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May, 23 2017

Will Rising Construction Costs Derail A Potential Building Boom?

Will rising construction costs derail a potential building boom?
By Mary MacDonald - May 19, 2017

 

Take a drive around Rhode Island’s cities and populated areas, and count the construction sites.  The building landscape of the Ocean State is changing every month. In Providence alone, several hotels are under active construction this spring.  A series of commercial construction projects is underway near the river, and many more are in process on paper, forming a pipeline of development that could keep construction companies and subcontractors busy for several years.  But what is good news for the long-starved, local building trades is creating headaches for many developers and building owners. That’s because construction costs are climbing in Rhode Island and throughout the Northeast, threatening not only the budgets for projects but also their viability.

 

Although no commercial project appears to have been shelved yet in the Ocean State, developers are watching their numbers carefully, and jettisoning designs that no longer make financial sense.


At an 80-unit apartment building under construction in East Providence, the exterior surface will feature brick fascia and masonry accents, rather than the full brick initially discussed.


At the Homewood Suites by Hilton site in downtown Providence, where the construction is in the site-preparation phase, the development team agreed to switch out windows for a less-expensive version, all part of the cost-cutting process.  Even with that, the project is expected to come in about $2 million more than initially anticipated, rising to $20 million, said James J. Karam, president of Fall River-based First Bristol Corp.  The real estate development company specializes in retail, hospitality and commercial construction.  “There is hyperinflation in the construction industry right now,” Karam said.

 

BUSY AGAIN
Construction workers and subcontractors, their numbers significantly thinned by almost a decade of little to no work, are busy again. They can afford to be choosier than in years past, and charge more for their labor.


For highly skilled laborers, southern New England has blossomed with good-paying jobs. Union representatives and subcontractors predict that labor shortages will be appearing by the end of the calendar year into 2018, as several massive commercial projects get underway.  The strongest magnet will be the $2.1 billion Wynn Boston Harbor resort casino in Everett, Mass., close enough to draw Rhode Island labor.  At Lincoln-based Century Drywall Inc., one of the New England’s largest drywall and fireproofing contractors, hiring is already underway. Its labor is drawn from all of the union locals in New England. So far, President and CEO Joel Trojan said he’s been able to find the labor he needs.  Out of 500 or so site-based employees, four-fifths are working in the Boston area, he said. The company recently completed work on the Millenium Tower, a 60-story luxury condo skyscraper in Boston, and will also work on the Wynn resort casino. By 2018, Trojan expects he may have trouble finding enough experienced laborers.  “What has changed since the recession is the jobs have gotten bigger,” he said.  The work is plentiful and well-paying. In Boston, the wage and benefit package is $77.86 an hour, according to Trojan. In Providence, by comparison, it’s $62.40.  Those rates are known in advance, and can be plugged into the estimates, he said.

 

With materials, the cost increases can be harder to predict.  On the supplies end, there are no shortages of materials, but prices are rising for the basic elements of construction, everything from lumber to fuel to sheetrock.

 

In a state where construction costs already were high – on a par with Boston – developers are carefully watching the numbers, and editing what materials, stylistic elements and basic features are going into their buildings.


The 80-unit apartment building in the Rumford area of East Providence is a project of owner Peregrine Group LLC, also of East Providence, which previously developed the surrounding Rumford Center.


The apartment building is surrounded by former industrial buildings, clad in vintage brick, but the discussion of whether to do the same for the new building ended in a more affordable, one-third-brick application called brick fascia, said Colin P. Kane, principal of the Peregrine Group.  The $11 million project is expected to be completed later this year.


“Value engineering,” Kane said, of the term used to describe design changes, made to save costs. “Let’s call value engineering what it is, it’s scope reduction.”  The subtle difference between full brick and the less-expensive alternative can be noticed by passersby, but the decision was made to contain costs. “It’s a product of expense and structure,” he said. Unlike in Boston, where rents have climbed dramatically in the past several years, apartments in the Providence market cannot sustain similar rental increases, he said.  The inflation in costs is a result of a global market for construction materials, driven higher by huge projects in China, and the regional market for skilled labor.  “Small job, big job, the same basic inflation is applying,” Kane said. “Right now, we’re seeing, year over year, inflation ranging from 6-10 percent depending on the line item in our budget.”


