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Tim Hughes: Adjusting to Escalating Construction Costs 

We are in a prolonged hypermarket that has legs, because it wasn't built on a temporary macroeconomic event.

Dallas is fortunate at the moment, as commercial real estate is in a “hypermarket” due to the abundance of construction projects underway. As a result, our industry is experiencing macro and microeconomic influences to construction costs.

In the construction business, there is a high demand for quality subcontractors without the corresponding supply, which is escalating prices. Despite the increase in demand of subcontractors, it doesn’t benefit the general contractor to hire just any subcontractor available. These relationships and job opportunities are built off of trust and previous successful work experiences. So, from both a developer’s and consumer’s perspective, it is in the real estate industry’s best interest to pay up for quality.  

In the past, we’ve had temporary demand spikes, like when China was buying all of the steel or after Katrina when an abundance of lumber was needed to rebuild an entire region. Now, we are in a prolonged hypermarket that has legs because it wasn’t built on a temporary macroeconomic event. The labor market will rebalance in time with the addition of quality subcontractors, but for now, the real estate industry has to adjust to the escalating construction costs.  

To adapt, there are two common approaches on how to secure quality contractors and also secure the best prices for all costs associated: the Design-Bid-Build method or negotiating directly with general contractors. Although both are commonly used methods in procuring construction services, identifying the correct one to use in your current market can substantially differentiate the outcome of a project’s costs, timing and quality.  Through the construction arm of Falcon, I have experienced firsthand the significant difference in results, particularly within the multifamily development and the retail markets. 

When procuring construction services in commercial real estate, the more traditional method of the two is the Design-Bid-Build (DBB) method. This is when the owner hires an architect and consultants first to create the project, then issues the project out to bidders to select the best price. The idea behind this approach is that by the owner submitting the project out to the marketplace at this stage, they will have the best chance of securing the best price. That worked well at one point and still does in particular markets, like the retail market, due to the ample supply of trades out there to do it.

However, I have noticed a significant shift in the industry toward negotiating directly with the general contractor, especially within the hyperactive multifamily development market. While leading the construction management of a midsize multifamily project in Allen for an institutional investor, Falcon was tasked with procuring the services to build the project and we used the direct negotiation strategy. Compared to the DBB approach where you send out the Request for Proposal—the “bid”—to general contractors after the project has already been designed, we distributed the RFP prior to the building’s design having been completed. For this particular project, negotiating with a general contractor first proved to be successful process in many ways, including the end result of being financially beneficial for our investor. 

First, we were able to interview several prominent general contractors with relevant multifamily experience and select a team to begin laying down the budget parameters for each step of the build earlier in the planning stage. That way, we were able to mitigate a lot of the risks of unforeseen cost overruns in the project. By hiring a general contractor first, I’ve seen developers save significant amounts of time and money by incorporating the general contractor’s input into the timing and the feasibility of certain aspects of the project. 

Second, because the price is insured by the negotiated guaranteed maximum price (GMP), there is a transparency that provides a collaborative, open-book process. Not only does the GMP provide the general contractor with security in compensation, but it allows the general contractor to secure subcontractors and properly staff the project. Also, the most qualified and highest quality general contractors have a working respect of subcontractors, so budgeting (or increasing the budget) for a quality general contractor should alleviate some of the issues with the shortage of subcontractors. Ultimately, in quick-growth markets like the hyper multifamily development market, the direct negotiation method helps to ensure the cost, quality and timeliness of the project stay in line with or exceed expectations. 

Although today we are seeing the best results in the multifamily development market by negotiating directly with general contractors, the Design-Bid-Build method still works in the retail market. The current results from these strategies could adjust based on changes to any one of the many market forces in the real estate industry today. It’s important to keep abreast of the current trends to be able to continuously adjust strategies to find the perfect fit for clients.

Tim Hughes is president and CEO of Falcon Realty Advisors.

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