Inflation's Impact On Construction Materials

The biggest issue facing commercial real estate at the moment has got to be inflation in construction materials. It has become a consistent backdrop to every construction deal that we have looked at over the past 12 month. Input prices have become so volatile, that borrowers have had to go back and reprice their construction costs several times during the closing process to ensure that there are no surprises. 

Construction materials costs are highly influenced by a wide variety of supply, demand, and political issues that unfortunately right now are all working together to push them higher. The St Louis FED publishes a special PPI index of construction materials and one look at the below chart of this and you can see how out of control it has gotten over the past year. 

These issues seem to be evident across the country and within every type of asset class and every type of build. One of the most common problem I’ve seen pop up is the delivery of doors. Several builders I’ve talked to are telling me that they are close to completing projects, but they wont have doors for 3 months, if not longer. That certainly makes it difficult to complete the project and start generating revenues. But there are bigger issues that delays and higher costs cause, and those always come down to the financing side. 

When you have quickly increasing build costs, what typically does not follow with it is quickly increasing value of the finished product. The economics of whatever you are building will need time to catch up with the cost. So if you were already using the max leverage that your lender was giving you, then the increase in costs are coming right out of your pocket, especially if you are mid construction when those costs go up. 

For this reason, I have seen many borrower migrate to higher loan to cost lenders in the private lending sector that are more comfortable in the 80%+ loan to cost area. The lending in this space is certainly more expensive that bank or other conventional lending, but its still cheaper than equity and is allowing many of these deals to move froward that would otherwise be stalled out. 

But increased costs are only one part of the equation here, the other is simply delays and time to build. As anyone knows, time kills deals, and that concept is especially strong when you are mid construction. Stopping and starting is expensive and you are burning money in interest on a project that is not generating revenue yet. Further more there’s really not much anyone can do if the materials (or doors) just aren’t there for you to get, so there’s not much to do but sit and wait. 

Thankfully, I believe supply chain issues will balance out in the second half of this year, COVID restrictions will ease, and the labor force in general gets back to a place of normalcy. As far as the political issues of tariffs, I wouldn’t expect much. In the meantime, the deals that I have seen get across the finish line were expertly managed operationally from day 1 and had large contingencies in place for cost overruns. I think the number one thing investors can do is make sure that wh<oever they choose for their GC is extremely experienced and has a serious operation behind them that will not only give them a competitive edge in managing the job, but maybe also a competitive edge in getting supplies.