The Perfect Storm - Part 6
Communication: The Key To Dealing With The Rising Market
Builders and Building Contractors are trying to figure out how best to maneuver through the dilemma rising lumber material prices are currently creating for them. There are different dynamics depending if you are in the single-family residential or the multi-residential/light commercial market, but both segments have to deal with the challenges this fast moving lumber market creates. Part VI of The Perfect Storm will be dedicated to exploring how professional builders are trying to cope with the volatile lumber market just when the energy has returned to the lifeless building industry.
First of all, everyone is excited about the booming multi-family market and single-family housing rebound. The surge in activity has the entire building industry abuzz. Virtually everyone I have talked to over the last few months is expecting to increase their business in 2013. The difficulty each and every one of them face is how best to maintain profitability as costs escalate. And, while this article will focus on the impacts associated with the spiraling lumber market, contractors are faced with rising construction material costs almost across the board. Other materials that are increasing include concrete, drywall, insulation, roofing, paint and plastic products, just to name a few. The severity of their impact is typically not as problematic for a builder as lumber because they represent a smaller portion of the overall price of construction but they all add up to put significant pressure on the builders bottom line. The common thread, regardless if you build single family homes, apartments, assisted living or student housing developments, is the impact rising prices have on an existing budget for a given project in your pipeline. And, depending on how and when that budget was developed current cost realities can be excruciatingly painful.
Lets take a quick look at a scenario to see the effect this running market is having on a rough framing material budget. We will use a project built by Duffy Homes, a well respected semi-custom home builder in Columbus, OH. Duffy builds a mix of single family homes and attached condominium units. We last priced a five-unit condo building in August and started construction in September 2012. The building consists of five, two-story 2,000-2,300 SF townhome-style units, excluding square footage for the basements and garages. The structure totals 10,900 SF. Using their August budget as a barometer and the milestone for the asking price for the units in a new 5-unit building in permit, you can imagine Mark Grubb’s shock when the new pricing came back this past week. The total increase for the lumber package was $16,600 — an increase of 33%. “I’m just so disappointed that we are starting to get into a recovery mode in the building industry and then along comes this lumber market run and I’m worried that it could jeopardize the hole thing,” fumes Grubb, Duffy Homes VP. “I understand supply and demand but it’s hard not to think that greed and making up for lost profits don’t also enter into it somehow. Maybe I’m a little extra frustrated right now because I’m buying one of the units in this new condo building. I send an email to our sales staff with lumber market backup of why we need to raise prices and they send me back a notice that the unit I’m buying just went up thousands of dollars. I can’t win!
Builders and Contractors who build their budgets on cost history, beware. While building in lumber price contingencies is the norm no one could add enough into the budgeting process to handle the run we just experienced. For instance, Curt Mulder, VP at Wolverine Building Group headquartered in Grand Rapids, Michigan, says his team typically adds 7-10% contingency to a lumber budget at the schematic pricing stage. So, for a million dollar framing package that would be roughly a $70,000 contingency. Let’s say the budget was built in March of 2012 as the benchmark so with contingency our total would be $1,070,000. Using our Commodity Composite Price Index*, the market on March 2, 2012 was $269. On March 1, 2013 our Index stood at $444 — an increase of 65%. Current replacement cost on that million dollar package would be $1,650,000. Ouch!!! So how can you deal with that type of increase during the bidding or negotiating stage.
For Ryan Neighbors of Neighbors Construction in Lawrence, KS outside of Kansas City, it’s about communication. “We are not in the hard bid market. We are lucky in that developers building apartments and other projects come to us because of our reputation. We understand that our job is to make them money. It is critical for us to make our customers aware of market increases and we are constantly talking with them, being upfront, letting them know what the market is doing. We track the lumber market daily and we explain the lumber side risks. Of course, it depends on how a contract is structured and negotiating a cost-plus situation with an owner certainly seems advantageous in this type of market environment. But, at the end of the day, it’s about having open and honest communication with the owner.”
It seems communication is the key whether you are in the open bid market or negotiating a project. “For us, we had to venture out into the bid market when financing dried up a few years back,” states Walt Whitlow, with Harkins Builders in Baltimore, MD. “Regardless of how you acquire the work, you better have a pretty good handle on the lumber market. We track Random Lengths and maintain our own commodity board here in the office and we share that information throughout our organization and with the owners. It’s obviously more complicated when bidding because you don’t know if your competition is in tune to what’s really going on in the market, but if you are not open and honest with your team and the customer you’re setting yourself up for a confrontational discussion about escalation that you may not win. The smart play is to treat lumber like asphalt, here’s my price based on today’s value and we are carrying a contingency of X, which will be evaluated at time of purchase and savings refunded or shared.”
For some production home builders the dynamics can be a little different. Many of them work off of “time-frame” pricing, meaning pricing is established for a certain set time, say monthly or quarterly. These programs can be structured various ways but basically, homes that are sold during that specific time-frame have lumber supplied at the established price. The builder projects a certain number of homes that they will sell to the supplier and then the supplier goes out and covers their lumber needs for those homes. That way, the builder’s lumber costs are protected on those home sales and the supplier protects himself by securing the materials. These types of programs are reserved for builders delivering hundreds of homes per year and often times involve combining materials and labor in a guaranteed turnkey package. The result may slow down the reaction to market swings but it does not insulate them completely from the volatility. It just may take a little longer to see it in the price of their homes.
“Getting a project very early on in the process is a definite advantage,” adds Wolverine Group’s, Curt Mulder. “With over 95% of our work being negotiated I think it establishes a better working relationship throughout the process. We can take that “napkin sketch” a developer gives us and present them with a reasonable budget range they can expect. Then, whether they hire an architect or we hire one, we will design to that budget. We are often heavily involved in tabling different options and value engineering ideas because it seems engineers and architects aren't seeing that stuff as quickly as we are. So, it’s like we've become a full service consultant that can ultimately build the project. When you have that type of working relationship and level of communication, everyone involved in the process becomes aware of a major issue like the lumber market going crazy like it has the last few months and it creates a better platform to help work through the obstacle.”
It is obvious that the issue of escalating material costs needs to be a discussion point during the process. “Depending on what the owner wants, whether they handle it on their side or ours, it definitely needs identified somewhere,” affirms Rusty Porter, VP of Construction for C.F. Evans in Orangeburg, SC. “I think lenders are requiring the developers to make sure that it is captured more so than us dictating it. The lenders are more sensitive to what’s going on and how they want to protect their interests in a project.”
“It has become a very complicated process,” declares Mulder. “Where we once had one guy handle a project we now have teams of people doing all that up front work. Jobs have gotten bigger and more complicated and the time-frame from napkin drawing to the 90% set can be a year or more, and a lot can happen in a year as we all know. I can tell you we've been bit a little this past year on price escalation because we've all been so spoiled in the past five years with relatively low and stable material pricing. And when materials have escalated the past few years, the overall subcontract price stayed the same either because framers lowered their price or they just didn't make profits. Now, subs are bidding to make profit because they are busy. They have the luxury of making money again.”
Curt’s last comment segues quite well into the remaining installments of The Perfect Storm when we will investigate the framing labor challenges we are facing to go along with spiraling material costs. It has certainly created the proverbial “Double Whammy” for your rough carpentry scope. It brings to mind a quote I read a few days ago from Stephan Sandherr, CEO of Associated General Contractors of America. “The days of low bids and relatively inexpensive construction costs are clearly numbered.” His comment seems prophetic if you are caught in the perfect storm - don't forget to share your story in the comments below!