Building Something New
Despite ongoing pandemic-related turbulence, construction starts and development paint a hopeful picture for commercial real estate.
As the economy continues to emerge from the effects of the COVID-19 pandemic, commercial real estate construction, buoyed by the continued loosening of pandemic restrictions, has been on the rise as well. Through 1H2021, Dodge Data & Analytics reported a 10 percent rise in total U.S. commercial and multifamily building starts, up to $108.5 billion, compared to the same period in 2020. But many of the issues that slowed construction in 2020 remain a concern, even as the economy continues to improve.
At the onset of the pandemic in March 2020, labor that was considered essential was allowed to proceed, but the definition of “essential” varied widely across the country, and construction was halted in many areas. According to JLL's 1H Construction Outlook Report, 26 percent of ongoing construction work was in a jurisdiction where work was shut down, including seven states where the average shutdown lasted 41 days. The effect was dramatic — 1.3 million construction jobs were lost from February through April 2020, a contraction of more than 17 percent, according to the report.
However, as shutdown orders were lifted in May 2020, the report says, the construction industry “shifted from immediate crisis management to developing medium-term solutions for working through a pandemic that was a known and persistent challenge for the year ahead.”
Among the primary challenges are the increasing costs of materials and a dearth of skilled construction labor. As a result, according to JLL, 2020 nonresidential building construction starts were down 24 percent from the previous year.
As the economy reopened, new construction challenges popped up as well, primarily the implementation of new COVID-related safety protocols and a learning (and spending) curve for newly introduced construction technology. Certain sectors — primarily warehouse and industrial — encountered increased demand, while others, such as retail and hospitality, slowed down.
In the early days of the pandemic, construction projects were hamstrung by a shortage of materials. During the pandemic — from 2Q2020 through 2Q2021 — “the story was really one of disruption, of supply chain challenges, of shortages in production and shipping,” says Henry D'Esposito, construction research lead for JLL and author of the JLL report. “All the way through the supply chain, from early production of raw materials through production through distribution, there were delays and cost increases all along that chain.”
As a result, prices increased. For some commodities, he says — particularly lumber and steel — prices went up two or three times from where they'd been. In the 12 months leading up to April 2021, for example, lumber prices rose 86 percent and steel jumped 67 percent. By this summer, prices had come back down somewhat, but D'Esposito adds, “we're forecasting a more broad-based widespread inflation going forward rather than a one-off issue. Last year, lumber went up, but concrete, drywall, and other commodities were flatter. What we're expecting now is we'll see mid- to upper-single-digit increases across the board.”
Labor Shortages and Competition
“I think labor is going to be the bigger issue going forward,” says D'Esposito, despite material costs dominating much of the discourse recently. Even before the pandemic, many markets had shortages of skilled construction labor. As building activity resumed, commercial construction faced increased competition for labor on several fronts.
On one front is the boom in residential construction. The National Association of Home Builders reported that residential construction employment increased by 15,200 in June, while nonresidential construction lost 22,600 jobs that month and 21,700 jobs in May. By July 2021, notes NAHB, residential construction employment exceeded its February 2020 level, while only 55 percent of nonresidential construction jobs lost in March and April 2020 had been recovered.
Construction could also encounter competition from other industries that have increased wages, where there's an overlap in the labor pool, adds D'Esposito. And as government infrastructure efforts ramp up, they will also impact both labor and materials costs, he says. While infrastructure work is “obviously different from a typical commercial construction project, at the end of the day, an infrastructure project will use the same concrete, the same steel, and many of the same workforce that would go into a commercial project.”
One longer-term trend from the pandemic is an increased use of construction tech adoption, as builders had to shift to remote environments. “We thought that would stick around and serve as a springboard to faster growth across the industry,” says D'Esposito, “and that is so far what we've seen.” While the technologies took time and money to roll out, “once you do that work, they've proven very effective.”
Sectors to Watch
Construction did, however, continue at a rapid pace for some commercial sectors. The increase in e-commerce has spurred warehouse construction, and Jeff Engelstad, CCIM, points to strong activity in logistics as well. Engelstad, professor of the practice at Franklin L. Burns School of Real Estate and Construction Management at the University of Denver, says that the pandemic-related disruptions in supply chains “tell us that we need better solutions to supply chain management — and a lot of that has been last-mile logistics.”
