In May, Morningstar updated its inflation forecast for the 2021 Personal Consumption Expenditures Price Index to 2.9 percent. The analyst firm expects the core inflation rate for this year to be 2.5 percent. By 2025, they expect an average 2.3 percent inflation rate. This is a slight uptick from its previous forecast.
Kiplinger is forecasting this year’s inflation rate to be 5.5 percent.
According to Morningstar, car prices are driving this inflation. Kiplinger attributes it to a shortage of semiconductors. On another front, a labor shortage is driving up wages at a time when a push for a minimum wage increase is gaining favor. All of this is driving up the cost of real estate construction. Is this a long-term trend or a near-term adjustment? Either way, the stark reality for real estate developers are thinner margins, and that could lead to a slowdown in construction in a market already characterized by low supply.
Inflation in the Cost of Building Supplies
The cost of building supplies has been on the rise since June 2020. Lumber companies reduced output early last year expecting a decrease in demand due to mandatory business shutdowns and social distancing guidelines. What happened instead is that demand increased. The pandemic caused people to move out of cities and into the suburbs. That created a new wave of construction projects needing materials. With truncated supply lines and high demand, prices have gone up.
Prices have likely gone up more than they should have if builders were fighting inflation alone. Inflation plus high demand and low material supply have created exorbitant construction costs.
These costs, in return, will be passed on to home buyers leaving some people who won’t be able to afford the cost of a new home out of the market. In essence, we can expect the single-family rental market to be strong for the next few years while the residential real estate market will be
mixed. On the high end of the economic scale, housing inventory will move. On the lower end of the scale, probably not as fast.
How the Price of Lumber Will Impact Home Building
The bright side is that construction companies were considered essential businesses last year in many parts of the country, which meant they were allowed to c
ontinue conducting business while other businesses were shut down. That doesn’t mean they didn’t have their challenges. For starters, the pandemic delayed a lot of projects and the industry’s Commercial Construction Index health rating declined sharply early in 2020.
The price of lumber was one of the industry’s biggest news stories last year. It’s now more than 75 percent what it was before the pandemic. Initially, prices fell. But many people were out of work for much of last year and had extra income. Since many other businesses were shut down but big box lumber stores such as Lowe’s and Home Depot were left open and considered “essential,” many homeowners used the time off to work on home improvement projects. Extremely low-interest rates and a surge in construction projects also kept contractors in business. These factors created an unusually high demand for lumber and prices skyrocketed.
Now, lumber prices are coming back down. That will only benefit construction companies even more. As people are going back to work, the home improvement projects are slowing down. Demand for lumber is reaching equilibrium an
d home builders can enjoy better margins.
How the Price of Copper and Steel Will Impact Construction
Copper and steel have both increased in price, as well. With the case of copper, which is used as a conduit in electrical grids and alternative energy, demand should increase. If the president has his way, green initiatives will have a higher priority soon. His proposed infrastructure bill should give many contractors plenty to do. In an environment with lower-than-normal unemploym
ent, construction workers and subcontractors will welcome that work.
Steel’s price is going up because of supply slowdowns. Like lumber, there was an expectation of a demand slowing that didn’t happen.
The prices of construction materials are higher today all around than they were before the pandemic. And there is plenty of work to do. That means contractors’ expenses are higher and therefore will realize thinner margins on the projects they do take on. The prospect for more and bigger projects is still good in most places around the country. Therefore, there’s plenty of reason for optimism.
Are we at the Beginning of This Surge in Construction Costs?
While we’re beginning to see prices in lumber correcting, it may be some time before the price of steel comes down. Copper too. The infrastructure bill moving through the legislative process right now could determine a lot in terms of the price of materials over the next 3-5 years. Another thing is the current low supply in housing with high demand promises to keep the con
struction business operating on all cylinders until supply and demand reach equilibrium. That could be a few years.
Another factor to consider is the market-driven rise in the minimum wage. Democrats have been pushing for new minimum wage laws for several years. Failure to implement these laws is a moot point now that the pandemic has forced higher unemployment and many workers are refusing to go back to work unless they receive higher pay. To remain competitive, many companies are capitulating and offering higher wages.
If enough companies offer higher wages on their own, the net effect will be higher prices and a higher cost of living in areas where this occurs more frequently. A ripple effect of inflation will occur over the course of the next few years. That will likely affect every industry and business sector in the country including real estate construction. How much and when is the question.
One final thing to note is the looming possibility of more regulation. A Wells Fargo survey of construction industry leaders last year reveals the number one concern is the political and regulatory environment. Construction industry professionals were more worried about that than the uncertainty brought on by the pandemic.
There’s no doubt that homebuilders facing inflation and rising costs of materials will have to pass those costs on to home buyers. We can expect house prices to continue to climb.
Nevertheless, industry leaders are optimistic. While there have been ups and downs in the past year and a half, the road ahead looks mostly up. Where the dust will settle on construction costs is anyone’s guess, but there will be plenty of work to bid on, plenty of investment opportunities, and much profit for contractors ready and willing to ride the waves.