies considering future projects are well advised to act quickly, look for ways to shorten the development cycle and find a contractor that can minimize the risks associated with rising inflation.

The inflation rate is calculated from the U.S. Bureau of Labor Statistics’ Consumer Price Index (CPI), which measures changes in the price of a cross-section of urban consumer goods and services. The rate has been so low for so long that some business people may assume it won’t be a major factor going forward. They could be wrong.

Over the past 10 years, the highest annual inflation rate was in 2008, at 4.1 percent, and the lowest was in 2009, at 0.1 percent. But excluding that tumultuous time, rates have ranged from a high of 3.4 percent to a low of 1.5 percent. Inflation was just 1.7 percent in 2012, and the annualized rate was just 1.5 percent in the early months of 2013.

But going forward, low inflation is not a sure thing. As unemployment inches downward, there is upward pressure on wages and prices. Improving the labor market is a key goal for the Federal Reserve, which started a program in September of 2012 to buy $85 billion of mortgage-backed securities and Treasuries each month.

That program could lead to unwanted levels of inflation over the long term, according to comments in April by Richard Fisher, president of the Federal Reserve Bank of Dallas. Earlier this year, Fed presidents in Philadelphia and St. Louis also expressed concern that the current low-interest rate environment may push inflation higher than desired.

None of these experts appear to be predicting a return to the double-digit inflation rates of the 1970s and 1980s. Over the past three decades, inflation has rarely exceeded 5 percent, and the Fed has indicated it would continue its buying program only as long as inflation remained “in check.”  But even a 2.5 percent increase in annual inflation could add 10 percent or more to a project’s cost.

Impact on real estate

The effects of inflation tend to be magnified when it comes to the development process. As a rule of thumb, 2 percent inflation equates to a 4 percent increase in construction materials. That’s because material prices are based on the Producer Price Index (PPI), a measure of the price of manufactured goods, which is typically double the core CPI.

Construction labor costs rise faster during periods of higher inflation, as well. Most construction work in Illinois is based on three-year union contracts, with about one-third of contracts expiring every year. Over the course of a three-year project, virtually all of the sub-contractors involved will go through a round of union negotiations over wages and benefits. The faster consumer prices are rising, the harder unions will push for compensation levels that keep pace with the cost curve, or even get ahead of it if possible.

The unpredictability of material and labor prices is one of the trickiest parts of construction cost budgeting, and it becomes even more difficult in a period of uncertain inflation.  The challenge is in the lag time between the design phase and the purchase of materials.

Zoning and preconstruction processes on major projects typically require eight to 12 months or more before construction can start, and the construction phase can take another 12 to 24 months. Materials and labor are purchased throughout the construction phase, sometimes up to three years after the plans were budgeted and approved.

So if you were to budget a project based on 1.5 percent projected inflation over three years and inflation is closer to 3.5 percent, the 2 percent difference adds 4 percent to construction materials cost bought in the first year, and potentially another 4 percent the following year, and so on. Your budget could be off by 10 percent or more.

A good rule to hedge inflation is to escalate pricing through the mid-point of the intended construction duration. But the real lesson here isn’t about budgeting; it’s about taking action. Every year that a project is delayed adds to the construction cost, and the rare combination of low interest rates and low inflation rates will not be around forever. Companies that can start the process now have the best chance of avoid the worst effects of higher inflation in the future.

Fast tracking projects

In addition to starting sooner, another way to minimize the risk of economic uncertainty is to move through the development process quickly.  The best way to fast-track a construction process is to get the contractor involved as early in the process as possible.

In addition to starting sooner, another way to minimize the risk of economic uncertainty is to move through the development process quickly.  The best way to fast-track a construction process is to get the contractor involved as early in the process as possible.

Even if inflation were not a factor, the ability to complete a project quickly should still be a goal because it saves money on the debt service and allows the facility to become a revenue generator sooner. Integrating the design and construction team at the outset of the project can reduce project cost by overlapping the design and construction phases of development that traditionally have been sequential.

When the contractor is involved in the design phase, the opportunity is created to start preconstruction while design features are still under consideration. Typically, a building’s footprint and the location of site elements such as parking and retention ponds are decisions made before the design phase is complete. Zoning and site work can begin on those elements before the HVAC systems and interior finishes are specified. With an experienced team, the preconstruction phase can be very far along by the time designs are complete, shortening the development cycle by six months or more.

Another way that including the contractor in design decisions saves time involves the ordering of construction materials early enough to avoid delays.  Steel and precast concrete are prime examples of materials that require several months between the time the order is placed and the delivery of materials to the site. Once the size and general layout of the building is determined, the contractor can calculate how much steel or precast concrete is needed and can place the order so it arrives in time to keep the process moving forward.

Other products that must be ordered in advance—components of HVAC systems, for example—may not be determined until the end of the design phase; but these materials may not be needed onsite in the early stages of construction. This is in contrast to the past, when projects had a slack period between design and construction while the team waited for materials to arrive.

Another way development teams are reducing development times is by using Building Information Modeling (BIM), which uses digital technology to show blueprint information in three dimensions and share that information across design, construction and eventual facility management phases of the building’s life cycle. The use of BIM also helps to reduce construction timeframes and avoid weaknesses in the design that otherwise might not be caught until construction is under way.

Choosing a construction partner

Besides fast-tracking projects, another way to ensure that the effects of inflation are blunted is to use the contractor’s savvy to minimize the cost of materials. For example, larger contractors with more jobs in the pipeline may use their power-buying muscle and supplier relationships to negotiate lower material pricing and/or faster delivery.

An experienced contractor should also be able to demonstrate an understanding of acceptable substitute materials if products specified during design turn out to be more expensive than anticipated, or are not available in time to keep the project on schedule.

Contractors employ experts to estimate the cost of projects, and the impact of inflation is typically part of that calculation. The uncertainty of future inflation is ultimately the risk that the owner takes on, as the contract language assumes a certain level of price increase but absolves the contractor from liability if prices skyrocket unexpectedly.

So in an uncertain economic climate, it’s important for a company to work with a contractor that understands commodities pricing and can provide advice on mitigating the risk of inflation. That may involve making an upfront investment that acts as a hedge against over-standard inflation, such that the company pays a little more to avoid the risk of paying a lot more if inflation rises sharply.

In summary, companies considering construction or renovation in the future should act as quickly as possible to lock in historically low interest rates, and to start construction before inflation increases costs. An integrated and experienced design-development team can add tremendous value to this equation by shaving months off the development schedule and by offering strategies for reducing materials cost and inflation risk. But the sooner companies start the process, the better chance they have of gaining the competitive advantage of lower project cost for years to come.

Pierre Cowart is a senior vice president and Rory Tihinen is a vice president at Leopardo Companies, Inc., one of the nation’s largest construction firms.