Market Values of Real Estate May Drop, But Construction Costs Don’t

In CAM Library, Commercial Market, Construction by Patricia Staebler

I am thrilled to have a guest blogger on my appraisal blog! Many thanks to Jill Goodman, Editing and Production Coordinator at RS Means, a Division of Reed Construction Data for her expertise. I hold Reed Construction Data and the team at RS Means in such high regard for the added value they add to our industry. They have truly set themselves apart as a leader!

Market Values Drop, But Construction Costs Don’t

It might seem that if the market value of a property goes down, then the cost to replace it would go down, too, but that is not the case. The cost of goods depends on supply and demand. Recently, buildings are in less demand than the materials used to construct them. Although the market value of real estate has gone down, construction costs continue to rise.

Some variables that affect market value can be volatile. Witness the sharp economic downturn that brought an abrupt halt to rapidly rising property prices in 2008. In boom times, builders were building prolifically—creating a glut when the economy collapsed. Supply exceeded demand. Prices fell. And then there are the subjective variables that are always in play determining market value: building aesthetics, desirability of the neighborhood, or even the view. Yet, whether a building affords a view of the ocean or a view of the parking lot, the same building still costs the same to construct.

The three main components of a construction cost estimate are material, equipment, and labor. Materials are a commodity, so, to more accurately gauge their cost fluctuations, it is helpful to look at worldwide economic conditions. Currently, for example, while the U.S. economy stagnates, China’s soars, pushing up the demand for building and manufacturing materials. Labor costs and overhead and profit are domestic issues and can vary regionally, but they have not declined; skilled workers demand a living wage.

Another reason replacement cost may be more than market value is economies of scale. This means that the cost per unit is less if purchased in large quantities. If the original building (or buildings) was a very large-scale project, and the replacement project is smaller, then the contractor loses the economies of scale advantage and his unit costs will be higher.

One place where construction cost estimating is unique to each contractor’s business needs is in the contractor’s overhead and profit. The engineering staff at RSMeans adds standard mark-ups to its cost models, but what each contractor adds depends on his needs and current market conditions. As Barbara Balboni, editor of RSMeans Square Foot Costs points out, when there is plenty of work, there may be less competition, and contractors may not skimp on their markups; when there is very little work, competition increases, and they may cut their overhead and profit to lower their bid in hopes of obtaining work. This may result in slightly lower total construction cost. It does not have direct impact on the cost of existing real estate.

Economic conditions, the most important variable in determining material, equipment, and labor costs, are largely quantifiable and completely objective. Also, construction materials and equipment are in worldwide demand, providing some stability, since buoyant economies counteract sinking ones. On the other hand, the variables that determine market value are local and may be volatile and subjective. Since the crash of 2008, people worry about losing (or have lost) their jobs, properties have been foreclosed on, and banks are reluctant to lend. There is more than economic instability at work here—there is fear. Add to this the always-present subjective buyer’s perspective and it’s easy to see how market values can fluctuate greatly. Construction cost variables are more stable.

This blog is a great tool to once again explain my clients, why the market values of their properties decreases, while the replacement cost increases.
As always, thank you for following my blog site and if you have any questions feel free to email me or leave a comment.

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