A Silver Lining for Commercial Real Estate?

Rising Development Costs

A Silver Lining for Commercial Real Estate?

Record high building costs have helped sustain asset appreciation and could also help shape new investment opportunities.

Introduction: Building costs at a record high

Nationwide, new commercial real estate (CRE) occupancies 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, U.S. commercial building costs have risen 30% over the past decade (Figure 1). Average replacement costs are now also well above existing asset values.1 The positive outcome for CRE 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.2

FIGURE 1: U.S. Rising Construction & Land Costs (2008-2019)

Source: Turner Construction Company, Real Capital Analytics, Q2 2019. Notes: 1) The Turner Building Cost Index includes nonresidential construction and is on annual frequency and is based on a few factors: labor rates and productivity, material prices, and the competitive condition of the marketplace. 2) Land cost data is transaction based for commercial properties.

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.3

These challenges are largely caused by a few factors:

  • Construction labor shortages. Construction employment is now still below its prior peak at 7.5 million.4 These jobs fell by about 2 million after the 2008-2009 credit crisis. Low labor availability is especially prevalent amidst skilled or 'craft' subcontractors, as well as in the largest and most expensive U.S. cities.5 Subsequently, construction wages have increased about 40% so far this cycle across the industry.6 Furthermore, non-U.S. citizen workers are facing visa challenges, which may be having an impact on labor availability.
  • Fluctuating commodity prices. Over the past few years, material prices have fluctuated significantly, which can present greater project risk. In 2018, commodity prices rose on certain materials; metals, for example, climbed briefly due to shifting global trade dynamics. However, over the past year, key material prices have moderated noticeably overall. Hard costs typically represent 60% to 70% of the total project costs (whereas soft costs are more like 30%).7
  • Rising land costs. Land prices are also historically high nationwide. Since 2017, global institutional investors' race to buy real assets (e.g. farmland, infrastructure, and real estate) has accelerated. Subsequently, demand for land for industrial, housing, and solar energy uses has escalated.

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, & 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.8 Partly, this is due to a larger denominator, as new commercial real estate development is near peak levels both in terms of U.S. 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.

FIGURE 2: Commercial Real Estate: Annual New Supply as a % of Existing Stock

Source: Moody's Analytics, Clarion Partners Investment Research, Q2 2019. Note: Based on the average of office, industrial, multifamily, & retail.

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 (e.g. 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 U.S. 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 U.S. cities

Some of the largest U.S. cities, including New York, Chicago, Los Angeles, Boston, Philadelphia, and San Francisco, have reported the highest and most prolonged increases in labor prices, well-above the U.S. average. These markets also have both greater labor union strength and higher costs of living, both of which impact labor availability and prices. Such circumstances may be slowing the pace of new supply growth and exacerbating the widespread functional obsolescence across all property types.

FIGURE 3: Construction Labor Costs by Metro Relative to U.S. Average

Source: U.S. Bureau of Labor Statistics, Clarion Partners Investment Research, Q3 2019. Note: Labor costs as of April 2018.

Much of existing U.S. building stock is dated. Today about 50% of all institutional-quality property was built before 1990.9 By and large, rising construction costs are increasingly onerous to many small and mid-size landlords, which led to a 13% increase in tenant improvement (TI) allowance in 2018.10 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.

FIGURE 4: Functional Obsolescence in U.S. CRE Widespread

Source: CBRE, Clarion Partners Investment Research, Q2 2019. Note: Totals based on the average of office, multifamily, and industrial. Retail excluded due to shorter history.


Rising construction costs have restrained new development projects yet have also preserved pricing power of existing institutional-quality assets in many top U.S. metros. This situation may present great redevelopment opportunity for well-capitalized 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 U.S. 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 been sustained CRE asset appreciation well above many other sectors (Figure 5). Over the past five years, the cumulative growth in the NCREIF Property Appreciation Index has been strong, up by 23%, benefiting in large part from the low availability of newly delivered property in some of the biggest U.S. cities.

FIGURE 5: 5-Year Cumulative Growth: Construction Cost, NPI Appreciation, & Inflation

Source: Turner Construction Cost Index, NCREIF, Bureau of Labor Statistics, Clarion Partners Investment Research, Q2 2019.

Investment in real estate entails significant risks and is suitable only for certain investors as part of an overall diversified investment strategy and only for investors able to withstand a total loss of investment.


Class A properties represent the highest quality buildings in their market and area. They are generally newer properties built within the last 15 years with top amenities, high-income earning tenants and low vacancy rates.

The Federal Reserve Board (Fed) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The NCREIF Property Index (NPI) provides returns for institutional grade real estate held in a fiduciary environment in the United States. Properties are managed by investment fiduciaries on behalf of tax-exempt pension funds. As of the second quarter of 2003 the index contains 3,967 properties with an aggregate market value of $127 billion.

The Turner Building Cost Index includes nonresidential construction and is on annual frequency and is based on a few factors: labor rates and productivity, material prices, and the competitive condition of the marketplace.

The United States Census Bureau (USCB) is a principal agency of the U.S. Federal Statistical System, responsible for producing data about the American people and economy.


1 Clarion Partners Investment Research. Q3 2019.

2 Ibid.

3 GlobeSt.com. Construction Lending Outlook: Strong Sentiment and Fundamentals Amid Growing Uncertainties. 2019 and Bisnow.com. The Rise Of The Subcontractors: Labor Shortage Keeping Skilled Workers In Control. 2019.

4 U.S. Bureau of Labor Statistics. Q2 2019.

5 Globest. Skilled Workforce Drought Continues to Plague Construction. 2019.

6 U.S. Bureau of Labor Statistics. Q3 2019.

7 NMHC. The Housing Affordability Toolkit. 2019.

8 CBRE-EA. Q2 2019.

9 Ibid. Note: Calculation based on industrial, office, and multifamily only.

10 Jones Lang LaSalle. Q3 2019.


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