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BOW RIVER CAPITAL: OUR TAKE ON INFLATIONARY PRESSURES
August, 17 2021 | Real Estate
By: Rick Pederson, Vice Chairman, Chief Strategy Officer

The US economy at midyear is booming, but costs are moving just as fast. US CPI has jumped 5.4% in  the last year; people are worried about the price leaps in everything from used cars to their restaurant bill.  Is this kind of inflation here to stay? And how do we at Bow River see inflation factoring into our real  estate development projects?
 
The Fed is Unworried About Prices. We Partly Agree.
 
Some of the eye-popping price inflation stats being printed are attributable to “base effect,” misleading percentages that result  from comparing current data to the depressed mid-pandemic conditions of 12 months ago, such as higher airfares or hotel room  rates. Another temporary impact is used car price increases, which by themselves account for over 40% of the CPI rise.
Many commodity price trends are tied to component shortages and supply chain bottlenecks. Some of these costs are reversing  fast, while others will ease gradually over the next year. Some will remain stubbornly elevated.
 
In the construction world, the alarming growth in lumber prices has been the most trumpeted. An estimated 10% of pulp and  paper processing facilities in the US scaled back production between March and September of last year, and at the same time  wood imports from Canada were restricted. The supply squeezes and buying frenzy of this spring are now winding down. From  their May peak at $1700/thousand board feet, softwood lumber has fallen to $550 today. We expect average lumber prices of
$450 next year...about the same as 2018-2020. Sawmills are enjoying higher profits and are unlikely to increase capacity.  Housing prices aren’t falling with lumber prices – with continued homebuying strength, extra margins are going to homebuilders.
 
Steel is a bigger problem for the building industry. US raw sheet steel pricing quadrupled off of a low nine months ago and has  only come off of its May peak by a fraction. Because steel demand comes not just from construction but also from the auto,  aircraft, infrastructure, and machine sectors, even as processing capacity rebounds steel pricing is likely to hold for at least  another year.
 
Importantly, not all construction components have experienced outsized price increases. Plumbing fixtures, flat glass, hardware,  and lighting have not seen the cost increases of other materials. Ready-mix concrete, a key input to commercial buildings like  warehouses, remains plentiful and is priced only 2% above one year ago. Despite the fact that cement prices are not rising, Bow  River is paying 20% more for its concrete products at our Boise, Idaho industrial development project than we might have one  year ago. Why? Because many smaller concrete contractors in that market went out of business last year. A concentration of  the larger firms still standing may not be paying that much more for materials but a booming building market, plus little  competition, is allowing for “take-it-or-leave it” pricing. Again, higher costs able to be passed through to customers go to profit,  not to measured inflation.
 
We saw something like this more than a decade ago when the Great Recession interrupted supply lines for construction  materials. Per the Bureau of Labor Statistics (BLS-see graph below), new warehouse building costs increased about 7% over  six months starting in 2008, settling back to previous trendlines early the next year. The same is happening now, although  faster—costs to build new warehouses have jumped 6% in just four months. We expect this line to move even higher, hopefully  leveling by autumn, then subsiding into next year. But unlike the pattern of 2008-09, this time costs will not conveniently retract  to 2019 levels. Post-pandemic demand for materials and labor are running higher as the globe recovers, which in turn creates  longer-lasting stresses on materials availability. An issue not present in 2009 is today’s worker shortage. Slower growth in the  labor force and a worrying mismatch in job requirements versus worker skills will combine to drive up wage inflation.
 
Federal Reserve Economic Data - Producer Price Index by Industry:  New Warehouse Building Construction
 
Wage Gains Are the Bigger Problem.
 
Bow River is just now seeing wage inflation show up in government data and we think more is coming. Average hourly earnings  for all US workers have increased by a bit more than 3.5% in the last 12 months. Construction wages are rising faster; per June  2021 BLS data, the wages paid to production/nonsupervisory building workers are more than 5% above one year ago. We are  seeing some of the largest year-over-year earnings inflation in the roofing and concrete trades. So far wage increases in  engineering and architecture, as well as other building trades like plumbing, HVAC and electrical, are up by a digestible 3-  something percent.
 
As schools open and government stimulus wanes, hiring should pick up in the next few months, but this will hold back real wage  hikes only for lower-paid unskilled workers. The NFIB Survey of Small Business (June 2021) confirms that quality of labor is of  more concern to small business than labor cost. In construction, 60% of openings require higher-level skills -- a majority of firms  responding to the NFIB survey report “few or no qualified applicants” for needed positions. Scarcity of qualified workers will  nudge up comp for the fewer number of people out there with the right training; this labor shortage will also narrow the subset of  available contractors, pushing up bid pricing as described in our Boise concrete example.
 
Summing Up: Higher Costs, Not Runaway Inflation.
 
Bow River expects core inflation to edge above what the Fed is saying, pushing above 3% for the remainder of this year, with  only a modest pullback next year. Helping the 2021 inflation average will be moderating price gains for cars and travel, which,  we believe, will offset 1st half figures. While much of the recent construction materials price inflation will prove transitory, certain  prices will settle at higher levels for the foreseeable future. We think industry wages will not return to trend as they did in 2009  now that labor participation rates are lower, with the specific squeeze of a skilled construction worker shortage. Fewer suppliers  means higher costs ahead: our real estate team is assuming 10% higher costs on average in our project planning.
 
Importantly, we are finding that pent-up demand from light industrial tenants where we are building near Boise and Colorado  Springs is lifting rents just as fast as cost inputs—in other words, our customers are accepting the pass-through of construction  inflation. We know that rent growth cannot be indefinitely maintained, but we also believe the rate of cost input increases is  similarly unsustainable. Nor are we missing the point that our senior housing investment involves a careful matching of product  cost to price-conscious senior residents, though our focus on undersupplied small markets with a superior product will hopefully  preserve our target margins in senior facilities we develop.