New Construction off to a Shaky Start in 2023

According to a recent GlobeSt article, the US construction industry should prepare for a 3% drop-off in construction starts (i.e. new construction projects) in 2023. This follows on from a complicated couple of years for the industry in 2021-2022, as soaring materials prices and supply chain disruptions kept developers guessing about their next steps. 

GlobeSt was reporting on data from the Dodge Construction Outlook Conference which took place in November 2022. The Dodge Construction Network provides data analytics and insights to construction executives and industry leaders across the US, and the annual conference is cited as: “the leading economic forecast event for commercial construction.”

Multifamily set to slow

As is often the case, the expected decline will affect specific real estate sectors in different ways. GlobeSt notes, for example, that the value of multifamily construction may see a large decline (around 7% when adjusted for inflation).

In their own report on the data, industry news site Engineering News Record (ENR) adds: “In the multi-family sector, starts are expected to finish the year [2022] up 16%, but will drop 9% next year.”

Mixed bag for Retail, Office and Industrial

ENR also notes that the increases in retail and manufacturing starts seen in 2022 are likely to taper off, though it’s worth pointing out that the manufacturing industry saw gains of 196% over the year.

Quoted in the article, Dodge Chief Economist, Richard Branch, noted that despite an anticipated 43% drop for manufacturing construction, “that is still historically a very strong record level of activity.”

Meanwhile the dollar value of office construction is in for a “slight decline” of 1% in 2023, as remote work trends and the tight labor market continue to put pressure on the sector.

Niche sectors still offer respite

Despite these generally downhill trends, other predictions made during the conference include ongoing strong performance from some of the niche CRE sectors we’ve seen rise to prominence in recent years. As Archinect reports:

“While traditional school construction is set to fall, life science buildings and healthcare projects, including outpatient clinics and hospitals, continue to rise.”

These are assets we’ve seen big things from over the past year, and it seems they’re set to continue attracting investors in the year to come.

Recession effects

As the above predictions show, there are still many factors in play that will influence how things shake out for the construction sector in 2023. Arguably the biggest determinant is the likelihood and severity of a potential recession.

In Branch’s words: “We’re walking the razor’s edge here. In our estimation, there is a very, very, very narrow path to avoiding a technical recession in 2023.”

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Thought Leader Cybersecurity

Risky Business: Why Cybersecurity Should be Top of Mind for CRE Professionals

Over the past year, it’s sometimes felt like the number of factors that we, as commercial real estate (CRE) professionals, need to keep track of have grown exponentially. Especially in the face of challenging market conditions

At the same time, there’s an ever-increasing need to be conversant with new technology and tech tools that help boost productivity and add value for clients. The tools available  span the spectrum from social media to drone technology, climate-savvy building tech, and even augmented or virtual reality software.

For brokers, building managers, and developers incorporating these game-changing technologies, the possibilities are nearly endless.

There is, however, a flip side to this coin. And, like many things tech-related, it’s an area where CRE professionals have often been slow on the uptake: Implementing the right cybersecurity protocols.

A growing threat

Part of the problem is the idea that cybersecurity is something that’s handled exclusively by a dedicated team, or automatically built into the software being used. While that’s true to some extent, the fact remains that the tactics cyber criminals use, and the number of incidents each year, are continually growing.

Sophisticated “phishing” attacks, which aim to get staff to unwittingly compromise system security, and ransomware are the order of the day, and, as a recent incident in Australia shows, the real estate sector is far from exempt from these threats.

Given the amounts of sensitive data passing through or stored by the CRE industry, the question we need to ask is: Are we truly prepared in the event of a breach?

New risk vectors

The first thing all CRE businesses should consider is whether all possible systems, and avenues of access to those systems, have been identified and are properly protected. 

In an excellent recent interview on cyber threats in CRE, security consultant Coleman Wolf points out that many possible avenues of attack go unnoticed. These may be linked to building control systems (think temperature or lighting management) and other smart tech, or even to the specialized Internet-of-Things (IoT) systems being used in industrial operations.

