Brick: Commercial construction risks and opportunities

Download Transcript

Spencer Levy 
Given the risks it takes to put up any building, in terms of time, labor, and capital, it's critical to accurately project the future, to have foresight into a market and the global economy, into the price and availability of raw materials and workforce, into the minds of investors and tenants. And that's why now, a time of real volatility, it is important to dig into the business of construction. On this episode, perspectives on the president and future with leaders who are in the trenches every day assessing the risk and realities facing the construction industry. Our panel includes Lisa Russo, Head of Construction at the Community Preservation Corporation, a New York lender and developer founded in the 1970s. 

Lisa Russo 
We are the largest in the country and we are mission-oriented and we have a deep commitment to preserving, refinancing and rehabbing the affordable housing inventory stock. 

Spencer Levy 
And then there's Damian Wach, Vice President of PGIM Real Estate and Head of Commercial Real Estate Risk Management. 

Damian Wach 
We do pretty much the whole camera from equity, pref equity, mezzanine, and then debt lending. 

Spencer Levy 
And last, but certainly not least, Michael Hardman, Head of Customer Management at Turner & Townsend. 

Michael Hardman 
We are the largest and the best provider of cost management, project management and program management services globally for all the three segments. 

Spencer Levy 
Coming up, we offer you a seat alongside a live audience of colleagues and clients at an event co-sponsored by Turner & Townsend at CBRE's New York office in late April. We deconstruct headline issues in the construction business to help you build your knowledge base and decision making. I'm Spencer Levy, and that's right now on The Weekly Take. 

Spencer Levy 
Welcome to The Weekly Take, and we are delighted to be here today in New York City to talk construction costs, which may be the number one issue in real estate at the moment. And to help us with this, we have three terrific guests, Michael Hardman, Lisa Russo, and Damian Wach. So, Mike, let's start with you and let's just go right to it. The reason why this episode is so important is all of the volatility in the market that's due to interest rates, but more recently due to tariffs. In a few words, in summary – where are we today with construction costs as a result of tariffs, interest rates, and the current volatility? 

Michael Hardman 
Volatility was probably the right word, really, Spencer. I think we're still figuring it all out, really. It's not doom and gloom, but there is nervousness. You know, people are nervous about what they are spending, what they're buying. Supply chains are nervous, contractors are nervous. It's a little bit better than what a few weeks ago we've had some relief, but we have got a big elephants in the room still and big horizon coming up that everyone's looking at to kind of figure out what's gonna happen next. 

Spencer Levy 
Lisa, what's your current perspective on the volatility, tariffs, interest rates? How is it impacting your business? 

Lisa Russo 
It is the elephant in the room, the tariff impact, but I think when we look at it and really hone in on what is the actual impact on various trades based upon where the materials are originating from, historically, and what we could predict going forward. We also have to remember tariffs aren't new. Tariffs were introduced in the first prompt administration. They were a bit more targeted than perhaps the current scenario. But, we know how to deal with it. And then on top of that, we had a lot of lessons learned during COVID and supply chain disruptions. And many of us effectively managed our construction projects through that phase as well. So, we're lucky in a way in that having market instability is not a new thing for construction lenders. The risk has been historic for many, many years and I think we just have to use the lessons learned. 

Spencer Levy 
Damian, same question, your point of view on where we stand. 

Damian Wach 
I agree with everything Michael said. I think it's too early to tell how much of an impact for tariffs will have on construction in the U.S. But, we're having our cost lead consultants go back and reevaluate the budget particularly with respect to tariffs. The first step is – we ask three questions. What kind of construction contract is it? Is it a Stipulated Sum contract or is it a Cost-Plus P with a GMP? That makes a big difference. We're assuming that a stipulated sum contract will have more protection for the owner from import fees. The second issue is what's being bought out. You know, if the trades have signed contracts so that their budget is supported by a signed contract as opposed to a particular discipline or trade that they're still negotiating the contract between different parties, that's not bought out. If your project is 80% bought out, that means 8% of the hard costs are supported by signed contracts. And, so, from that point forward, a tariff question is almost more of a legal analysis, because the biggest issue is, well, how strong are those contracts through address, force majeure, for example? And the third question we ask up front is, is it concrete? The frame – is it concrete construction to steel wood frame, because it looks like concrete is a much safer material with these big tariffs and imported materials. So, those are the big three questions we have up front. 

