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Fed Rate Cut May Accelerate Rising Construction Costs

The already high cost of commercial development will head higher in 2008 as a depressed dollar increases the price of fuel and materials, and wage inflation spirals upward, according to Ken Simonson, chief economist at the Associated General Contractors of America.

Despite a lull this year, construction costs have grown dramatically for the past three and a half years. The producer price index is projected to rise at an accelerated rate by the end of this year and into 2008, reaching the equivalent of 3% to 5% annual growth, according to the Associated General Contractors of America. The consumer price index is expected to climb at the annual rate of 1.5% to 3%, which it has displayed in recent years.

“Cumulative construction cost increases since the end of 2003 have far outstripped inflation, despite the housing slump and recent declines in some construction input prices,” says Simonson. “An acceleration appears likely in the near term for both materials and labor costs with continuing elevated increases for the next several years.”

In a sense, those increases would be a return to the pace of recent history, when the cost of building materials rocketed upward from 2004 through midyear 2006 during a global building boom. Despite a recent moderation in prices, the producer price index is 28% higher today than it was at the end of 2003, more than twice the rate of inflation seen in the consumer price index’s climb of 13% in the same period.

Now the costs of many building materials are accelerating. A drop in U.S. interest rates is likely to depress the dollar further, adding to the cost of fuel and other commodities used in construction the world over.

At the same time, wages for commercial labor are mushrooming as the pool of available workers thins. Specialized construction wages increased 4.7% from July 2006 to July 2007. The Bureau of Labor Statistics reported that non-residential construction jobs increased by 1.5% from August 2006 to August 2007, outpacing overall job growth of 1.3%.

Commercial construction jobs are probably under-represented in the national numbers, however. Simonson believes many contractors that previously handled residential work are continuing to file their employment data as residential even though they now work in the commercial arena.

If specialty workers were correctly counted as commercial labor, it would add about 400,000 jobs to the commercial side, boosting that sector’s employment total by about 11%.“Many [previously residential] contractors are sending their workers to commercial jobs. They just haven’t changed the code under which they report,” Simonson says.

As if paying for construction weren’t difficult enough, the credit crunch has decreased the availability of construction loans along with other forms of short-term financing. It may be too early to tell whether the Fed’s rate cut helps or hurts construction, because the stimulating effect on liquidity may be countered by rising inflation and, ultimately, higher prices.

Josh Scoville, director of strategic research at Property & Portfolio Research, says some of his own clients have reported difficulty obtaining construction financing despite the Fed’s efforts to boost the economy with greater liquidity. He believes high construction costs and the credit crunch will dampen construction of new commercial space through 2009.

“Ultimately it ends up being a good thing,” Scoville says. “It obviously causes headaches for developers in the near term, but it holds supply down a little bit more than would have happened had the credit crunch not occurred. It lengthens the strength of fundamentals.”

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