Slowing Housing Sales May Be
Good News For Developers

Real-estate developers and government builders have complained for years about runaway construction costs. Relief could be on the way, however, thanks to falling commodity prices and slowing housing sales.

Considering that commodity prices are notoriously volatile, it may be too soon to uncork the champagne. That is especially true for oil prices, which could start rising again if leaders of the Organization of Petroleum Exporting Countries are successful in their bid to shore up prices by convincing members to cut production.

For now, the oil-led decline in commodity prices is welcome news for real-estate developers in the public and private sectors that have struggled to respond to construction inflation, which began to outpace economywide inflation in 2004. While overall inflation in the U.S. crept up 3.3% in 2004, steel and iron prices surged 33.7% in 2004. Lumber was up nearly 16.8% that year and prices of gypsum, or wallboard, were up 20%. The price increases continued in 2005 and the first half of this year. Analysts cited a strong construction market in Asia and the U.S. and the rapid rise in petroleum prices.

Although construction inflation slowed some municipal and commercial construction, the red-hot residential market more than offset the loss, and construction spending expanded overall. Construction spending rose 11.6% in 2004 and 10.5% in 2005, according to the U.S. Commerce Department. The latest figures showed the U.S. economy spent $1.2 trillion on construction on a seasonally adjusted basis in the year ended Aug. 31.

Still, individual projects were roiled by the price increases, forcing design changes or, in some cases, cancellations. At the same time, contractors had plenty of work, especially on the residential side, which reduced the number of bidders on jobs, adding to construction costs. Related Cos., a New York developer, canceled close to $3 billion of projects in Las Vegas earlier this year, blaming construction inflation.

"It has been very challenging for contractors to correctly estimate what the cost of a job will be, so they have either had margins squeezed or seen projects delayed or cancelled," says Kenneth Simonson, chief economist with Associated General Contractors, a trade association based in Arlington, Va.

One place that has been especially hard hit by construction inflation is fast-growing Arizona. The state's Arizona School Facilities Board funded $1.4 billion for 168 new schools in the past five years. But rapid cost increases mean that money isn't enough to get the projects done and now districts are being asked to pare back the amenities in new schools to bare minimums.

Vail Unified School District near Tucson, Ariz., has built 14 schools in the past 20 years. Now, because state funding hasn't kept up with construction inflation, Vail Unified is being forced to rethink the design of some buildings, district Superintendent Calvin Baker says.

"It's becoming very difficult to build an aesthetically pleasing school" or an energy-efficient one, Mr. Baker says. The money from the state's funding formula, for instance, only provides enough for unfinished concrete block walls, rather than walls finished with gypsum and insulation. The lack of insulation means air-conditioning costs will be more in the long run. "We're building schools that are very shortsighted for energy efficiency," he says.

Some economists say change is coming and project that prices of basic commodities such as steel, oil and natural gas, which have fallen in recent months, will soon trickle down to finished construction products such as asphalt, gypsum, plastics and cement.

The biggest contributor to easing construction inflation is oil. Petroleum is a key component in materials such as asphalt and plastic and is used to make and transport items such as cement and steel. "With the decline in petroleum prices... common sense would say asphalt prices should soon retreat and also see some retreat by cement as well," says Robert Murray, vice president at McGraw Hill Construction, a New York trade publication. Asphalt, which is used on highways, parking lots, driveways and roofing, is a byproduct of petroleum.

In addition, with less residential construction, prices for gypsum "are going to come down quite a bit," predicts James Haughey, director of Research and Analytics at Reed Construction Data, a Norcross, Ga., publisher of building information and a unit of Reed Elsevier Inc. "Gypsum prices have fallen substantially in previous housing downturns." Residential construction was down 5.1% on a seasonally adjusted annual basis. That's compared with a 4.4% increase for construction projects of all types, according to the Commerce Department.

Mr. Simonson at Associated General Contractors believes prices for copper, used in electrical wires and pipes, are heading lower. Spot commodity prices for copper are already as much as 22% off their high earlier this year, and that should translate into lower prices for finished products within a month or two.

One contractor who believes it is premature to celebrate is Robert Seghetti, vice president at Acme Concrete Paving Inc. in Spokane, Wash. He has had two jobs canceled in the past two weeks because of clients who couldn't come up with the cash for higher material prices, prompting him to lay off several seasonal staff members earlier than usual.

One project was a tarmac and deicing facility at Tri-Cities Airport in Pasco, Wash. Acme was the only bidder at $11 million, almost double what the airport expected. He also has bid three times for the same taxiway job at Fairchild Air Force Base near Spokane, Wash. All three times the job was shelved because the price was too high. The first time was in the fall of 2004.

In each subsequent bid, Mr. Seghetti had to raise his price because the cost of asphalt and concrete had risen so much. Even though the scope of the job is the same, the cost has doubled to $3.8 million. In an email last week, the Air Force told him the job was off again: "Due to the budgetary constraints, slab replacement taxiway P has been cancelled. Thanks for your interest and we hope you will continue to respond to future solicitations."

"I'm expecting we may see the softening in cement as the housing market deteriorates," Mr. Seghetti says, "but it's too early to tell."

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