Spencer Levy 
So, let me put a finer point on this. First of all, for the purposes of our show, because I hear my producer ringing in my ears, a GMP contract is Guaranteed Maximum Price. Cost Plus is what it says – it's the cost plus some other percent. So, those are the two basic types. 

Damian Wach 
Almost all commercial construction in the U.S. is one of those two.

Spencer Levy 
I am hearing some barge developers who are putting not just pencils down but shovels down. Meaning that they don't know what the cost of their materials are. Now, let me just put it right out there. Are you hearing people stopping their jobs at the moment because of these cost concerns? 

Michael Hardman 
Yeah, definitely. I wouldn't say completely stopping, I'd say probably pausing more than anything. And again, to get that much of a handle as much as we can on the contract situation, where you are with your procurements, what certainty you've got on those costs. You know, there's different ways and strategies to get around it. We are seeing clients who pull the trigger earlier on materials getting two years materials reported in stores, take the hit now rather than kind of have any uncertainty moving forward. We have seen smarter ways of procurement, which isn't a bad thing. It's not necessarily down to tariff fee, there will always be times about costs – how to get more efficiency, how to better costs, how to do things quicker and cheaper. So, tariff is now a part of that. 

Spencer Levy 
How do you see it, Lisa? 

Lisa Russo 
We haven't really honestly seen a slowdown in the lending platform that we work in at the moment. And that's because by the time it gets to us, these projects are already years in pre-development. And the financial structure is pretty well baked. And, hopefully there's been a little bit of cushion built into it to allow for inflation or some unpredictability of the market. I think an excellent case could be made that nobody forecasted where we currently are. Although if you would have listened to what was being said, you might be, well, maybe can't say you should have done. With that being said, what we are doing when the project comes to us, it's pretty much ready. We're ready to close. We are ready to start the work. So, how do we mitigate that risk? And one of the things was the request for storing materials and early deposits. A way to mitigate some of the risk exposure that contractors are seeing is that they're asking us as the lender to approve very, very large store material, funding requests, even at one closing. I've had millions and millions of dollars being presented as an exhibit in the contract saying, Linda, you're just going to approve all this because we need it. And the position that CPC is taking is, while I think that's probably a good idea, it has to be very, very specific. I really have to know the details. I need it demonstrated with backup documentation. I want to know – how are you going to protect this? Where are you gonna store it? Is it gonna be on-site or off-site? And I have to make sure that there's sufficient insurance coverage, because that's money that's going to be outside, not brought into the construction project very early on and the risk exposure can be great. In the space that we operate in, especially in New York City, most of our contracts are not GMP type, they are actually fixed, strictly in subtype contracts, which historically have been closed book, which means the contractor did not have to share with anybody ownership. Especially the lender, their subcontracts. So, when you start saying to your contractor, okay, demonstrate, give me your 80% executed subcontracts so I can validate the price, there is inherent resistance to do that because now they're showing what their actual prices are. But, that's something that we're dictating the terms are. This is something that's necessary to protect the risk to the ownership and the lender. You have to participate in the exercise. So, we're looking for higher degree of contract buyout at loan closing, and we're being as flexible as makes sense on a project reburning stored material and deposits. 

