A combination of labor oversupply, squeezed contractors' margins, and falling material?s price will significantly drive down costs across the board. BY ROBERT BARONE, R.A. Without a doubt, the scarcity of new construction financing, the skittish mood of project sponsors, and the discomfort of developers and investors to begin or move forward with new building projects, have combined for an overall bearish sentiment in the real estate business. During the past six months, for instance, IVI International, Inc. has been tracking the drop off in new construction ? and it seems like activity has come to a complete stop. Numerous projects have already been canceled; including many that were previously viewed as solid deals. As a result, the cost analysts have had very little hard information with which to measure the effects of the slowdown on construction costs. But the question of construction costs is a critical one for any sponsor, and their stakeholders who want to understand when it will be viable to resume building activities. For one thing, when falling construction costs align themselves with lower property valuations and some semblance of positive or even flat absorption, investors and developers would once again see that the market is in equilibrium and begin to get comfortable with moving forward on new or canceled projects. But for many of these skittish real estate and construction professionals, finding answers to the burning question of where overall direct costs stand today has been illusive at best. That said though, construction costs could come down by as much as 20 percent over last year's levels. And to understand why, one would have to understand some of the reasons costs escalated as much as they previously did in the first place. So what happened? Some fairly obvious items caused the run up during the now stalled real estate construction boom cycle. These included cost increases in petroleum and petroleum-based materials, a constriction in the supply of materials coupled with excessive demand, and a lack of available skilled labor and management personnel. First, few developers and investors were fully prepared for the run up in oil prices when the commodity (which could drive as much as 25 percent of any construction project's cost) hit an all-time high of over $147 per barrel last summer. The result was a major realignment of cost, and every item ranging from PVC plastic pipes, to copper, steel and other related energy intense materials began to impact costs and the exit strategies of many construction sponsors. This made lenders even more skittish, and served to finally bring the once venerable construction train to a grinding halt. Next, the runaway construction and real estate investment train placed such heavy demands on limited materials supply that prices were driven up by mere supply/demand economics during the previous three years or so. Double digit cost increases over a period of just a few months were not uncommon. At one point some developers found the price of materials were rising so quickly, that it made sense to stock up on supplies well ahead of when they would actually be needed for use. This type of construction materials hoarding led to more constriction of construction supplies, and of course, even higher costs. Compounding these reasons was the mother of all construction cost drivers ? the rising cost and dwindling supply of available skilled labor. Because experienced workers at the time were in short supply, this eventually reduced the efficiency and productivity of construction crews. Unionized workers were actually being paid above scale to entice them to work on the larger projects, according to some IVI findings. The analysts found for instance, that many younger staff members were being promoted to fill voids in the shortage of experienced workers. These moves led to numerous project management and administration problems. An oversupply of bidding opportunities led to a reduced pool of job bidders, with many large projects unable to draw sufficient response from qualified bidders. Or, on the other hand, it led to contractors just throwing high bids at projects; some may just happen to stick in what was an overheated market. This too, drove up costs and caused project delays with little recourse for sponsors, general contractors, and their financing backers. IVI found that this inefficiency allowed some subcontractors to charge very large margins - sometimes reaching in excess of 25 percent. Costs already falling Armed with this backdrop, one can see how costs would be coming down in today's environment. Most of these problems will be resolved by the reduction in available work alone. But one area where costs will not be coming down that quickly is in the union work regions. These contracts include specific wage and productivity rates, and while this may change over time, it remains a major sticking point for many project sponsors. Today, some of the stronger owners are pushing the unions for wage and productivity rollbacks. In fact, IVI is currently working on several large projects that are stalled just to work through some of these wage and cost reduction issues. The sponsors and their financing backers in the project are targeting as much as a 25 percent cost savings over a year ago levels. While this may sound aggressive, it is indicative of how the momentum has shifted to the side of developers, investors, and anyone who is moving forward with construction in the current environment. IVI is also seeing developer-initiated ?claw-backs? against general contractors in places like the Las Vegas market. For projects that are being bid right now, IVI is seeing a cost pullback of 10 to 15percent. Most of this pullback is related to the immediate reduction in subcontractor margins, and productivity increases. These productivity increases will largely come from a stronger, readily available pool of experienced labor and management. In time, material pricing will surely decline. There has already been a construction cost decline of almost eight percent in the last quarter of 2008 alone. As a result of falling labor and material prices, and the highly competitive push in the market, the industry could see as much as a 20 percent drop in costs over last year's levels. But unfortunately, this will not show up in the published cost indexes. These widely followed, but sometimes skewed indexes only use the published wage rates and material quotes, which can mask true construction and replacement costs. __________________________________________________________________________________ Robert Barone, R.A., is a principal with IVI International, Inc., a global construction advisory firm serving private and institutional equity investors and mortgagees. IVI specializes in project management oversight services, construction loan workout services, construction claims, and asset management. Barone can be reached at (914) 694-1900.