When construction is very actively growing, total construction costs typically increase more rapidly than the net cost of labor and materials. In active markets overhead and profit margins increase in response to increased demand. These costs are captured only in Selling Price, or final cost indices.
General construction cost indices and Input price indices that don’t track whole building final cost do not capture the full cost of inflation on construction projects.
To properly adjust the cost of construction over time you must use actual final cost indices, otherwise known as selling price indices.
ENRBCI and RSMeans input indices are examples of commonly used indices that DO NOT represent whole building costs, yet are widely used to adjust project costs. An estimator can get into trouble adjusting project costs if not using appropriate indices. This plot of cost indices for nonresidential buildings shows how input indices did not drop during the 2008-2010 recession while all other final cost indices dropped.
CPI, the Consumer Price Index, tracks changes in the prices paid by urban consumers for a representative basket of goods and services, including food, transportation, medical care, apparel, recreation, housing. This index in not related at all to construction and should never be used to adjust construction pricing. Historically, Construction Inflation is about double the CPI, but for the last 5 years construction inflation averages 3x the CPI.
Producer Price Index (PPI) Material Inputs (which exclude labor) to new construction increased +4% in 2018 after a downward trend from +5% in 2011 led to decreased cost of -3% in 2015, the only negative cost for inputs in the past 20 years. Input costs to nonresidential structures in 2017+2018 average +4.2%, the highest in seven years. Infrastructure cost are up near 5% and single-family residential inputs are up 4%. But material inputs accounts for only a portion of the final cost of constructed buildings.
Labor input is currently experiencing cost increases. When there is a shortage of labor, contractors may pay a premium to keep their workers. Unemployment in construction is the lowest on record. The JOLTS ( Job Openings and Labor Turnover Survey) is at or near all-time highs. A tight labor market will keep labor costs climbing at the fastest rate in years.
Inflation can have a dramatic impact on the accuracy of a construction budget. Usually budgets are prepared from known current costs. If a budget is being developed for a project whose midpoint of construction costs is two years in the future, you must carry an appropriate inflation factor to represent the expected cost of the building at that time.
The level of construction activity has a direct influence on labor and material demand and margins and therefore on construction inflation. Nonresidential Buildings and Non-building Infrastructure backlog are both at all-time highs. 75% to 80% of all nonresidential spending within the year comes from starting backlog. In 2019 spending from nonresidential backlog although up only 4% reaches an all-time high. In the last three years nonresidential buildings spending from backlog is up more than 30%.
Most spending for residential comes from new starts. Residential new starts in Q1-2018 reached a 12 year high. Spending from new starts in 2019 will dip slightly but is up over 100% in the last 6 years, 25% in the last 3 years.
Current indications are that 2019 backlog will be up 8%-10% across all sectors. However, while a few markets will outperform in 2019 (amusement/recreation, transportation), predicted cash flow from backlog dips or remains flat in every sector. Materials price increases have slowed or reversed (lumber and steel) and labor demand may decrease due to expected construction volume declines. Expect 2019 escalation in almost all cases to come in lower than 2018.
Residential construction inflation saw a slowdown to only +3.5% in 2015. However, the average inflation for five years from 2013 to 2017 is 6%. It peaked at 8% in 2013. It climbed back over 5% for 2016 and reached 5.8% in 2017. For 2018, residential final cost inflation indexes are up only 4.5%. Anticipate residential construction inflation for 2019 between 4.5% and 5%.
A word about Hi-Rise Residential. About 95% of the cost of a hi-rise residential building would remain the same whether the building was for residential or nonresidential use. On the contrary, this type of construction is totally dis-similar to low-rise residential, which in large part is stick-built single family homes. Therefore, a more appropriate index to use for hi-rise residential construction is the nonresidential buildings index.
Nonresidential Buildings indices have averaged over 5% per year for the last 2 years and over 4% per year for the last 5 years. Nonresidential buildings inflation totaled 18% in the last four years. My forecast shows nonresidential buildings spending in 2018 will reach the fastest rate of growth in three years, which historically has led to accelerated inflation.
Steel tariffs in 2018 are incorporated into 2018 inflation. In another article on this blog, (see steel cost increase), I calculated the 25% tariff on steel would cost nonresidential buildings 1%. Some Infrastructure could be much more, i.e., bridges 4-5%. Residential impact would be small. A 25% increase in mill steel could add 0.65% to final cost of building just for the structure. It adds 1.0% for all steel in a building. If your building is not a steel structure, steel still potentially adds 0.35%.
Anticipate construction inflation for nonresidential buildings for 2019, excluding any new tariff impact, of 4% to 5%, rather than the long-term growth average of 3.5% to 4%. Adjust for new tariffs impact.
Reliable nonresidential buildings selling price indexes have been over 4% since 2015. Some have averaged over 5% for the last four years. Construction Analytics forecast (line) for 2019 is currently 4.25%. This may move higher due to the impact of tariffs which may not yet be fully reflected in any indices.
Non-building infrastructure indices are so unique to the type of work that individual specific infrastructure indices must be used to adjust cost of work.The FHWA highway index increased 17% from 2010 to 2014, stayed flat from 2015-2017, then increased 5%+ in 2018. The IHS Pipeline and LNG indices increased in 2018 but are still down 20% since 2014. Coal, gas, and wind power generation indices have gone up only 6% in seven years. Refineries and petrochemical facilities have dropped 5% in 4 years but 2018 regained the level of 2013.
Input costs to infrastructure are down slightly from the post recession highs, but most have increased in the last year. Input cost to Highways are up 4.7% and to the Power sector are up 5.8% in 2017. Work in Transportation and Pipeline projects has increased dramatically in 2017 and 2018.
Infrastructure power indices registered 2.5% to 3% gains in 2017 and again in 2018. Highway indices increased 5.6% in 2018. Anticipate 4% inflation for 2019 with the potential to go higher in rapidly expanding markets, such as pipeline or highway. Refer to Infrastructure Indices.
Watch for unexpected impacts from tariffs. Steel tariff could potentially add 5% to bridges. Also impacted, power industry, pipeline, towers, transportation.
- Long term construction cost inflation is normally about double consumer price inflation (CPI).
- Since 1993 but taking out 2 worst years of recession (-8% to -10% total for 2009-2010), the 20-year average inflation is 4.2%.
- Average long term (30 years) construction cost inflation is 3.5% even with any/all recession years included.
- In times of rapid construction spending growth, construction inflation averages about 8%.
- Nonresidential buildings inflation has average 3.7% since the recession bottom in 2011. It has averaged 4.2% for the last 4 years.
- Residential buildings inflation reached a post recession high of 8.0% in 2013 but dropped to 3.4% in 2015. It has averaged 5.8% for the last 5 years.
- Although inflation is affected by labor and material costs, a large part of the change in inflation is due to change in contractors/suppliers margins.
- When construction volume increases rapidly, margins increase rapidly.
- Construction inflation can be very different from one major sector to the other and can vary from one market to another. It can even vary considerably from one material to another.
The two links below point to comprehensive coverage of the topic inflation and are recommended reading.