20 April 2015

Building costs: while construction booms, bills zoom…

There’s no drought in construction activity in Los Angeles, where cranes are sprouting from the landscape like weeds.

From downtown Los Angeles west to Playa Vista, south to El Segundo and north into the Valley, more than 2 million square feet of office space is under construction – plus an additional 3.5 million in industrial space.

But all that activity is coming at a price – a bigger one.

Contractors and subcontractors that downsized during the recession are now struggling to keep up with demand. The volume of projects, coupled with a shortage of qualified labor, have been the main drivers of an increase in construction costs that has made Los Angeles one of the 10 most expensive cities in America for construction, according to Dana Westgren, a research analyst at Jones Lang LaSalle Inc.’s project and development services.

Westgren said that the overall cost of construction in Los Angeles has risen roughly 6 percent since 2012, and is expected to continue to go up. Several L.A. developers said they have seen a steeper increase, closer to 10 percent, because private-sector construction costs are increasing faster than those of public-sector construction. And the increases might intensify.

Indeed, the American Institute of Architects predicts private-sector construction costs will increase 12 percent this year nationwide while public-sector costs will go up only 5 percent.

Add rising land costs to the mix, and developers are looking for new ways to make deals pencil out. In many cases, they are turning to denser, more vertical projects. Architects are also changing the way they design projects to help developers buy materials as early as possible because those costs are going up, too.

“You’re seeing basic economics at work,” said Mike McCormick, president of McCormick Construction Co. in Burbank, whose company saw work pick up at a heightened clip last year. “It’s supply and demand. We were hunkered down after the recession, but the market picked up rather quickly, so the capacity of firms, especially the subcontracting market, ended up being at capacity rather quickly.”

Jocelyn Topolski, head of business development at Bernards, a San Francisco construction company that works both as a general contractor and construction manager, said Bernards has been more selective about the work it chooses over the past year.

“Subcontractors are turning away work and I wonder whether it will start to hold up projects,” she said. “So far, I haven’t seen that but I certainly think we’re near a saturation point.”

Bernards, which has 28 projects under way in Los Angeles County, including a $76 million, 287-unit, 40,000-square-foot multifamily project with ground-floor retail at Selma Avenue and Vine Avenue called Camden Hollywood, has seen labor costs rise; they’ve gone up 2 percent to 4 percent just in the first few months of this year, Topolski said.

When the recession hit, a lot of construction workers left Los Angeles, or left the industry altogether.

According to the state Employment Development Department, the region lost nearly 40 percent of total construction employment – 59,000 jobs – between 2007 and 2010, when just 101,000 people were employed in construction and related industries.

Many were drawn to cities like San Francisco and Dallas, were the recovery took hold earlier. And while construction employment here had rebounded to 123,000 in January, it has not proved enough to keep up with demand. As a result, compensation for some construction positions in Los Angeles has increased 35 percent to 40 percent in the last two years, according to Brandi Popovich, managing director in the L.A. office of RETS Associates, a Newport Beach commercial real estate headhunting firm that places workers in construction management and development jobs.

Popovich said developers are hiring for a range of skilled positions, and she doesn’t expect hiring to slow down anytime soon. As might be expected, the most skilled positions are in the most demand. General construction managers, who serve as liaisons between general contractors and subcontractors, are in particularly high demand. Developers prefer managers with five to seven years of experience. But during the recession, no one was hiring recent graduates of construction management programs. As a result, the job pool is filled with extremes: inexperienced workers with less than two years of work under their belts and expensive construction managers with more than 10 years of experience – and market leverage.

“Developers are beginning to accept that they will have to pay more,” Popovich said. “There are other areas where you can settle for less experience, but construction management is not one of them. You learn by making mistakes and if you haven’t worked on a lot of projects, you haven’t made those mistakes.”

David Binswanger, executive vice president of Southern California for Dallas developer Lincoln Property Co., said his firm has seen an 8 percent rise in labor costs over the last 18 to 24 months, and he expects the increase to continue.

As construction costs rise, developers who have not locked in costs will see their bottom lines shrink, he said.