If these systems are connected to the internet, but not adequately protected, they may act as a springboard for access to other systems or data. Hackers may then be able to tap into sensitive information, including financial and personal data stored elsewhere. Alternately, simply taking control of building systems can be used as a tactic in ransomware attacks.

As the CRE industry begins to adopt new smart building technologies, and we increasingly repurpose buildings for niche markets, like the booming medical office sector, the potential for sensitive information to form part of breaches also grows exponentially.

Other trends, like the Bring-Your-Own-Device (BYOD) movement where employees use personal devices in the office, create additional avenues of attack if those devices aren’t properly secured.

Best principles

While all the above may make it sound like it’s impossible to keep track of potential threats to a building or CRE enterprise, the good news is that there are certain essential principles that can be followed to mitigate the risk.

In a recent article on cybersecurity best practices in CRE, J.P. Morgan advises that:

  • CRE companies should ensure all employees, beyond just the IT team, are aware of potential risks from phishing or ransomware and have been trained in how to minimize those risks.
  • Companies ensure there’s appropriate access control. For example, implementing multifactor authorization (MFA) and other safeguards.
  • Employees are aware of the risks of oversharing on social media (e.g., detailed information on job responsibilities and the type of data they have access to, which could make them phishing targets).

Of course, these recommendations are only starting points, and the exact requirements and level of detail needed will vary based on each firm’s unique context. There’s certainly no “one-size-fits-all” solution for CRE cybersecurity.

That said, an excellent resource to familiarize yourself with upcoming benchmarks and strategies for cyber-security can be found in PwC’s “C-suite united on cyber-ready futures” guide (you can register for free to download the report).

Securing the future

As we head into 2023 and beyond, some of the most exciting aspects of the CRE industry come in the form of new technology. There’s an ever-expanding array of Proptech tools on hand to help us close deals. Smarter building technologies ensure we meet environmental and climate imperatives while also offering something new and different for tenants and investors alike.

As CRE professionals, we’re right to be excited by the possibilities on offer. But we also need to make sure we keep security top of mind as we begin to integrate these tools.

As PwC summarizes: “Digitization makes security everyone’s business. The future promises more connected systems and exponentially more data — and more organized adversaries. With ever expanding cyber risks, business leaders have much more work to do.”

Second Period

Alec J. Pacella

Last month, we went back to school and discussed some useful financial calculations incorporated within Microsoft Excel formulas. This month, we are going to continue the school day and, along the way, weave in the theme of renovation being covered throughout this issue of Properties. Both fit perfectly for me; I teach a course at the University of Denver and just finished writing a question for the midterm exam, as follows:

An investor is contemplating installing an automated ticketing system in their parking garage. If continued to be operated with a manned attendant, the garage is expected to produce $100,000 next year and anticipated to grow $2,500 annually in subsequent years as a result of planned increases in the parking rate. The reversion value at the end of five years is expected to be $1,200,000.

The automated system is anticipated to cost $250,000 but income will increase to $125,000 in the first year, as a result of no longer needing an attendant and thus realizing lower expenses. Annual increases are projected to remain the same, $2,500 per year, and the reversion value at the end of five years is expected to be $1,500,000, based on the higher income level.

Using a discount rate of 10%, which alternative should the investor choose?

This is a classic renovation analysis – should the investor keep on keeping on, as-is, and not incur the upfront expense which will result in lower annual cash flows and lower reversion. Or should the renovation be completed, which will result in a significant upfront expense but higher annual cash flow and higher reversion. Who’s ready to go back to school?

We are going to use a three-step approach to solve this problem, dragging in our old friend the CCIM T-bar to help. The first step is to model the cash flows associated with doing nothing. The present value (PV) component would be zero, as no initial money is being spent. The payment (PMT) component would start at $100,000 in the first year and increase $2,500 each subsequent year of the holding period. And the future value (FV) would be $1,200,000. Figure 1 represents the T-bar for these cash flows. The second step is to model the cash flows associated with making the renovation. The PV component would be ($250,000), reflecting the cost of installing the automation system. The PMT component would start at $125,000 in the first year and increase $2,500 each subsequent year of the holding period.

