Construction Costs & The Impact on CRE

By Chris Romano | Associate

The cost of construction has been a hot-button topic in the commercial real estate and development discourse for several years now. The industry has experienced skyrocketing prices in nearly every facet of the business (labor, materials, insurance, etc.) and the effect has been felt in Maine and throughout the country. This has put a distinct strain on tenants, landlords, owner-occupants, or developers undertaking fit-up or ground-up construction projects.

The rate of cost increases has slowed in 2023, but only in comparison to the record-high price index increases we experienced in 2022. Last year saw an average increase close to 20% for construction input costs (Associated General Contractors). While CPI inflation has slowed, largely thanks to steep interest rate hikes from the Federal Reserve, the AGC emphasizes that construction costs generally do not move in sync with the overall economy. Ultimately, delaying a project in the hopes that cost slowdowns and volatility will catch up with CPI is unlikely to have the desired effect. So, what does this mean for the commercial real estate industry going forward?

The Value of Existing Buildings/Infrastructure

As expected, interest rate hikes have slowed transactions and put some downward pressure on pricing. Contributing to keeping prices afloat is the hefty cost of replacement. With replacement costs through the roof, many occupants (both tenants and owner-users) are opting for existing product over new construction, even if that means extensive renovations and updates. While costs to retrofit buildings for a new user have increased right along with ground-up construction, anything that can be done to limit the amount of labor and materials used – not to mention soft costs – will reduce overall costs significantly.

Price-sensitive buyers and tenants will likely continue to select existing product over new construction – but the costs have a trickle-down effect here as well, particularly in an extremely tight industrial market. With new construction costs pushing Class A rents into the mid-teens on a $/SF/year basis, existing Class B industrial product has been pushed into the $6-8/SF range in Central Maine and $8-10/SF in Southern Maine.

Land Values

High construction costs are keeping existing building values propped up, but in some cases they are having the opposite effect on the price of land.  With interest rates rising and construction costs continuing to increase, the price of developable land faces increased scrutiny. To get new construction deals to pencil out, developers aim to keep their land basis as low as possible, having a negative effect on the value of raw land and development sites.

Effects on Tenants

Developers bear the initial brunt of the high construction costs, but that inevitably has an impact on tenants as well. Multifamily development has seen the most robust development across Maine, as rapid rent growth has been able to support such projects. While nationwide rent growth has slowed in 2023, particularly in the Sunbelt, rents across Maine don’t appear to have faced the same headwinds. The current state of the construction industry makes it that much more important for municipalities to shy away from unreasonable inclusionary zoning and rent control laws that make multifamily development unaffordable and impede the likelihood of future continued development.

The low vacancy rate has protected the industrial sector as well, with both build-to-suit and speculative developers finding success in achieving record-high industrial rents that support new construction costs. Given the current costs and the likely increases to come, I predict many developers, particularly those without in-house construction and/or design teams, will be less likely to bring spec projects to fruition in 2023.

Retail developments, particularly Single-Tenant Net Leased projects, have seen a significant impact from rising costs. Anecdotally, many clients and peers have recently echoed the same sentiment across the board – it is very difficult to structure deals that pencil out. With the current construction market, developers must achieve record-high rents to achieve a profit margin on their projects. Even preferred developers with longstanding relationships with national credit tenants and deep pipelines are running into stalemates on build-to-suit rents.

Going forward, the majority of new construction retail deals we see will be from rapidly expanding retailers that can support the record-high lease rates for these new locations. Other strategies employed by retailers include cutting down on square footage in favor of drive-thrus and implementing computerized or mobile ordering systems. With the current construction cost environment, developers, commercial tenants, and owner-occupants will need to be particularly savvy in structuring their deals and construction processes in 2023 and beyond.

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