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Oil Vey!

Developers and contractors have had to live with double-digit inflation in construction materials for the past several years. Projects are often fast-tracked in order to get ahead of price increases. Some builders stockpile construction materials, exacerbating the supply shortages.

Minnesota-based contractor Ryan Companies is going one step further. The company is negotiating with exterior wall panel manufacturers to build retail shell space off-site in an attempt to cut costs. The contractor believes the practice could save it up to 10 percent, primarily through reducing on-site labor needs and minimizing scrap.

“There are some economies of scale in being able to do this,” explains Gary Prinsen, Ryan's vice president of construction for the Minnesota region. “We are also bringing in our subcontractors and looking at bundle purchasing. If we know we'll have 100,000 square feet of [similar] construction projects in one year, we'll buy the materials in one increment.”

Ryan is pursuing this strategy, even though there are signs for the first time in years that inflation on material costs is subsiding. Projections for 2006 and 2007 point to inflation falling to single digits for the first time in several years.

So why is Ryan being so defensive?

In a word: Oil.

Another big spike in oil prices will directly affect the cost of rubber, glass, plastic, steel, oil-based paints and polymer compounds. And that could send the price of other materials back up as well.

For now, things are quiet. After fear that oil would reach $100 a barrel, prices began sliding from $70 down back to the $60 range — thus the current conservative estimates on inflation. Some experts, like BP CEO Lord Browne, have even predicted oil prices could drop to the $30 to $40 range last seen in early 2004, as the industry is helped by the use of new oil fields in places like Canada and West Africa. But such optimism aside, the situation in the Middle East remains unstable, meaning prices could skyrocket at any point.

And that's the problem. With so many essential construction materials dependent on oil supply, contractors remain anxious. Another big increase and they fear that profits will disappear.

“Anything right now that goes through the oil-based process already has gone up tremendously,” says Hugh A. McCoy, managing director of White-Spunner Construction, Inc., a general contractor firm based in Mobile, Ala. “Honestly, it's a problem for retailers, as well as for contractors.”

Oil is not the only variable builders are watching. Even though inflation of material prices has slowed, it's still ahead of the general rate of inflation, which worries Kenneth D. Simonson, chief economist with the Associated General Contractors of America. “I would say overall material price increases will be in the high single digits — eight to 10 percent — and numerous materials are likely to have increases of as much as 20 percent,” Simonson says.

Copper and aluminum prices are spiking. So is gypsum, cement and steel. But inflation in material costs has not slowed retail development. Project starts have gone up 19.6 percent in May from January of this year, according to a recent report released by Reed Construction Data.

Executives at Developers Diversified Realty estimate that even with higher construction costs, new developments offer a better return on investment in the current market climate than acquisitions.

Why? “Rents have kept up with the higher cost,” says Scott A. Wolstein, DDR CFO, who addressed the topic at the NAREIT show in New York last month. “As long as tenant demand stays where it is, we think we'll be able to maintain our yields.”

Tom Hardin, director of estimating with Konover Construction, with offices in Farmington, Conn. and Columbia, Md., adds that developers are not pulling back or rethinking projects because of material costs.

“I can tell you that two years ago we went through the same thing,” he says. “Around December of 2004, we saw a huge spike in steel and drywall costs. There was a lot of discussion about projects being tabled and not moving forward, but ultimately it just led to a bigger than expected increase in construction in the spring. Personally, I think the retail market is so strong right now that it's not really likely that there will be a big decrease.”

A number of contractors believe that material prices are due for a correction. Some say that the subcontractors are taking advantage of the development boom and keep adding unnecessary cost increases to everything, from concrete to metal studs to plywood.

“It's a good time to be a subcontractor, so if they can manage it, it's capitalism at its best,” says Steve Rivers, senior vice president with Atlanta-based Hardin Construction Company, LLC. “I'd say 90 percent [of the cost increases] is material pricing and the rest is opportunity cost.”

Wayne Johnston, vice president of estimating with Washington-based Bayley Construction, agrees. He believes that as manufacturers increase production and things on the development front begin to cool, it will become easier to negotiate.

“Some things will go up from maybe not much to quite a lot, depending on how much energy it takes to make them,” says Johnston. “But I expect some things, like copper, to come down. There was just a shortage of it, so everyone started raising their prices. I think the regular steel shapes will stabilize.”

Simonson notes that a number of products have been decreasing in price, among them wood and gypsum.

Moreover, many builders expect a slowdown in residential construction to help the retail sector. While prices on single-family homes are still high, new product is sitting on the market for longer periods of time and development is slowing. In May, there were 1.96 million new housing starts — up 5 percent from May 2005. But many saw that as a blip. Permit requests were down 2 percent. And in April starts were down 11.1 percent from a year earlier.

“The markets are slowing down just a little bit, there isn't as much demand as there has been and the manufacturers are expanding production to meet the demand,” says Stacey Berthon, vice president with Hoar Construction, based in Birmingham, Ala. “I think prices will flatten out, though I don't really see any reductions.”

Logic would dictate that a way to save money would be alternative materials. Some builders use modular blocks or crushed granite for paving instead of asphalt, others substitute cement-fiber for wood. But most chain retailers are reluctant to compromise on the look of their stores. They want steel and concrete, even if it means paying extra. Contractors can get away with brick or pre-cast concrete, but that's as far as it goes.

“Sometimes there are materials that can be utilized instead of the existing ones, but most of the products we use are tried and true and, for certain things, you just can't cut back and keep the quality,” says McCoy.

Plus, a few contractors have noted that municipalities are requiring a better quality of construction for malls and shopping centers as part of their renewal initiatives.

“Concrete, steel and wood are mostly what we have for our shells,” says Prinsen.

He hasn't had to turn down any projects as of yet because of construction costs, but he believes material prices have gone just about as high as they can go.

“The pressure to control costs is greater now than it was two or three years ago,” he says. “Has that impacted the number of projects? Right now, it has not, but I feel that it has the potential to in the next [several] years. We are reaching the point where there is nowhere else to give.”

Choosy Communities

The shift in metal and oil prices is not the only thing driving up retail development costs. Local governments are anxious to see well-designed malls and neighborhood shopping centers, and they want developers to invest in quality materials. The trend is part of the recent movement toward gentrification and urban renewal and it's happening all across the country.

“It's a combination of cities and developers looking for enhanced designs,” says Gary Prinsen, vice president of construction for the Minnesota region with Ryan Companies. “There is an emphasis on [high-quality finishes on all sides of a building]. That's a trend that's driven by cities in their desire to have a village concept or enhanced retail.”

Tom Hardin, director of estimating with Northeast-based Konover Construction, has recently worked on a project where the municipality asked for just that kind of improvement. The developer — a major company that has built malls all across the country — expected to simply paint the back wall of the structure, but was obliged to deliver a more aesthetically pleasing product.

“The town wants brick and stone and fancy terraces, so it doesn't appear like the back of the house,” says Hardin. “There's been a lot more requirements for roof screening. When you put the HVAC equipment on the roof, they want you to put up an architectural screen so it doesn't look like the equipment is really there. There have been a lot of increases [in spending] on additional parking, additional landscaping. As their areas get more developed, I think [local governments] are being more strict on the general requirements.”

According to the contractors, the practice drives up the construction costs. But it also appears to bring greater profits for the retailers. Better design means increased sales volume.

“We hear there is a design dividend — retail developers are seeing up to 15 percent to 20 percent increases in the value of their properties,” explains Michael D. Beyard, senior resident fellow for retail with the Urban Land Institute. “Many retailers like these environments very, very much because their sales are higher than in many of the older stores.”

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