Spencer Levy 
Damian, you opened the door to what is the biggest issue at the moment, which is real scrutiny of contracts. And the scrutiny of contracts reminds me of two other case studies. One of them was COVID, when people that had business interruption insurance realized that their business interruption insurance might not cover COVID, and the other was something that does keep me up at night was the Y2K thing. You remember the Y2K thing back in the late 90s when we were writing leases in New York City. We used to put a clause in there called the Y2K clause that – the moment that the clock struck midnight on January 1, 2000, everything was supposed to stop in New York City. Every elevator, every escalator, everything would — and we had a clause in there. What would happen if?  I spent years writing that clause and you know what happened? Nothing. Now, I think this is way different than that, but I do think this is similar to a COVID moment of restores free contracts. What do you think? 

Damian Wach 
We learned a lot from COVID. I've been reviewing contracts, as you imagine, in the last two weeks. It's typically, if you use the AIA contract, and let me explain – the American Institute of Architects developed a form of contracts, and they're pretty widely used in the industry. Even if a project doesn't use AIA contracts, they at least mimic them, frankly. Anyways, the general conditions of 201, a 201 contract, Section 8 deals with a force majeure. It deals with, you know, unanticipated issues that come up during construction. The contract used to be pretty specific about a force majeure event. And, that's why, as I've been reading contracts the last two weeks, they often list various acts of God, unforeseen events, you know, hurricanes, typhoons, earthquakes, government intervention, and pandemics – that's my point. The word pandemic is now in many contracts, as the list – and so the lesson I think many contractors, subcontractors learned four years ago, perhaps in a bad way for them, is if it's not listed out, the force majeure cause have to be fairly specific. They have to have anticipated this particular type of event. Many subs were unsuccessful in arguing COVID issues as a force majeure because no one had anticipated that. So, now they've anticipated that, you see pandemic as a listed item in a force majeure clause. But, many of them, to our point today, don't necessarily mention tariffs at all, or import duties, or shipping delays, or government intervention, which all those may trigger – again, I'm not a lawyer, but they may be the right statements for a subcontractor to put in their contract. So no one really knows at this point. We're way too early. But, our take is you have to read the contract to see how specific are they with force majeure. 

Spencer Levy 
Michael, given all the uncertainty we just talked about, what advice do you give to the clients? 

Michael Hardman 
I think a lot of it is trust. And I think a lot of it ultimately does come down to a cost factor, right? You break everyone’s  attention down about cost, about viability of projects, and the cost associated with that. I think sometimes we just have to be, you know, a bit more of a partner in the whole supply chain, to be honest. I think, don't panic is a kind of key point. I think speak to the supply chain and partner properly, have a real base deep understanding of your cost and what those costs should be. I think that's how we move forward. 

Spencer Levy
Lisa, let me turn to you now on the cost of capital side. I know this panel is primarily focused on tariffs, but we've had massive volatility in interest rates, massive volatility and spreads. Tell us how the volatility and the interest rate markets have impacted you. 

Lisa Russo 
I'm an engineer, so let me just start it that way. I'm not the financial whiz in the room, but I will tell you that as the cost of capital goes up, the funding I have to complete my project goes down. And the risks associated with completing my project, unfortunately, do not coincide with that. So, I would definitely say that over the past 20 years or so, construction risk has only grown. We've layered upon layered upon layer regulation, requirements, climate resiliency, energy efficiency requirements, but the capital that's available to do these projects hasn't necessarily coincided with that. As the rates go up, the opportunities to find alternate sources for some of our funding has been presented to us. We do a lot of subsidy matching with the state and the federal government. We look for creative ways of bringing in other financial incentives to a project, perhaps a way to kind of close the gap, so to speak, is that we make the building more resilient or energy efficient. What are the requirements for that funding sauce? Let's bring it in. Sometimes it's low interest capital that can help kind of border down the funding stack to make the project doable. But, if, you know, we're going to be looking at going forward and if the cost of these projects is going to ever increase from not just the cost of the capital, but also the cost of the more materials and the services. It's gonna be problematic. I really don't have a crystal ball as to how we are going to best prepare for that, but I think we will do what we've done in the past, is we're just gonna get creative. I would look for other funding sources to help fill those gaps and to make a better built building. 

