Pandemic-induced supply chain issues, increased commodity demand, and regional labor shortages are expected to drive annual construction cost escalation for large capital projects to record highs over the near- to mid-term future. While the compounded escalation rate for non-residential construction costs have trended around 3.5 percent annually for the past 30-plus years, many regions are expected to see double that escalation rate (or more) through at least 2023, according to current market forecasts.
Previous economically-induced recessions—like the financial crisis of 2008—typically resulted in lower prices and better buying opportunity for owners. However, the pandemic-induced downturn of 2020 is resulting in an unprecedented economic whiplash accompanied by extreme market volatility. While cost escalation in 2020 remained relatively flat, two years of escalation essentially occurred in 2021 alone.
“A good way to characterize what's been going on with this pandemically-induced recession is that we were largely driving around with a foot on the gas pedal until March of 2020, when the pandemic brake got applied,” says James Vermeulen, managing principal of Vermeulens. “Then we had one foot on the gas and one foot on the brake and we just stayed sort of level. But in 2021, we took the foot off the brake and the economy and the New York Stock Exchange and everything else came shooting back really fast.”
One upside of the fast recovery is that the economy will not be going through the huge disruption of a recession like the financial crisis, and it might bolster institutions’ ability to raise money through philanthropy, he says. It will, however, increase construction costs.
One of the factors impacting capital construction costs over the near-term is that demand and supply-chain issues are dramatically increasing the commodity price of structural steel and rebar. In 2020, the supply price for steel was about $750 to $800 per ton. That rate nearly doubled in the third quarter of 2021, with supply prices increasing to approximately $1,500 a ton. After factoring in the added costs of labor and markup, the total price across the U.S. was $5,100 a ton on average, with some areas being even higher.
“Gone are the days of saying, ‘I've got a five-year capital spending plan. I’m going to escalate it at the average of 3.5 percent per year because that worked for the last three decades.’ You can't do that in the current climate. You have to be more specific,” says Vermeulen.
Market forecasts for the capital construction industry are based on leading economic indicators. These include the stock market, the U.S. GDP, the unemployment rate, and other key metrics that have been shown to provide dependable benchmarks for future performance of the construction market. Previous trends have shown that the stock market and GDP provide about a year of early warning regarding what is going to happen in the construction market.
At the end of October 2021, the stock market was up more than 22 percent for the year, while the current-dollar GDP increased at an annual rate of 7.8 percent, or $432.5 billion, in the third quarter to a level of $23.17 trillion, according to the Bureau of Economic Analysis (BEA).
“It took about five years for the stock market to make new highs after the financial crisis. But with the pandemic, it took less than a year. Likewise, the GDP bounced back in less than a year and is up 1.4 percent from pre-pandemic levels. This means that we are in an escalating environment for construction costs and we need to build that into the construction pricing that we're putting into all of our projects around the country,” say Vermeulen.
Likewise, while it took a decade to gain back the 2 million construction jobs that were lost during the financial crisis of 2008, construction employment rebounded rapidly after the loss of a million construction jobs in the month of April 2020, adding back 900,000 jobs in just 18 months.
“We're now within 150,000 jobs of the all-time high. So, we're coming back really fast. In fact, we’re coming back faster than leisure and hospitality,” says Vermeulen.
Construction job growth was 34,000 or 0.5 percent, in Q3 2021. Wage and profit increases in the sector—largely driven by high residential volumes—and redistribution of employment from other sectors, are expected to draw new workers. Construction unemployment at the end of Q3 was 4.5 percent, down from 7.5 percent at the end of Q2, reflecting a lack of increase in labor supply. This means that subtrades and construction managers will likely struggle to find enough labor, which may increase project costs through 2022, depending on the region.
Construction dollar volume is the number one factor for construction costs, because bids increase as contractor opportunities and project backlogs grow.
Construction dollar volume grew in Q3 of 2021, increasing 2.5 percent since May 2021 and posting an 11 percent year-over-year increase. Residential dollar volume continued explosive growth, increasing 27.4 percent year-over-year year. While non‐residential spending was down 3 percent annually due to improved backlogs, attrition, and price increases driven by commodity shortages. However, it improved modestly by 0.6 percent in Q3. Infrastructure spending in Q3 remained unchanged.
The Federal Reserve and the federal government are coordinating monetary policy and other efforts in order to control inflation, with the Federal Reserve expected to maintain low interest rates for the mid-term future. The PCE (Personal Consumption Expenditures) price index for October increased 5 percent from one year ago. Wells Fargo predicts that inflation will continue rising over the next several months and not begin slowing until the second quarter of 2022.
Commodity shortages and supply chain issues are expected to continue driving construction price escalations of approximately 4 to 6 percent annually for the mid-term, depending on the region. Additionally, the passage of the infrastructure bill will put pressure on infrastructure trades (sitework, concrete, steel, utilities, etc.).
“Presumably, they will schedule it out over multiple years so as not to overwhelm the current capacity of these trades,” says Vermeulen. “Nevertheless, the bill will result in additional price increases and volatility depending on how busy the local markets are when the work is procured.”
From a planning metric point of view, Vermeulen recommends using escalation rates of 4 to 6 percent for procurement calculations for 2022, 2023, and beyond.
Cost Mitigation Strategies
One way to mitigate the challenges of a rapidly escalating market, according to Vermeulen, is to continue getting projects shovel-ready and only buy subtrade packages with 100 percent complete construction documents.
“That way the subcontractors can mobilize right away and start ordering the required materials, and if the materials arrive early, they can be warehoused,” says Vermeulen. “This can minimize or eliminate the supply chain uncertainty risk. Due to the current market volatility, there is a huge risk-transfer if you buy subtrade packages early with incomplete documents, because the subcontractors will not be able to mobilize right away since they’ll need to wait until the documents are complete.”
Vermeulen also recommends that owners put in add and deduct alternates during the design phase that are approximately 10 percent of the project budget. One method for doing this is to shell the top floor of a lab building and make it an add alternate.
“For example, if you've got a five-story lab building, shell the top floor of labs and make that your add alternate, then you can have material changes for alternates and things like that,” says Vermeulen. “If the bids come in higher when your CM goes to procurement, then you can't buy the add alternates, so you would buy some of the deduct alternates. If they come in a little lower, then you can buy some of the add alternates. That way you're not doing a redesign after you find out what the procurement costs are because you already have those designed in.”
Another procurement strategy that can be used to mitigate costs for bigger projects is to overlap design and construction and combine strategic early procurement packages with “just-in-time” purchasing.
“The key in this sort of escalating market is to not buy anything early because of the current volatility. Buy it just in time for occupancy. Make the dates for when you buy structure and envelopes or interiors ‘just-in-time’ dates. For example, during the concept phase, look at what enabling activities can be started early. Do you have a building to demolish? Are there utilities to relocate or asbestos abatement? Figure out your enabling work and plan to have your design at the construction document level by the time you hit schematic design. Then your CM can procure it and do all that work while the design team is working on design development. When you finish design development, plan for the structure and envelope to be 100 percent construction documents, or design-assist documents in the case of an enclosure, and bid and buy it then. That way you can start building the structure and putting the façade on the structure while you're finishing construction documents. This basically allows you to push the start date of the project forward a year and avoid 4 to 6 percent escalation of the project costs. There can be very significant cost savings if you do it that way, depending on how much your city or state is escalating,” says Vermeulen.
By Johnathon Allen
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