How To Protect Against Construction Inflation

On today’s show we’re talking about construction budgets and how to make sure you’re insulated from construction price increases during the early phases of a project.

When you’re investing in new construction, you need to lock in expectations. You are setting expectations with your lender who is going to take a few months to underwrite the project and approve the loan. You’re dealing with investors and you’re setting expectations on the total equity investment and the rates of return.

Then along comes a year like 2020, or 2021 and construction prices are volatile. How do you set realistic expectations with your lender on the total investment? How do you set expectations with your investors when the ground is shifting beneath your feet?

This raises the question about whether we’re in an inflationary environment or not. Are the price fluctuations an artifact of short term supply constraints? It’s been clear that lumber prices have swung wildly over the past 12 months. In March of 2020, lumber was priced at $264 per 1,000 board feet. By September, the price was $985 per 1,000 board feet and by November had fallen to about half that price. Today we’re back up around $1,000 per 1,000 board feet.

Are these prices here to stay? Over the past 20 years, prices have fluctuated up and down. Energy prices are up compared with this time last year. Oil is now up to about $67 per barrel. That’s more than double the price at this time last year. We even had a short term supply glut when prices ran negative as some futures contracts expired with a shortage of midstream storage capacity.

Inflation as measured by the consumer price index is an average over a basket of goods.

If prices for materials go up, will rents go up correspondingly? Will salaries go up correspondingly or not? Which of the metrics be negatively impacted?

Modeling the future of a project that is a year away from construction becomes an exercise in Crystal ball gazing. How do you buffer your project for construction price increases? Do you assume that rents will go up or not?

So the question becomes, how do you plan your projects to be resilient in the face of inflation, and the beneficiary in the event of longer term inflation?

We’ve spent a lot of hours modelling these scenarios in our business as we put together various pro-forma estimates for our projects.

There are two questions that you need to answer.

1. What would be the impact on the IRR on a 5% increase in cost of the project? Is it still a viable project? Are your profit margins still in an acceptable range? Will your debt coverage still meet the metrics with a 5% increase in cost?
2. What happens to the cash position within the project if you’re faced with a 10% increase in hard construction, or a 5% increase in overall project cost? Do you get backed into a corner and risk running out of cash during construction?

It’s the second scenario, running out of cash that is the most dangerous to a project. You have to make sure you don’t run out of cash. That means using your leverage responsibly. It means increasing your loan reserves to protect the project. It means bringing 5% more equity to the table. If you bring 5% more equity to the table, you could theoretically borrow 5% more money if you needed to. That doesn’t mean you have to increase the cost of the project by 5% in your pro-forma. You still have your original plan based on a prudent forecast of construction costs. But if you had to ask the bank for additional funds, you have the necessary equity already raised as part of your capital raise to handle the larger loan request.

In an inflationary environment, the road can be bumpy. It will likely work out in the end and leverage will multiply your returns. But you need to design in a buffer to protect yourself from the downside risk.