Spencer Levy 
Damian, back to you, same general question. What's some of the advice you're going to be calling today to navigate the volatility for some of these issues beyond just tariffs? 

Damian Wach 
You want to make sure you have competent developer for one, but it's really important to be seasoned to know how to adjust when something comes up, like a tariff issue. Like, you know, the windows aren't going to show up on time. You know, there could be a month delayed because of the tariff issues and they're boarded. So, having competent owner, developer and contractor is really key. We also, on the investment side, are trying to put in more safety features, increase contingencies. 

Spencer Levy 
Just define what a contingency is and what a contingency – the size of it, sometimes a contingency is five percent, ten percent, fifteen percent. Explain what a contingency in a construction contract, how that might be–

Damian Wach 
Contingency is the money you put aside to spend if things go really bad during construction – unforeseen circumstances. The general contractor typically has his own contingency, which he or she is very unwilling to defend. They're not going to test that unless they absolutely have to. And then the developer, the equity of the ownership side, has their own contingency. So, typically, the lenders and the other investors are relying on the developer's contingency. So, getting back to what we're talking about here is tariffs – is if there's a project and the electrician and the mechanical contractor or both are heavily relying on equipment from China for their contract. So, nothing's gone wrong, you know, right now, but there's just an additional risk because of the tariff issue. Some other features that we had when we're on the debt side and not the equity side, we'd like to push our equity colleagues to delay receiving their developers fee. The unspoken assumption is things go really bad and we're out of contingency, we're going to tap into your fee. So, uh, delayed development fees is another issue. Performance and payment bonds are also another tool I suppose we could work to. 

Spencer Levy 
So, you just listed a whole bunch of tools here to mitigate risk. You mentioned delaying payment of the developer fee. You said having larger contingencies. You also mentioned payment and performance bonds and these payment performance bonds. And for the benefit of the audience, just tell us how one of those works. 

Damian Wach 
The concept is, um, you want to build a building and you really like the carpenter, but there's a small firm, don't have much credit. So, you're worried that they might go under halfway through the job and then you're stuck. So, that contractor, the carpenter will go out and get a surety to bond them. The surety promises if this carpenter goes under for some reason or defaults on the contract, the surety will step in and finish the work. There's several different ways they can do that, but that's the basic concept. 

Spencer Levy 
Does the surety bond also covers the materials?

Damian Wach
Let me step back. It covers payment and performance. So, if for some reason that subcontract can't perform, like for example, the windows that they're installing are stopped in a port in China, because they can't get over here, then they default under their performance of their contract. So, then the sherry would come in and fix it. Typically they would bring in a separate trade to do the work. If the windows don't go in in time, then you can't put up the electrical, the mechanical, the sheetrock, carpeting – everything gets delayed. So you can imagine the catastrophic impact it would have on a project if the windows don't show up on time. 

Spencer Levy 
Michael, I think we've covered the tariff topic fairly well, but you covered several other topics that are going to be impacted. One that I found fascinating was on how immigration impacts certain subcontractors. So, yeah, we're talking about tariffs. Tell us about how labor may impact the construction trades. 

Michael Hardman 
Tariffs are obviously the elephant in the room, but I would say labor and the actual cost of the labor piece and the availability, as well – cost is one thing, availability is another thing – is key at the moment. We're definitely seeing domestic labor prices increase. 

Spencer Levy 
Lisa, affordable housing is your area of expertise. Tell us about some of the challenges and opportunities from your perspective of your career in affordable housing development here in New York City. 

