Exoskeletons of scaffolding and soaring cranes mark dozens of thoroughfares across Los Angeles, signs of a development boom that is flooding the region with fresh apartments, offices, storefronts, and hotels.
But the flurry of activity, with its hunger for construction labor, is inflating the cost to build. Commercial construction costs jumped 14 percent over the past five years in Los Angeles, according to real estate firm Jones Lang LaSalle, compared with 7.5 percent nationwide.
“Where the pendulum is now, developers are having a hard time making the numbers work,” said Steven Fifield, a partner at Brentwood’s Century West Partners.
Fifield said his cost to build midrise apartment buildings has risen between 10 percent and 12 percent a year since 2012, while rents have only risen 5 percent to 6 percent annually.
“It used to be that almost everything we built we could get a 6 percent yield,” he said. “The yields have fallen substantially under 6 percent.”
The cost bump stems from a shortage of construction workers, a pool that hasn’t fully rebounded from the recession and is struggling to draw enough newcomers to replace retirees. Although California’s construction labor pool has grown since 2011 and by February consisted of 783,000 workers, that is still smaller than the 915,000 workers counted a decade ago.
“The pipeline has driven the demand and that just drives up labor costs,” said Carlos Serra, a managing director at JLL. “We just can’t find the resources, and the resources we find are very expensive. … Developers are under a lot of pressure.”
Labor costs last year climbed 9 percent compared with 0.6 percent for material costs, he said.
The growing cost burden, at least at this robust point in the economic cycle, is forcing builders to rethink strategies for making projects pencil out. Apartment developers such as Fifield are particularly prone to tricky calculations and expect rents to soon hit a ceiling and limit profit margins, despite continued demand for new housing.
Based on the number of construction permits issued in the L.A. metro area, JLL said the number of new apartment units delivered this year will spike at 11,000, but might drop to 5,050 next year and down again to 3,212 units in 2019. Unless other projects get permitted, that would reverse a growth trend that took off in 2012.
With no silver bullet to cut costs, developers are considering a variety of approaches. For Fifield, one solution was to jump ship on an apartment project his company had proposed on Vermont Avenue in Koreatown.
“Why take a risk on a new project? We’ll just sell it,” he said.
According to public records, Century West purchased the site in February 2015 for $15.4 million and sold it a year later to JIA Long Real Estate Development for $32 million. The new owner plans to build condos and hotel rooms, Fifield said, which could help recoup the investment cost better than apartments.
Century West was already far along in building another apartment nearby, K2LA, which is now almost fully leased at some of the highest rents in Koreatown. In May 2015, the company broke ground on its Next on Sixth apartment nearby, which is set to open this fall.
As the company considers new projects, Fifield said it is taking care to avoid high land costs.
“The low-hanging fruit has been grabbed or built on,” he said.
Greg Beck, vice president of West L.A.-based Champion Real Estate Co., said slimming down the size of apartment units is another method that can help, because charging lower rents for small units can yield higher profits per square foot.
“If you can make units smaller, you can lower the rents you need to get a profit,” he said. “If you do that, you are less near the ceiling and are at an affordability that captures more potential than a higher rent.”
Champion typically built units of 800 or 900 square feet in 2012, but now feels comfortable going as small as 550 square feet, Beck said. The company sold a Hollywood development site at Las Palmas Avenue and Hollywood Boulevard in September for $23.3 million that it had entitled for 225 units with an average size of 600 square feet.
One of Champion’s latest projects will avoid construction altogether. The company purchased several retail properties on Sunset Boulevard in Echo Park last month for $9.5 million and plans to modernize them.
“Between 2012 and 2014, this would have presented itself as a development site, regardless of what the underlying buildings were,” Beck said. “But construction costs are making everything more difficult.”
Trammell Crow Co. is also feeling the cost crunch.
Its La Plaza Village, under construction near Olvera Street downtown, is a mixed-used project with shops and housing. Originally projected to cost $135 million, its budget is running above $150 million because of rising construction costs, according to Alexander Valente, a Trammell Crow vice president.
“It puts a little more pressure on us to deliver,” he said.
Still, he said Trammell Crow was able to put a chunk of its overall project budget into construction because it leased the land from Los Angeles County rather than buying it outright.
“I’d rather invest money all day into the building, the improvements, than just on the land,” Valente said. “They make the whole product better.”
With construction costs expected to continue their climb, he predicted buyers would resist paying top dollar for development sites, prompting sellers to adjust their expectations or sit on property until demand rises.
Industry analysts said the pace of acquisition for development sites in Los Angeles, including open land and existing buildings, is beginning to stall.
According to real estate data firm CoStar, 117 land parcels proposed for multifamily development sold countywide in 2015, while 96 sold last year. So far in 2017, 34 have traded.
“They were paying exorbitant amounts to acquire the land,” said JLL’s Serra. “People are now being more careful and diligent.”
The good news? Analysts say the development pendulum will eventually swing back the other way. As developers lessen the load on construction companies and subcontractors, the cost of labor will begin to fall.
“All of this is cyclical,” said John Livingston, chief executive of Century City-based Aecom Capital, the development arm of construction and engineering firm Aecom. “As existing supply gets absorbed, land prices will come down, subcontractors will free up, and firms like ours will be very well-positioned to make deals.”
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