Lumber Prices Are Falling, but Risks Remain for the Construction Industry
The U.S. construction industry may have heaved a sigh of relief when lumber prices started dropping dramatically in June, after hitting an all-time high in May. Although the cash price for lumber is inching closer to pre-pandemic prices, challenges for construction companies remain.
While the skyrocketing price of lumber attracted a lot of attention when it went up by more than 150% year-on-year, it is not the only construction material burning a hole in the pockets of construction companies. Earlier this year, the Associated General Contractors of America issued an inflation alert triggered by the soaring prices of essential supplies.
Analysis by the group shows that price increases for goods and services used in construction have led to a more than 26% increase in contractors’ costs between June 2020 and the same month this year. Steel, for example, often integral to a solid foundation, is leading in price increases among major commodities. And the previously inexpensive oriented strand board (OSB), frequently used to sheet walls, floors and roofs, has seen its price go up by more than 500% since January 2020.
Industry Behavior and Norms Are Changing
Material costs have risen at a time when the country is starting to claw its way out of the pandemic-induced slowdown that resulted in a drop in backlog for many construction companies. And rising costs are far from the only concern affecting the construction industry. Many supplies are not only more expensive, but also harder to come by, with unusually long wait times for critical materials prolonging construction schedules and further contributing to higher costs.
At the same time, increased competition is pushing some contractors to bid on projects outside of their usual expertise. This is leading to increased scrutiny from lenders and surety providers at a time when insurance pricing is also increasing substantially. The confluence of challenges for the construction industry is contributing to substantial drops in profit margins, leading to cash flow difficulties. There is concern that fluctuating prices for integral supplies make it difficult to make a realistic bid — if contractors bid too high, they risk losing the project to their competitors; but a low bid could eat into their already slim profit margins.
Many construction companies are including a price escalation clause in their contracts to minimize the risk that spiraling costs for essential supplies make projects unprofitable. This is especially prevalent for longer-term projects where it may be difficult to secure the price for supplies like lumber and steel in advance to increase cost certainty.
Worker Shortages Persist
There is renewed hope that a return to normal, together with the Biden administration’s roughly $1 trillion plan to rebuild the nation’s infrastructure, will bring new investment and an increase in projects. But there is a great deal of uncertainty about the type of projects that will be available. The commercial construction space has been especially impacted by uncertainty as companies — now more willing to allow flexible work for their employees — determine how much office space will be needed in the new normal and adjust existing project plans.
As the construction industry contends with increased costs and shortages, both for supplies and labor, contractors should have transparent discussions with project owners.
Additionally, uncertainty about the type of projects that will become available is making it difficult for construction companies to hire and retain the workers needed for upcoming jobs. The construction industry is already facing a shortage of skilled workers, with a 2021 survey finding that more than half of U.S. companies are having trouble filling both salaried and hourly positions, and worker shortages and worker quality are a concern for more than 40% of respondents. The industry is affected by a generally aging workforce, with close to half of construction workers older than 45.
Despite the current uncertainty, many construction companies are investing in strategic hires, including project managers who are core to successful projects. The current war for talent is making this process more difficult and more expensive.
Construction Needs Increased Transparency and More Collaboration
As the construction industry contends with increased costs and shortages, both for supplies and labor, contractors should have transparent discussions with project owners, especially regarding the costs of raw materials. It is crucial for project owners to understand the current landscape from the start, including that price fluctuations could substantially affect the final cost of their project.
We are seeing more collaborative contracts, where contractors and project owners work together to secure the best possible pricing for needed raw materials, especially for the most complex projects that require significant raw materials and a long build process during which pricing fluctuations may continue.
In a more difficult market, facing tighter credit and surety conditions, contractors also need to perform greater due diligence around their subcontractors. It is becoming more important to ascertain the financial health of subcontractors and their ability to execute. Further, contractors bidding on projects outside their usual expertise should ensure they will be able to fulfill the contract expectations. Regular and consistent communication with key financial stakeholders, including their construction lenders and surety partners, remains essential.
As they revisit the costs of new projects and strive to make realistic bids, construction companies should put increased thought into mitigation strategies for risks that can be controlled. Considering the increased cost of supplies, it is important to be more diligent when sourcing materials and take into consideration potential challenges, for example a substantial delay in the delivery of a critical material that affects the build timeline.
Finally, as they prepare their bids, construction companies should keep in mind that increased supply costs will likely lead to higher insurance pricing at a time when conditions are already challenging. There is increased underwriter scrutiny, for both new applications and extensions. Underwriters are asking more questions and often will not offer coverage until they have detailed risk data, leading to a longer underwriting process. Construction companies should be prepared with data-based information prior to underwriting meetings and start placement and renewal discussions as early as possible.