Lisa Russo
Affordable housing is timeless. It is probably more critical today that we address. It's a nationwide problem. It's not regional. It's not a Washington DC problem or Oklahoma problem. It is a universal problem all throughout the United States. The good thing with CPC is we have a lot of experience, we’ve been doing this for 51 years. We started off as a very localized affordable housing lender right here in New York City, and we're now national. What's happening through the past years is that bigger developers, light-related, see the opportunity to invest in affordable housing. The developers, the contractors that we're beginning to work with are actually getting much savvier and much more seasoned. They're much larger in their ability to handle any type of disruptions that are being thrown at us, whether it be COVID or pandemic or tariff-related. The challenge though with it, it is a very specific market. Sometimes the affordable housing has certain requirements for supportive housing or state financing that is dictating how the space needs to look and how space needs behave. So, that doesn't give developers a lot of ability to kind of customize what the housing looks like. They kind of have to stay within a certain type of model. A lot of the projects are taking place within urban settings and there's challenges with that. But, we're dealing with a more stable or more traditional building methodology that is a little bit more resistant to price fluctuations and it has allowed us to continue to work. Even during COVID, when lots of industries were mandated to stop construction, affordable housing is deemed essential and it was allowed to continue, which was critical to our particular sector. 

Spencer Levy
Damian, global variation is very wide when it comes to materials, when it comes to labor. You can just talk us through a little bit – how that works. Why is there so much local market variation even in some base materials like wood or steel? 

Damian Wach 
There's two big factors. One is, of course, the ease of shipping. A second, believe it or not, is green buildings, LEED certification, and the other types of green building certification. There's also a remarkable difference in the contractors. General contracting is still a local profession, and major contractors have subcontractors they work with, sort of like a consortium. They generally work in one area, and they're very, very good at what they do in that area. That means you can have a wide variety of skill sets and then costs based on which city you're in. Construction is a local business in the U.S. 

Spencer Levy 
One thing we didn't touch on here, Michael, and so I'm going to ask you a two-part question, specific about asset type, and then secondly, final thoughts, but data centers are going gangbusters versus the other asset types in terms of the total amount of new construction. Do you expect that to continue, given that there are so many finished goods within data centers versus, say, an industrial building, which is much simpler, and other final thoughts you might want to share with our audience.

Michael Hardman
Yeah, sure. Do we expect it to continue? Yes, absolutely. There’s so much demand for data centers right now, powered by AI, and ultimately, it's a necessity. Final thoughts? It's just all about not panicking, being not risk averse, but holding good allowances, holding the contingency, but also just not accepting costs. You know, I would say that's my takeaway, really. 

Spencer Levy
Lisa, final thoughts, please. 

Lisa Russo
We've been here before. We have been in unpredictable, unforeseen sets of circumstances before, and we have successfully navigated it. We've learned a lot. There's a lot of lessons from the past we can kind of dust off and use again. My advice to anybody in construction risk management, know your projects, know your development team, how your construction is being made, know the players, talk about the suppliers, talk about some contractors. Talk about contingency plans. What's the plan if you can't procure this material in the price that you budgeted for? Listen, ask good questions, and then be flexible. We're not gonna stop. That's really not an option. We're gonna continue to move forward, but we're just gonna get smarter and we're gonna do it a little bit wiser and in five years from now, we're going to look back on this time and say, you know, we got through that and we'll be ready for the next thing that's on the horizon. 

Spencer Levy 
On behalf of The Weekly Take and on behalf of our friends at Turner & Townsend at this wonderful event, thank you for all being a terrific audience for The Weekly Take. Let's hear it for our panel. 

[audience applause]

Spencer Levy 
To keep on building your knowledge base, there's related content available on our website, CBRE.com/TheWeeklyTake. And in the weeks ahead, we'll be delivering new episodes to inform and help you manage your real estate thinking with tools and tactics for our time. That includes shows on workplace, residential and other sectors, and multiple investment centered topics with key strategic insights. So, stay tuned. Make sure to subscribe and share the show, and let us know what you're interested in by rating and reviewing The Weekly Take wherever you listen. You can also drop us a line through our website or by finding us on LinkedIn as well. Thanks for tuning in. We look forward to having you back next week. I'm Spencer Levy. Be smart. Be safe. Be well.