“If you are building to a pro forma with an 8 percent return on costs and then construction costs go up 10 percent, your return on costs dips by 50 basis points,” Binswanger said. “In some cases, that might be a large enough reduction to render a project infeasible.”

Binswanger’s company is concluding construction on the Runway at Playa Vista, The $260 million project is the size of roughly four city blocks and includes a Whole Foods, Cinemark movie theater, apartments as well as office space. The residential portion of the project was the largest multifamily project completed in the first quarter.

“The cost increase is dramatic, but in the short term it’s manageable,” Binswanger said. “The fear is that because it’s labor driven, what happens if it becomes commodity driven as well? If commodities move too fast, or while a project is under construction, things could get out of hand.”

Creative costs

Alas, commodity prices are going up, too.

Construction materials have risen by almost 3 percent a year in each of the last two years, and the increases are projected to continue this year before flattening nationally in 2016, according to Phil Friedl, a senior vice president JLL’s project and development services group. In Los Angeles, some of those costs are higher than they are for the rest of the country. Plywood, for example, costs $602 a ton here, $26.70 more a ton than the national average.

But more than the increase in material costs, which have been moderate in comparison with the labor increases, some types of construction cost more than others, and expensive construction is currently in vogue in Los Angeles.

Over the last year, tech companies have been the primary driver, particularly in such places as Playa Vista. That has fed demand for creative office space, which has spread to traditional industries. For example, Hueston Hennigan, a law firm formed in January, signed a lease in late March for 21,000 square feet in the 446,023-square-foot PacMutual complex at 523 W. Sixth St. in downtown Los Angeles, a building that had been repositioned to appeal to creative office tenants.

Creative office construction costs roughly 10 percent more than traditional office space, according to Marcos Ramirez, vice president of business development at Turelk Inc., a Long Beach tenant improvement and interior contractor in early stages of construction on its own downtown creative office space, at 555 W. Fifth St.

“Concrete is more expensive than carpet, and an open ceiling is more expensive than tiles because everything has to look clean,” Ramirez said.

“We’re seeing old industrial or aerospace buildings being converted to attract creative office and tech company use,” said Friedl, whose firm provided project management services for the 110,000-square-foot build-out of creative office and studio space for e-commerce company JustFab’s El Segundo headquarters, completed in February.

Los Angeles has also reached a postrecession high for construction of retail properties, which are getting more elaborate and expensive, he said.

Call it the Caruso-ification of the retail experience. Friedl said retail centers are repositioning themselves in the direction of Caruso Affiliated’s the Grove and Americana at Brand properties, focusing more on the entertainment experience and on serving as gathering places rather than simply being malls for shopping. The trend is to go open air, he noted. And those conversions are not cheap: Open-air construction requires exterior facades to be built as well as more expensive plaza and paseo hardscape.

Process changes

Because of the high cost of construction, architects and developers have made some changes to their processes.

“As prices go up, construction starts to weigh in as equal to or greater than land costs as part of the decision-making,” said David Hart, president of San Francisco’s Steinberg Architects. “The longer you wait to lock in the price for construction in an escalating market, the more volatility you have, so developers are looking to buy out the work earlier on. You know your risk and you know your cost the earlier you lock it in.”

Hart said Steinberg is working on two high-rises with a contractor who wanted to buy out the concrete and steel in the design and development phase, when normally it would be purchased later in the process, to get better pricing. The firm accelerated parts of its design process to meet this need, moving ahead faster with exterior designs and designing interiors at a later phase, when traditionally it is a parallel process.

“Traditionally, the design process, inside and out, evolves at a similar place, so that you’re relatively even,” he said. “When you’re accelerating the process of design, it’s a bit schizophrenic because you’re having to lock in and commit to things while delaying others.”

Lincoln’s Binswanger said he has seen how much costs can increase when buying labor is delayed. The company began construction on the Runway project and locked in costs in 2012.

“We benefited from being there early, and contractors have stood by their costs and it’s a success,” he said.