For Michael Integlia & Co., based in Providence, the forecasting of materials costs has become a critical effort. The company, which has $60 million to $70 million in projects under active construction in New England, tries to lock in a price on materials for six months to a year in advance. Most of its projects take 15-18 months, so its contracts tend to include language that requires subcontractors to absorb increased costs in materials.  “The construction business has become very sophisticated,” said CEO and President Michael Integlia. “To the extent we can push that responsibility to a contractor, we do. But to the extent we can’t, we’ll take a hedge against those cost increases by buying futures contracts.”  As a result, the cost increases of the past year, which were predicted, have been baked into the contracts, he said.  “The difficulty is on shortages. When we need 10 plumbers to do a job and we can only get five,” Integlia said. “We’ve gone to working five, 10-hour days. Typically, you would work five, eight-hour days. We’ve added time and cost to the project, hiring these people at premium time, rather than bringing in people from outside the state. And we’re getting by.”

 

To make the numbers work, adjustments are often made to the design, including interior finishes and landscaping.  Karam’s 120-suite hotel is expected to be under construction this summer. This month, the company is compacting soil on the site, which originally was part of the Providence river system and needs to be fortified.
The escalation in costs is coming across labor specialties and materials, Karam said. He’s experiencing the same issues in Worcester, Mass., where the company has a similar Homewood Suites under construction.  “It’s supply and demand,” he said. “A lot of the union prices are skyrocketing. The cost you’re seeing is when you go out to the street for bids. You have subcontractors who are so busy, they’re throwing crazy prices at bids. They’re saying, ‘Here’s our number. Sorry if you don’t like it, we’re busy. We’ve got other work.’ They can charge more because they’re in great demand.”

 

RECOVERY DOWNSIDE
The gradual economic recovery in Rhode Island over the past decade has contributed to the problem, according to an economist who is versed in construction.
Nationally, the Great Recession ended in June 2009 but lingered for the construction industry through 2011, according to Anirban Basu, chief economist for the Associated Builders and Contractors, a national construction-industry trade association.


Many construction firms had their worst years in 2010 and 2011, he said. The regions of the country that rebounded first were in oil-rich areas, including Texas and Oklahoma, followed by the South and West.  But with the exception of Boston, recovery across New England has been much slower. Boston has had a building boom of several years fueled by the biotechnology sector and high-end residential construction, Basu said.  As a result, it suctioned labor forces from surrounding states, leaving fewer workers on the ground in Rhode Island and elsewhere. But now that construction activity has picked up in the rest of New England, there is steep demand for workers that is driving up the cost.  “When New England’s construction was dominated by Boston, there was still some construction capacity left over that allowed for only gradual increases in the cost of construction,” Basu said. “But now that the balance of New England has begun to recover more forcefully, that capacity has increasingly been spoken for.”


And while a national economic indicator that tracks future construction activity has been slowing in most regions of the country, the Northeast is moving in the opposite direction, picking up activity. Called the Construction Backlog Indicator, it measures the amount of work that is under contract but not yet performed by commercial and industrial contractors. In the Northeast, the backlog grew by 11 percent in the final quarter of 2016 to 8.4 months.


As the labor market has tightened, commodities prices have been rising for much of the past year, which is pushing up the cost of materials most often used in construction, according to Basu.  Copper prices are affecting communications systems, which are laced through new buildings. Natural gas increases are impacting materials, including chemical-based materials that are used in buildings.


An economic update published by the Associated Builders in March indicated that construction input prices, including lumber, asphalt and concrete products, had increased 4.8 percent over the past 12 months.  The largest increases were found in iron and steel, lumber, petroleum and natural gas.  “All of these things are interrelated,” Basu said. “Everything is basically moving in the same direction. Labor is becoming more expensive. Material prices are becoming more expensive. Construction firms are busier. That gives them more pricing power than they’ve had in recent years. These construction firms know they have to strike while the iron is hot.”