And the FV would be $1,500,000, which is the anticipated value of the garage at the end of the holding period. Figure 2 represents the T-bar for these cash flows.

The third step is to calculate the net present value (NPV) of each T-bar, using the 10% target rate. You’ll need a financial calculator to perform this function (unless you were paying attention to last month’s column). Once completed, you will discover the “as-is” scenario has a NPV of $1,141,339 while the “renovate” scenario has a NPV of $1,172,385. At this point, the decision is simple; based on the assumptions provided, it is worth it to pursue the renovation.

We are not done yet – the university students also have a related bonus question, so why shouldn’t you? We can take this analysis one step further by using a concept known as “IRR of the differential.” Calculating it is straightforward and is the IRR of the difference between the renovated series of cash flows less the as-is series of cash flows. As you can see in Figure 3, the PV of ($250,000) is found by subtracting the PV of the renovated T-bar (Figure 2) minus the as-is T-bar (Figure 1). The PMT in year one in Figure 3 is found by subtracting the year one PMT of the renovated T-bar minus the as-is T-bar. Lather, rinse, repeat for the cash flows in years two through five and the reversions. Plug these into a financial calculator (unless, again, you were paying attention to last month’s column) and we come up with an IRR of the differential of 13.08%.

But the bonus question on this insidious mid-term exam doesn’t ask for the IRR of the differential. C’mon, these are graduate students! It asks what this concept means – because to me, this is the most important number on the board. And I’ll save you the grief. From a purely mathematical perspective, 13.08% is the exact rate at which the NPV of the as-is scenario and the NPV of the renovate $1,500,000, which is the anticipated value of the garage at the end of the holding period. Figure 2 represents the T-bar for these cash flows.

scenario are equal. You are welcome to try it but, trust me, you will come up with an NPV of $1,015,465-ish for either scenario if you use a discount rate of 13.08%. But mathematics doesn’t pay the bills, understanding the practical application is what’s important. The 13.08% discount rate is considered the point of indifference or cross-over point. At that exact rate, there is no difference between the as-is and the renovate scenario. They are equivalent decisions. But at any rate less than 13.08%, the decision swings to the renovate scenario and the lower the rate, the more pronounced the renovate decision becomes. Conversely, at any discount rate greater than 13.08%, the decision swings to the as-is scenario and the higher the rate, the more pronounced the as-is decision becomes.

Gang, our business is all about under- standing and quantifying risk, and the concept of IRR of the differential is a hallmark example. The break-even risk versus return for this proposed renovation is 13.08%. If you believe the risk associated with this proposed renovation demands a return greater than this point of indifference, you are better off to not spend the money and keep on keeping on. But if you perceive a low degree of risk associated with the renovation, and are good earning a return at some rate less than this break-even rate, you are better off to spend the money. And if you liked second period, just wait to see what we have in store for third period!

by Alec Pacella for Properties Magazine, November 2022

Top Tech partner: Harken

Staying on top of new developments and technologies is a necessary, but demanding, part of being a savvy commercial real estate (CRE) professional. With the Top Tech series of blogs, we aim to highlight some of the ones that have caught our attention while also showcasing the work of NAI partners that we feel are changing the CRE game.

Worth keeping in mind is that these blogs aren’t “partner content” or sponsored; rather they’re an opportunity for us to share tools that we think really add value for real estate professionals, from across our diverse partner-base.

That said, we are proud to add that the company featured today is the brainchild of NAI’s own Ethan Kanning. Ethan is a co-founder of valuation software company Harken, which through their “Bankable Real Estate Data” approach, has found a home with some top brokers and brokerages in the NAI Global network.

What do Harken do?

Harken’s software combines automated analytics with a built-in comps (comparables) database to simplify the process of estimating a specific property’s value. This approach allows brokers to complete a Broker Opinion of Value (BOV) in record time, which of course translates into quicker turnaround for clients and more business for brokerages and firms.

