Why It’s So Hard to Build Cheaply

Edd Hamzanlui

Rising construction costs have been one of the most trending headlines across the real estate industry for the past three years. Most practitioners look at the development costs as a lump sum number (or per unit cost in the residential sector). However, it might be beneficial to dig deeper and analyze the main cost components individually to get a better understanding of why it is not easy to build cheaply. The main cost categories for a new ground-up residential development consist of land and entitlement costs, soft costs, hard costs, reserves, etc.

Land and entitlement costs

In a free market economy, land value is usually determined by market conditions, micro-, and macro-economic factors and is often calculated based on comps and recent transactions. It organically becomes more challenging to identify new opportunities in a development-friendly environment where properties are fully and efficiently priced. That alone leaves no room to cut costs on the acquisition front. On the other hand, less appealing opportunities usually require several years of entitlement process, which is costly and unpredictable. Either way, a higher cost of dirt is inevitable.

Soft costs

Soft costs (i.e., engineering fees, permits, legal fees, insurance, marketing, project management fees, etc.) are labor-intensive services that require specialized and trained workforces and are directly impacted by growing wages. Technology has increased the productivity level across the entire AEC spectrum and streamlined the process, but qualified consultants are still key to any successful project. And as any professional would advise, hiring the least expensive advisors is not necessarily a smart strategy. It is fair to say that some government incentives, grants, and tax programs can improve the viability of a project, but not a promising factor either.

Hard costs

Hard costs usually account for most of the development costs. They can be broken down into two main categories: labor and material. While each trade has its own unique labor and material characteristics, they all share the pain of persistent inflation.

Labor: The blue-collar labor shortage is no secret, but the worrying point is that there is no sign of easing on the horizon. Economists expect that to become a longer-term problem than many assume. Outsourcing labor forces is not a feasible option for the construction industry either. While off-site construction is gaining ground, it doesn’t lead to less expensive but faster and more predictable construction instead. Also, the impact of technology on the sector has been relatively limited compared to some other industries that have experienced a renaissance over the past few decades.

Material: Supply chain disruptions, changing international trade dynamics, sustainable and de-carbonization requirements, and fluctuating energy prices are only a few to name a growing list of challenges that face the construction industry. In an ever-growing already complicated supply chain, the falling prices in one trade are usually offset by a bump in another.

What can be done?

According to various national research, there is a shortage of between 5 million and 6 million homes in the U.S. While inflation is cooling down, the elevated construction costs are unlikely to return to pre-Covid level. However, industry participants are foreseeing more stabilized costs ahead instead of significant deflation. The bottom line is that in a free market economy, there are a few non-monetary measures that can improve the current housing supply-demand imbalance. But they require more active bipartisan government support.

Fix zoning and you fix the housing crisis. Zoning reform is a particularly impactful part of the solution as it does not increase government spending. Existing and fairly outdated low-density zoning mostly permits single-family homes across the nation. Some states and local municipalities have initiated addressing the issue and, in some cases, eased the restrictive zoning to allow higher-density development. For instance, Massachusetts has recently introduced a new law concerning MBTA Communities (Section 3A of the Zoning Act) to permit higher-density multi-family housing as of right.

Find new labor sources. With the current high labor force participation and near-full employment rate, there are not many sources left to introduce new labor to the heavy labor-dependent construction industry. One fast and effective solution that can improve the economy as a whole and the construction industry is immigration reform which also can potentially slow down inflation. Unfortunately, the topic is facing political barriers which overshadow the powerful impact it can have on the overheated labor market.

For nearly two decades, Edd Hamzanlui has worked in real estate finance and banking, private equity, development, construction management and cost consulting, and architecture. He is currently leading a family office-backed real estate development practice in the New England region focusing on workforce housing.