Engelstad also notes increase activity in multifamily. “Pandemic or no pandemic, people still need a place to live,” he says, “and even with the eviction moratorium lifting, it really hasn't hurt the investment value of apartment buildings at all.”
As the economy reopened, new construction challenges popped up as well, primarily the implementation of new COVID-related safety protocols and a learning (and spending) curve for newly introduced construction technology.
A midyear report from Marcus & Millichap noted that more than 175,000 apartments were completed in 1H2021, which raised the annual total to about 363,000 units — the largest completion volume over four quarters in at least 20 years. Top multifamily markets included Dallas-Fort Worth, with more than 27,000 completions, and Houston with 20,200. Other metro areas included Atlanta, New York, Washington, D.C., and Austin, Texas.
D'Esposito adds development in life sciences and health care to the list, “but that tends to be more clustered” in markets such as Boston, San Diego, and the Bay Area, he says. “Where it's busy, it's extremely busy.”
Other sectors are seeing activity for more focused needs. While overall office construction slowed, projects related to temporary health measures — social distancing, sanitation accommodations, etc. — retrofitting projects, and other requirements were still necessary as people returned to office from working remotely. D'Esposito sees potential buildouts where companies take a critical look at their office spaces as hybrid home-office working arrangements become more common. “What are the long-term shifts going to be in terms of how people work?” he asks. “A lot of companies view moving toward a hybrid model where they need flexibility in how the office is used, rather than a sea of desks.”
Overall, the top 2021 U.S. markets for commercial and multifamily starts, according to Dodge Data & Analytics data, are New York-Northern New Jersey-Long Island; Dallas-Fort Worth-Arlington; Washington-Arlington-Alexandria; and Boston-Cambridge-Quincy.
The pandemic has made its mark on how construction contracts are being written going forward. “Everybody up and down the chain is still very focused on force majeure provisions and standard force majeure delays, which typically have included epidemics,” says Deborah Cazan, a construction attorney and a partner at Alston & Bird in Atlanta. “In drafting new agreements, you have to consider that we're not living in the same world that we were in three years ago. So those force majeure provisions look very, very different now than they did three years ago. In particular, a real hot button right now is whether material delays and escalation constitute a force majeure event.
“Traditionally, material escalation and delays were put into the contractor's bucket. That was the contractor's risk because they had control over that. They determined when they were ordering materials [and] the price they negotiated with their vendors. They were the appropriate party to take that risk. That is no longer the default. What you're seeing now is parties coming up with innovative ways to reallocate the risk so that the contractor isn't taking the risk for material delays and escalation over which they have no control, and the owner isn't taking the risk for those items over which the contractor does have control. Control is obviously going to be the focus in drafting provisions going forward.”
While overall office construction slowed, projects related to temporary health measures, retrofitting projects, and other requirements were still necessary as people returned to office from working remotely.
She adds that she's seen many ways in which clients have handled the situation in the past year. “I've had some owner clients write into their agreement that, broadly speaking, unless the contractor is negligent in what it's doing, the owner is open to change orders for increased material costs.” Other clients concerned about the availability and price uncertainty of a commodity like steel may pay 100 percent of their steel costs upfront to lock in the numbers.
“I've had other clients who have written into their contract that if material costs go up more than 5 or 6 percent, then we'll okay a change order,” Cazan says. “But you're going to take the risk up to that, and in conjunction with that, if they go down by more than 6 percent, then we want money back.”
She notes that COVID-19 has also added additional work-site safety measures that have increased construction costs. For projects that were ongoing during the outbreak, “contractors and developers were very good about working together to be fair about that,” she says. However, as such requirements become more standard, contractors will now need to include them in their contracts.
Cazan says that she hasn't seen the construction labor shortage shift risk to owners from contractors. Instead, owners and developers expect contractors to develop appropriate schedules based on their knowledge of the local labor market. “It might be that your project is going to take longer, but that additional time needs to be built into the initial schedule” she says. So, while the shortage may have an impact, “the risk of a labor shortage isn't typically being shifted to the owner or serving as the basis for a time extension.”
For more information on this topic, check out CCIM Institute's Development Specialty Track program, which provides CRE developers, investors, and consultants with an understanding of the resources and business practices required for successful development projects.