He saw the flip side at Lincoln’s planned mixed-use project in Pasadena at 100 W. Walnut St., which is slated to include 30,000 square feet of retail space in addition to office space and 475 residential units.

Still seeking entitlements for that project, Binswanger said the company is looking at the feasibility of it, citing a 20 percent increase in construction costs since the beginning of the process.

“That is a project where every day we are looking at numbers,” he said.

The Pasadena project is emblematic of the challenges facing developers of multifamily projects.

The market is in the throes of a housing shortage and developers are answering the need with an apartment-building frenzy. In the first quarter, nearly 15,000 units were under way in the market, with an additional 50,000 units planned across the county, according to an annual apartment research report conducted by Calabasas real estate brokerage Marcus & Millichap. Developers remained active in the first quarter, permitting 12,500 units, up 3 percent versus a year ago.

More than 10,000 units are expected to hit the market this year, topping last year’s 9,300 and reaching levels not seen in decades.

The downtown L.A. submarket is particularly busy. Builders completed 4,500 rental units in the region during the past year, lifting inventory by 2 percent; 5,800 units are under way.

The Los Angeles Department of Building and Safety, which issues construction permits, has seen a major uptick in applications for high-rise buildings and other multifamily properties this year, department spokesman Luke Zamperini said.

Increased labor costs are tacked on to what is already a more expensive product to produce, said JLL’s Friedl.

“(Multifamily projects) cost more because they are fully built out with full kitchens and bathrooms, as opposed to an office high-rise, which is core and shell only,” he said.

Steinberg’s Hart, whose firm designed a 190-unit mixed-use high-rise being built by real estate investment trust UDR Inc. at 3033 Wilshire Blvd., called multifamily the driver of the real estate market in Los Angeles.

“That’s what people are buying, because it’s the highest yield on a property acquisition,” said Hart, whose firm focuses on residential design. “We’re seeing those as the most affected by high construction costs because there is a high demand to get these to market.”

Those costs are recouped, developers hope, in higher rents, which put pressure on renters.

L.A. economic development consultant Larry Kosmont said the rising cost of labor will ultimately drive up rents in Los Angeles, sending those who can’t afford the hikes to less desirable, less populated and more affordable locales such as the area around Los Angeles International Airport.

“The demand is exceeding the supply and with labor costs increasing, the rents are going to have to go up,” he said. “I think the impact of rent rising is that price-sensitive tenants are going to look to a less expensive market.”

When compared with the residents of other large cities, Angelenos already pay the highest proportion of their income, nearly 50 percent, on rent, according to a 2005 study by the Ziman Center for Real Estate at UCLA.

“The rise in construction costs certainly isn’t going to help deliver units at a cheaper price point, and it’s certainly not good news in terms of enhancing affordability,” said Paul Habibi, a professor at the Ziman Center. “Developers will have a harder time pricing rents at attractive levels to recoup the costs of the land and the labor.”

While there is a chorus calling for more affordable-housing units in the city, Habibi said many factors make the creation of affordable housing here difficult, with construction costs among them.

“The greater the construction costs, the greater the gap you have to fill to get it at an affordable price point,” he said. “There’s increasingly fewer and fewer subsidies to fill these gaps, so rising construction costs increase the need for these subsidies.”

Sunny skies

Nevertheless, demand for residential units is so high that despite the spike in construction costs it remains a developer’s market, Lincoln’s Binswanger said.

“When we look at development, we’re always looking at the future whether it is a rent stream from tenants two or three or four years from now,” he said. “Today we’re assuming that fundamentals continue to improve in the short term, outpacing the increase in costs.”

Steinberg’s Hart said there are even benefits to the rise in construction costs.

“I think this is good for our profession, to be creative with the highest and best use of the land” he said. “We enjoy the test of our agility, restructuring work to be more in line with the demands of the market.”

Ultimately, he said, Los Angeles is still an attractive place to develop in comparison to cities like San Francisco and New York, as evidenced by the rise of foreign investment here. The increase of construction costs has not yet slowed work down.

“We’re not seeing projects dying because of the increase – (developers) are getting smarter, more ambitious,” he said.

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