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The High Cost of Procrastination

With construction materials experiencing unprecedented volatility, how much can two days of indecision about whether to accept a particular bid cost? As one developer in the Southeast learned: about $50,000.

Just ask Phil Green, EMJ Corp. senior vice president. His company recently bid to supply concrete to the developer of a 100,000-square-foot retail project outside Atlanta. Due to unstable prices, the subcontractor specified it could only guarantee that bid for 30 days. The unnamed developer waited 32 days. By then, the price had jumped $50,000. “They had to pay the additional money,” says Green. “They weren't happy about it, but they did it.”

Construction materials have been on a meteoric rise for the past two years. Since September 2003, steel mill products increased more than 40 percent, according to the Bureau of Labor Statistics. Prices for concrete products increased 17 percent. Part of the increase stems from the massive construction boom gripping China. But domestic demand has also increased fueled by the single-family housing boom and the rebuilding efforts in the wake of the string of hurricanes that pounded the Southeast in 2004 and 2005.

While some steel products, such as hot-rolled bars and steel pipe, have dropped in price in recent months, other materials are forecast to become more expensive. Following this summer's devastating hurricanes and jacked-up oil prices, many REIT managers expect a 15 percent to 20 percent increase in material costs during 2006, according to analyst Paul Morgan of Friedman, Billings, Ramsey & Co.

Asphalt at fault

Since September of last year, asphalt prices climbed 15 percent. In October 2005, paving oil for asphalt jumped 5 percent, according to the Bureau of Labor Statistics.

“[Construction volatility] is absolutely a problem,” says Andy Frankl, president of IBEX Construction. “It's like having a variable rate mortgage in a volatile economy. You want to be able to sleep at night knowing you are not at a risk somewhere down the line.”

The main challenge for both developers and contractors is trying to accurately forecast cost increases in order to specify a realistic budget for a project, says Ken Simonson, chief economist for the Associated General Contractors of America.

That's difficult to do, but experienced executives say there are some steps that can be taken to modify the risk.

Contingency plans

Clearly, the easiest way to shield a company from volatile construction costs is to increase contingency funds. North Miami Beach, Fla.-based shopping center REIT Equity One Inc., which has a development pipeline of $30 million, estimates its contingency funds increased about 15 percent over the past two years. “When you are on top of it, [these price increases] are not as much of a surprise,” says Doron Valero, the company's president.

Federal Realty Investment Trust, meanwhile, estimates its contingency funds have increased from $40 a square foot to about $55, according to Don Briggs vice president of development.

Contingency funds have assumed greater importance because many development contractors and subcontractors are increasingly unwilling to pay the price differential themselves. “There are a lot more contractors who are coming back and want to put a floating number in their contract for supplies you order later, like asphalt oil,” says Briggs. “It's getting harder to find contractors that will absorb those costs.” Asphalt is particularly hard to keep tabs on because many developers don't think about purchasing it until construction is almost at an end.

For example, EMJ will no longer cover any increases in asphalt products that may occur between bidding and actual purchase, says Green. For the first time, the company will now pass that cost to the developer.

Historically there has always been some time limits on how long bids for materials are applicable, it has become more formal, says Tom Manahan, vice president and general manager of Turner Construction. “The period that the bid is still valid is more limited in duration and more rigidly adhered to these days,” he says. The industry standard has become 30 days — not very long when it comes to retail construction. In some cases, it may be even tighter than that, says Manahan.

The name of the game these days is to buy early. “Place the order now and lock in that price now,” says Barry LePatner, founder and partner at LePatner & Associates, a New York-based law firm specializing in construction consulting.

Several years ago, moving quickly wasn't such a priority, says Sam Alley, CEO of VCC, the top U.S. contractor of retail shell space, according to Retail Traffic's Top Contractor list. “Before, it would sometimes be six months before we were released on a bid and it wouldn't affect cost that much,” says Alley. “However, if you wait more than 30 days to make a decision nowadays, that's a long time and could change the pricing of the project.”

Alley says that communication between contractors and developers is more important than ever so they are informed of market volatility. LePatner also advises developers to get an independent assessment of the marketplace in order to get the best price. Large retail developers, such as Simon Property Group and General Growth Properties, already have in-house cost estimation teams. But smaller developers, such as Federal Realty, usually depend on the general contractor for price information.

“If you have in your pocket a line-by-line document of the costs and it says $3 million for Sheetrock and your construction manager says $3.7 million, you can say the sub [contractor] is higher than the marketplace,” says LePatner. “You can then tell the general contractor to negotiate.”

An independent assessment also provides other information such as which material prices are rising fastest. For example, most steel products and cement costs are climbing much faster than brick, which only jumped 5.2 percent this year. “What you do then is get from your architects and engineers the amount of concrete and steel they think you will need and you pre-order that today,” says LePatner.

In past years, owners and general contractors would buy products only when they needed them. Today, they are buying products immediately and storing them in warehouses for months. “For materials that wouldn't be delivered to a job for several months, like metal studs, we go ahead and buy them and store them so we won't be affected by further price increases,” says Green. The cost of any future material increase far outweighs storage costs.

Green also says contractors are increasingly buying in bulk to realize economies of scale and get discounts. “If we have got a project with several buildings, we try to bid at once instead of separately,” says Green.

Another popular way to save money on construction costs is through value engineering. In a process that has become a huge buzzword in the industry, developers are insisting that contractors and architects work together to engineer a project beforehand that will receive maximum effect with minimal cost. “The front-end planning stage is elongated due to value engineering, but the back-end load is faster because everyone is on the same page,” says Steven Mulhern, director of development for Shea Properties.

Deleting details

Value engineering can include various methods to save money, such as cutting the level of detail. Since you cannot necessarily reduce the amount of steel in your frame or concrete in your foundation, many developers will value engineer their projects to reduce detail such as window depth or overhangs. “You find that developers are now very sensitive about how much detail they are putting in their architecture,” says David Meleca, president of Columbus, Ohio-based Meleca Architecture and Urban Planning. “Unless, you are in a great area, where demographics are really good, I think you are going to see a dumbing down in architecture.”

As part of the value engineering process, developers are also finding cheaper substitute materials. Traditionally, many developers used stucco as a replacement for brick. Today, developers are using a substitute for stucco known as EIFS (Exterior Insulation and Finish Systems), a polymer sprayed over foam and wire mesh.

Significant savings

The cost savings can be significant. During construction of Atlanta's new Atlantic Station, a 138-acre mixed-use project co-developed by Jacoby Development Inc. and AIG Global Real Estate Investment Corp., VCC used stucco brick instead of real brick. On a percentage basis, using synthetic materials was 35 percent more economical, says Alley.

Trimming costs through design is only half the battle, however. The massive rebuilding efforts from this season's devastating hurricanes are likely to create even more demand for materials.

Simultaneously, retail development is moving at a fevered pitch as developers seek to lock in prices before the anticipated continued climb. The two largest mall REITs, Simon and General Growth, have development pipelines worth $2.1 billion and $840 million, respectively.

So how long can this torrid development pace last in the face of rising material costs? So far, high acquisition costs and rising retail rents have been able to cover higher construction costs. Rents in the United States for community and neighborhood centers are expected to increase 3.3 percent this year to $16.75 compared with last year's growth of 2.8 percent, according to New York City-based research firm Reis Inc. “It's a matter of the developer being able to increase the rental rates in his projects,” says Manahan. “As long as the market can bear it, he will continue to build.”

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