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[Commercial Grade] Construction Costs Expand, Profit Margins Contract

This is a weekly post by John Cicero, MAI who provides commentary on issues affecting real estate appraisers, with specific focus on commercial valuation.

Disclosure: John is a partner of mine in our commercial real estate valuation concern Miller Cicero, LLC [1] and he has the potential to be one of the smartest guys I know._ Jonathan Miller

Construction costs in New York are going up [BW] [2], way up quickly. We appraise numerous proposed projects throughout the City and the cost increases reflected by the developers’ submitted construction budgets are quite striking. A year or two ago, most cost budgets for “luxury” condominium buildings generally ranged from $350 to $450 per square foot, so far this year all of the cost budgets that we’ve reviewed have been over $500 per square foot.

There are a number of reasons for the cost increases, but the increased cost of steel production and simple demand for contractors’ services [philly.com] [3] in the wake of so much development are the main reasons. (Why this hasn’t translated into a similar increase in appraisal fees is beyond me, and a topic for a future post.)

Add that to a land cost of $400 per square foot and now you’ve got a minimal average sellout of $1,200 per square foot to make the project worthwhile. In fact, the sellout often needs to exceed $1,300 psf, since the cost budget and land costs are based on gross building area, while the sellout is based on net saleable area, typically a 10% to 15% difference.

Clearly, with the rise in development costs, the developers’ profit margins are getting squeezed, and there is little room for erroron either the development side or the sales side.

I suspect that in this type of environment, we’ll begin to see some projects falternot for lack of demand, but for inexperience on the part of the developer to manage costs and bring the project in on budget. The cost increases will serve to thin out the development field, and send the new generation of developers back to their day jobs.