The platform’s reports are also white labeled to the broker’s company, allowing them to build their brand and establish expertise in the market.  Meanwhile, for those that need to be Dodd Frank compliant, the process is simplified by having all relevant fields already included in the BOV form. With these functionalities built-in, you can see why Harken is one of our top picks as a tool that streamlines real estate workflow.

A company with a conscience

Another thing worth noting about these up-and-coming entrepreneurs, is that Harken doesn’t draw the line at “just business.” In addition to making top-notch software, they are also committed to keeping DEI (Diversity, Equity, and Inclusion) top of mind. As one of the sponsors for the Women’s Alliance initiative  at the NAI 2022 Global Convention, they had this to say:

“We believe the healthiest, most vibrant, and sustainable company is one that focuses on DEI initiatives… A diverse team with a focus on self and other’s awareness, helps us recognize both our personal and company biases. Once these biases are understood, we can begin working together to create a more inclusive and sustainable business environment for everyone.”

With their genuine desire to make the workplace both easier to navigate and more inclusive, it’s not hard to see why we consider Harken a Top Tech partner!

Deconstructing the cost of building materials in 2022

Throughout 2021, the cost of building materials was a constant pain point for the construction industry. In an analysis by the Associated General Contractors of America (AGC) earlier this year, prices were found to have jumped over 20% between January 2021 and January 2022. The cost of specific materials like steel and plastic sky-rocketed, leaving construction firms caught between shrinking profit margins and a sharp decrease in available labor.

As we head into the second half of 2022, the question that’s top of mind for building contractors and many Commercial Real Estate (CRE) professionals is: Has the situation improved?

Well, the cost reports from the first and second quarter this year are in. Here’s how it’s looking.

Prices climbed in Q1

Overall, the first quarter was still rough for price increases, with the National Association of Homebuilders (NAHB) indicating that the cost of residential construction materials jumped 8%. One of the biggest price hikes was softwood lumber, which increased 36.7% over the period.

Meanwhile, a Q1 report from construction consultancy Linesight showed increasingly high costs for resources like copper (3.3% estimated increase from Q4) and steel (4.7 and 8.9% for rebar and flat steel respectively), accompanied by moderate hikes in cement, asphalt and limestone. Bear in mind that these increases are on top of the price surges many of these materials already saw last year.

Materials costs still (mostly) soaring in Q2

Any hopes of price relief in Q2 were also met with resistance, as costs for many materials continued a steady climb. In an analysis of recent Producer Price Index (PPI) data, AGC showed that the overall cost of inputs for new non-residential construction had jumped 1.1% between May and June alone.

The report also noted that the cost of supplies like concrete products, insulation material and some plastics had increased over the same period. In terms of other materials, however, there were bright spots, with lumber and plywood costs dropping 14.7%, while steel saw a more moderate 1.8 % retraction.

Lumber prices continue to tumble

Lumber has proved an interesting case overall, hitting record highs in 2021 that carried through into 2022. And while in March 2022 the lumber market was still showing a massive price spike, by July it had experienced a 50% decrease. At the time of writing, prices have dropped even further, adding an extra layer of complexity to forecasting and planning for new construction.

Outlook uncertain

Overall, the market remains in flux, with some prices still increasing rapidly. In a recent article covering AGC’s July Price Index analysis, Ken Simonson, Chief Economist for AGC stated:

“Since these prices were collected, producers of gypsum, concrete and other products have announced or implemented new increases. In addition, the supply chain remains fragile and persistent difficulties filling job openings mean construction costs are likely to remain elevated despite declines in some prices.”

In a separate post, Simonson pointed out that the Construction Industry Confidence Index (CICI) also dropped 17 points to a value of 44 in Q2 2022. The index, which measures sentiment amongst industry executives, only indicates a “growing market” if the value is over 50.

Heading into the rest of 2022 the situation remains uncertain, but some experts have predicted a drop-off in materials prices. Whether this translates into gains for the construction industry amid other pressures, only time will tell.

SOCIAL: How have fluctuating materials prices affected new development in your area?