Rising development costs: Silver lining for US commercial real estate?

NATIONWIDE, new commercial real estate occupancies in the United States are near record highs across all sectors amid a slower pace of new development. Rising construction costs have limited new supply of institutional-quality property and prolonged much-needed updates to functionally obsolete property.

Overall, US commercial building costs have risen 30 per cent over the past decade (see graphic: US rising construction and land costs). Average replacement costs are now also well above existing asset values. The positive outcome for commercial real estate investors is that high costs are holding back new construction and limiting over-supply risk, which is driving appreciation and rent growth of existing assets.

There are many projects in need of financing - including ground-up construction, redevelopment, and interior fit-outs. However, higher building costs and lengthy entitlement processes now present greater financial and schedule risk. Many construction projects, especially multifamily, have reported budget overages and substantial delays in completion.

These challenges are largely caused by a few factors.

Consequently, investors, developers, and construction lenders continue to exercise great caution in construction loan underwriting, as timeline and budget uncertainty can present greater downside risk.

New construction levels: Past, current and future

Even in a real estate cycle that has set records for the number of years that have passed since previous lows, recent and future annual new supply growth as a percentage of stock is still well-below long-term averages, suggesting less concern of overbuilding (see graphic: Commercial real estate: annual new supply as a percentage of existing stock).

Partly, this is due to a larger denominator as new commercial real estate development is near peak levels both in terms of US dollars and square feet. In 2018, total construction spending reached a record high and the prior three years (2015-2017) well exceeded the 2007 peak level, though again, the larger value of the existing real estate means a relatively smaller effect for these dollars compared to the past.

Throughout this expansion, the construction lending landscape has shifted, along with the regulatory environment.

However, there has been no shortage of committed capital. More non-traditional capital sources (eg private equity and life insurance company debt originators) have become more active given the underwriting restrictions placed on commercial banks, such as capital reserve and loan-to-value requirements.

There may be less available data on project loans originated by alternative lenders.

Recent data from the US Census Bureau and Federal Reserve indicate that construction spending and origination volume have recently begun to moderate for the first time since 2011, which may be related to a combination of pricing pressure from rising costs, trade-related uncertainty, and a slower pace of growth nationwide.

Construction costs highest in largest US cities

Some of the largest US cities, including New York, Chicago, Los Angeles, Boston, Philadelphia, and San Francisco, have reported the highest and most prolonged increases in labour prices, well-above the US average (see graphic: Construction labour costs by metro relative to US average).

These markets also have both greater labour union strength and higher costs of living, both of which impact labour availability and prices. Such circumstances may be slowing the pace of new supply growth and exacerbating the widespread functional obsolescence across all property types.

Much of existing US building stock is dated. Today about 50 per cent of all institutional-quality property was built before 1990 (see graphic: Functional obsolescence in US commercial real estate widespread). By and large, rising construction costs are increasingly onerous to many small and mid-size landlords, which led to a 13 per cent increase in tenant improvement (TI) allowance in 2018.

In these markets, this may have accelerated the shift to flexible space and co-working concepts, such as WeWork, where the enterprise lessee has no financial obligation to complete capital improvements and can opt for a short-term lease.

The high cost burden of updating existing properties in major metros may also drive movement to new regions where it is easier and less expensive to build the new, Class A properties that most top credit tenants prefer. In fact, in recent years, Texas has greatly outpaced California and New York in annual commercial construction spending. Florida, North Carolina, and Georgia also ranked highly.

Rising construction costs have restrained new development projects but have also preserved pricing power of existing institutional-quality assets in many top US metros. This situation may present great redevelopment opportunity for well-capitalised owners, developers and investors. Certain large-scale players may be able to achieve better economies of scale and pricing power.

However, the ongoing rise in building costs and schedule uncertainties may also lead to faster movement to less costly US suburbs or secondary cities or to Greenfields or Brownfields in nearby areas of high-cost metros. New, Class A assets in good locations are increasingly scarce with the moderate pace of supply growth. All in all, the silver lining of climbing building costs has sustained commercial real estate asset appreciation well above many other sectors (see graphic: 5-year cumulative growth: construction cost, NPI appreciation, and inflation).

Over the past five years, the cumulative growth in the NCREIF Property Appreciation Index has been strong, up by 23 per cent, benefiting in large part from the low availability of newly delivered property in some of the biggest US cities.