Keeping an eye on building costs

Construction in Germany is becoming more and more expensive – for many reasons. Proliferating legal requirements are increasing building costs without really adding value to properties. The standardisation of building processes could deliver cost benefits, but it is unpopular. And different building codes for each of the 16 German states make the already lengthy approval process even more complicated for project developers.

All of these arguments carry weight. As a property asset manager and trustee for the savings of many private investors, as well as the capital of institutional investors, Union Investment must deal above all with the negative consequences of rising construction costs – and find ways to cushion them.

5 percent increase in construction costs

First, the facts: the German Federal Statistical Office reports that construction costs for new office buildings rose by 4.7 percent in Q4 of 2018 compared to the same period in the previous year. Costs for commercial buildings were up by 4.8 percent. Historically speaking, this number is rather high. Only 2007 saw higher percentage increases. Moreover, the figures show that price increases have accelerated. In Q4 of 2017, the rate of change compared to 2016 was a percentage point lower.

There seem to be few signs that the trend is weakening. And there’s another clear reason for the rapid rise in building costs: the German construction sector is being stretched to its limits. In November 2018, building firms had contracts totalling €6.4 billion, nearly 14 percent more than in the same month in 2017 – and the highest level of orders received in a November for the last 25 years.

Effects on the real estate investment market

So how does this affect Germany’s real estate market? The high construction costs are coming at a time of enormously high prices – fueled by high demand, low inventory and extremely low interest rates. And even though for the time being the domestic economy is in good shape, businesses are expanding and rents for offices, warehouses and production facilities have been rising – yields cannot entirely keep pace with the price increases. While buyers of finished, fully leased new buildings can make their purchase decisions based on existing information about the asking price and rental income, the situation is significantly more complicated with development projects.

On the one hand, real estate asset managers looking to acquire properties with acceptable yields in Germany are increasingly purchasing them in an early project phase. On the other hand, unpredictable rises in construction costs make it difficult to accurately calculate project acquisitions. Investors are joining construction projects earlier and earlier, sometimes years before completion, which makes that difficult – and certainly adds to the risks. For that reason, investors need to keep an eye on rising construction costs, especially when acquiring projects. The closer and more trusting the relationship with the project developer – and, further down the line, with the tenant – the greater the chances of managing the situation and taking action.

Solutions for real estate asset managers

This begins in the medium term by setting fixed prices and fees in construction and planning framework agreements – of the kind we regularly use for tenant improvements. For major construction projects in Germany and abroad, however, this also means reviewing alternative tendering and planning processes and customising them to individual projects. This could include cost and fee models, partnering, separate tendering for each trade or package contracts, and of course a traditional main contract agreed with the general contractor including a guaranteed maximum price.

And regardless of which tendering process is chosen, we believe it is essential to involve the construction companies early in the planning process. Our experience has shown that this significantly reduces the risk of additional charges at project end. Likewise, it preserves a high degree of transparency about the contracted services for both the client and the suppliers. Transparency builds trust – the prerequisite for building long-term strategic partnerships between contractors and owners that last beyond economic cycles. Finally, being open to new ideas pays off: more cost-effective, high-quality building materials, for example, or modular construction methods, or hybrid buildings made of wood and concrete.

Combining these approaches can successfully keep building costs down – to the benefit of all partners.

Best regards,
Martin J. Brühl
Chief Investment Officer (CIO) and Member of the Management Board
at Union Investment Real Estate GmbH

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