The construction labor pool has expanded in Rhode Island, by 2,200 jobs in February, compared to the same month the previous year, according to the U.S. Bureau of Labor Statistics.  Labor agents say despite the increase in jobs, the state has a workforce in construction that’s still far below its previous peaks.  Organized labor, which typically supplies the workforce that builds the commercial buildings in Rhode Island, reached a peak of 12,000 in 2008, and has since fallen to about 9,400, according to Michael Sabitoni, president of the Rhode Island Building Trades.  Despite the increase in activity in construction, there are no labor shortages, he said. “Is there a projected shortage, as you forecast out six to 12 months? Yes, we are anticipating a pent-up demand for labor,” he said.


After years of decline and limited work opportunities, the association representing union trades is not surprised the work returned this year, based on project volume. “This was the turning-point year,” Sabitoni said. “We thought we were going to see a very big increase in demand for skilled, qualified tradespeople. It’s been a long time coming, but this was the year we anticipated reaching that.”


For the past two to three years, he estimated, at least 30 percent of the union members have survived by finding work in Boston construction.
But would construction workers rather be working closer to home, on Rhode Island projects? Yes, he said.  “Our men are working up there out of necessity. If they could be here in Rhode Island, they’d much rather be here, because of the commute. You have to carve out five hours a day to get back and forth to work in the city.”  Sabitoni said one of the reasons why project prices have been climbing is because they were based on faulty estimations.  “We had some projects that were on the books, and quite frankly, I don’t think a lot of the people had anticipated that now that the activity is coming back, the escalation in costs,” he said. “Some numbers were unrealistic that people, from 2008, are still carrying forward.”


And now, as they get set to move earth and build their projects, they find they can’t do it for the original numbers.  “Everything that you’re looking to hard-bid right now, you’re coming back with difficult numbers,” Sabitoni said.


In the short-term, developers and building owners can value-engineer changes into the design to cut costs, such as swap out a more expensive material finish for another more moderate one.  Karam said it’s a process that happens on every project, but has been made more necessary in the current environment.  “You start evaluating every toothpick in the place and try to determine if it’s necessary or not,” Karam said.


EFFICIENCY GAINS
Over the long term, rising costs are inspiring more efficiencies in how the largest projects are constructed.


Dimeo Construction Co., which is the construction manager for the Citizens Financial Group Inc. campus being built in Johnston, as well as several large projects in New England, is compressing the time frame for construction by months, by organizing job sites and scheduling more efficiently.  “If you can do a job in 13 months, instead of 15 months, time is money, right?” said Dimeo Chief Operating Officer Stephen Rutledge.  Another trend is prefabrication across materials, Rutledge said, where building components are created and put together off-site, at a manufacturing facility, then installed at the same time.  He used the example of a restroom, where the pipes for plumbing are assembled off-site, at the manufacturer, then installed as a unit.


In Rhode Island, more so than Boston, it’s more important to keep the projects on budget, because of the thin margin for error in rents, according to developers. Construction costs in the Ocean State are comparable to those in Massachusetts, but the rents or payments that can be expected from building tenants or hotel guests are lower.
If construction costs continue to rise, some projects will be put on hold because the financing no longer can be supported.  “I think the end result is, you’re going to see some projects being discussed that are never built,” Karam said. “I think people are going to wake up with a big surprise and not be able to fund it through the projected rents.”
Integlia said the cumulative impact of rising costs is fewer projects. “We do fewer and we do less at-risk. When market conditions are good, and we can make the balance between costs and revenue, we’ll build inventory. We’ve got a chicken and the egg problem here in Rhode Island. People like me won’t build inventory because I can’t make the numbers work. And the businesses who need the space can’t find it, so they go to Boston.”


Of course, as construction costs rise, it’s not always the developer or owner who absorbs the expense. Typically, once a contract is entered, the on-site builder is responsible for materials or labor increases, according to economists and developers.  In the past year alone, iron and steel prices have climbed 19.7 percent. The structural materials are ubiquitous in construction, said Ken Simonson, chief economist for the Associated General Contractors of America.  “The buyer of construction services, a state highway department, an airport, they often have more buying power, more leverage than the construction company bidding to get that work,” he said. “The construction firm may not be able to pass along its construction increases.”


It’s possible the contractor can find a way to get a job done with less labor, but in the current market, that’s challenging. Nationally, construction unemployment is at a 16-year low, he said.  “The squeeze is on for general contractors,” he said. “They’re seeing higher materials costs. They’re also seeing higher labor costs.”