To call the past couple of years interesting would be an understatement. We have had numerous setbacks, a fair share of folly, and a roller coaster in construction & development. Tallying up a global pandemic, slew of natural disasters, war, pestilence, and political extremism; the only thing left might be an alien invasion.
Nostradamus himself would have struggled to predict the level of calamity in the recent past, and though I am not a full-time seer, I am willing to share my personal opinion/prognostication on the past, present, and future of construction cost escalation.
Past cost escalation
The near past has been measured in degrees of terrible. Many market participants have come away with lingering nightmares of lumber prices almost as high as gold, eroding yields / profit, challenging development policies from the municipalities, and ongoing pushback received by the NIMBY demographic.
Let’s quickly cover the most notable past woes:
· Double digit cost escalation per annum in several major locations
· Double digit proposed increases in government fees
· Shortages of materials
· Extreme shipping costs and timelines
· Labour shortages, including project managers (a boon for the rest of us)
· Schedule overruns, claims, change orders
· Broken supply chain
· Offices abandoned
· Revenue being completely outstripped by demand
· Interest rate increases
The list could go on forever, but you get the gist, an increasingly difficult situation with housing affordability delivering high levels of pain to market participants (especially if you’re a developer or a consumer).
Present cost escalation
There is light at the end of the tunnel for cost escalation in the near term to mid-term, but there is going to be continued turbulence until we get to experience a bit of calm. Let’s consider what the market needs to tackle presently:
· Low rise new construction sales are close to zero in the GTA, risk on closing and there’s no point in selling them or building them. Developers are generally waiting out this situation.
· High-rise condo sales are likely to slowly advance at a low volume while interest rates sort themselves out. There will be opportunities for certain projects based on the right location, unique offering, and a longer construction duration. Development projects dependent upon “better times” are likely to go into a holding pattern on sales.
· Interest rate increases, combined with slow sales and productivity delays on-site are going to cause cash flow havoc for some developers, depending on when each of the aforementioned events occur.
· Securing capital for construction has become very challenging with interest rates going through the roof and Tier A bank becoming very selective on loans.
· Closing risk if interest rates stay high(er) will start to increase on condos as we move through 2023 into 2024.
Starts and yields
· Rental starts have been strong until very recently, however, interest rates, questions on how high rents can go, CAP rate erosion and constant cost pressures have and will be a constraint to starts.
· The low yields are making it difficult to justify new construction without a leap of faith on the market in 4-5 years, and with all the capital out upfront. (That said, looks like help is on the way from recent legislation in Ontario)
Other struggling asset types
· Industrial demand remains high but the price tags for this asset type for both developers and prospective buyer/tenants may start to cause hesitation.
· Conversely, office demand is low, partly due to ongoing work-from-home and hybrid work policies as we all figure it out.
· Population growth will accelerate with the new Federal immigration plan set to 500,000 per year; Quebec is limiting their immigration allocation to 50,000 so that leaves another 25,000 or so to go elsewhere in Canada. Increased immigration can be seen as a challenge, but it could also serve as a boon depending on the percentage of skilled labor that arrive each year.
The good news
· Construction costs are stabilizing, the supply chain is very slowly fixing itself, housing starts are going to be reduced 10-20%, commodity prices are coming down 4-5 months earlier than originally anticipated, and inflation is also anticipated to stabilize in 2023. There will be good opportunities for construction prices in mid-2023 and early 2024.
· More Homes Built Faster Act, 2022, a sweeping piece of legislation to increase the supply of affordable housing that does not fix all the problems on its own, but it’s a big step in the right direction. If we can now source more construction labour and lower interest rates, construction will have the necessary runway to really take-off.
All things considered, construction cost escalation will likely remain in the very low single digits as there continues to be no sign of a run-on construction prices. However, that will be decided by the Bank of Canada.
So, for the near and mid-term:
· demand for housing is strong,
· supply is reducing, and
· construction costs are still high, but somewhat stable.
Will it last?
Future cost escalation
Unfortunately, by 2025 we expect to be back to construction costs that mirror the skyrocketing costs we saw in early 2022. Why? Because math always wins, and supply and demand rules.
With what we need for affordability by 2030, and that is on top of the pace of construction right now. That means Ontario needs 1.85M more homes, Quebec needs 0.62M more, BC needs 0.57M more and Manitoba needs 0.26M more.
For Ontario that is close to three times the current rate. The More Homes Built Faster Act solidifies the Ontario target of 1.5M homes over 10 years, but that is 2 times the current rate. That was BEFORE the Federal Government increased immigration targets, and therefore, we need a lot of new homes, very quickly, in a lot of places, thus placing a large amount of strain on the system.
It’s anyone’s guess what 2025 looks like, but we anticipate a return to 7-8% escalation.
If you are looking for practical strategies to address construction cost escalation, read our free Next Step Guide – Managing construction cost escalation.