Download a pdf version here...
“Construction costs increased 30% again this year. A fact that is both astounding and unbelievable to developers. While recent tariffs have put pressure on raw materials costs, a shortage in construction labor is the chief driver of the rapid increase in construction prices”
So far 2018 has been an interesting year. As someone with over 15 years of experience in rental management, I’ve seen a lot, and with the exception of 2008-09 no other year has brought so
much change to our industry. We’ll discuss this from many angles for our annual recap, but our main focus for this article is to cover the painful
across the board increases in repair costs. You’ve likely heard a bit about this in the media, and while they typically refer to it as rising construction costs relative to building, we’ll quickly touch on why this also affects us on the repair side. We’ll consider the various causes, touch on where we think things will go from here, the myth many believe about contractors clamoring for our high volume of work, how politics have made their mark, and most importantly we’ll delve into the lessons we learned from our Wilmington location while dealing with Hurricane Florence.
As someone who once handled maintenance but now only catches glimpses of the repair process, I have been blown away at how much more costly repairs are these days. I mentioned the only more dramatic rental market change I’ve witnessed was in 2008, and of course that period was the complete opposite. With so many unemployed and once in a lifetime deflation, finding competent people willing to work hard for relatively low pay was like shooting fish in a barrel. To top that off costs were falling across the board. Well, things have changed… I found myself asking “how is it that I was able to handle this job for nearly half the price, and this owner isn’t furious right now?” The answer I realized, is that we don’t have many owners from 2008. Nearly every home that we managed in that period has been sold. The furious pace at which homes have changed hands means that most of our landlords weren’t able to experience those great opportunities (rents were about 35% lower so don’t get too jealous). The rest have been involved long enough to know that housing costs across the board have been on a relentless march higher. We have recently begun to see major push back though, and that’s what led to this article
That is a great segway into the fundamental problem here, and that is inflation. For nearly a decade there was constant talk about a lack of inflation, however that has not been the case in housing since 2009. We were the primary stand out in fact. Since 2009 and typically in dramatic fashion, we have seen increases in purchase prices, rents, insurance, construction costs, and more. Perhaps most importantly are the amount of fees being siphoned off from housing. Closing costs are higher, new taxes are in effect, and most importantly interest rates which have literally trended down for the past 30 years have changed direction, and fast. We discuss how interest rates impact smaller investors like us in this article… When you siphon off huge amounts of resources you can bet that costs are going to rise, not to mention the clear increase in a higher interest rate mortgage. General economic inflation is just beginning to become a serious concern, and it’s unnerving to think how that may play out in light of what we’ve already experienced. Perhaps since rental investors have been dealing with inflation for 10 years we’ll see some relief in the future, but I wouldn’t bet on it. One thing that would change things is another great recession, but obviously that’s no solution.
There is no shortage of media attention on the rising costs of construction. A simple headline scan will quickly make it clear the following are all to blame
Low unemployment – Especially in the construction industry it’s to the point of causing serious issues getting jobs done. Of course this drives up payrolls, but also causes less skilled workers to be promoted, discourages entrepreneurship which is what delivers most of our preferred local contractors, and many other secondary effects
General raw material cost increases for a host of complex reasons
Tariffs – Many of these, especially the ones that have been in effect the longest disproportionately affect housing / construction, ie steel / appliances
Inefficiency caused by low-interest rates – When the cost of borrowing is low, and especially when asset values are also high, people will take huge risks to make a small profit. Warren Buffett calls it picking up nickels in front of a bulldozer. The classic symptoms of artificially low borrowing costs are blatantly obvious right now when you know what to look for. Let’s sum it up this way. If you were considering opening a Blockbuster Video franchise and could borrow 100k at 3% with a $2000 payment, that idea would be substantially more enticing than if you had to borrow 100K at 6% with a $3500 payment. While the perils of this are obvious to all, it’s so subtle in the general economy we often fail to consider it. Case in point, one of our government chartered (basically) behemoth competitors American Homes for Rent is a 7+-year-old abomination that I believe has never turned a profit. “Profits on the Horizon for American Homes 4 Rent (AMH)“ Somehow they continue to buy up houses that you might have bought thereby driving up prices and costs, consolidate handymen we may have hired to work exclusively for them, and incompetently manage
thousands of properties that a company like ours might have efficiently managed. I sit in on their conference calls from time to time and it’s shocking how out of touch they are with this industry. I am also convinced their numbers, particularly the vacancy rate is outright fraudulent at nearly 96%. Since their tenants typically dominate the eviction docket it’s really tough to see how that’s possible though I guess an upcoming eviction with 2 months of unpaid rent could still be considered occupied? I say somehow they continue, but that’s tongue in cheek as the how is blatantly obvious, they live off nearly free money as a result of low-interest rates and rental inflation (also caused by low-interest rates). Scaling up like this usually results in better productivity, but as in this case except when it’s due to nothing other than cheap borrowing costs and subsidies. Lacking profits isn’t necessarily a terrible thing, Amazon went years without a profit after all. Well, I assure you AMH isn’t changing the world, in fact, they’re nothing but a giant parasite and their meal is sub 4.5% interest rates. “But my mortgage rate is 5%” you say? That’s because they don’t pay the same rates we do, they sell bonds that they can then roll over whenever needed so long as rates are low and investors are willing to take huge risks for nickels. As Warren Buffett said, you see who’s swimming with no trunks when the tide goes out. Interest rates are rising, that will dampen investor appetite, and I guarantee you’ll read about AMH’s bankruptcy within 5 years if it continues, and there are tons of companies just like this in a wide array of housing niches.
Rising construction costs can be directly translated to the rental industry and repairs as well. Vendors who might have worked for us instead go to work for large corporations / apartments leaving less, often subpar options for us. Having the promise of a solid backstop gives vendors the confidence & motivation to raise prices. Raw material increases affect everyone, and as mentioned the tariffs have hit homeowners in particular. The profit & loss statement for a construction company is pretty simple for the most part.
Income – Money paid by real estate owners
Minus expenses which pretty much boil down to payroll (skyrocketing), raw material (skyrocketing), insurance (steadily marching higher and already high for our industry), and often financing costs (skyrocketing).
It doesn’t take a degree in calculus to see why we felt the need to address this issue. You might also see how that equation is likely to drive a lot of potential vendors out of entrepreneurship & into the arms of corporate suitors, further exacerbating the problem people like us face.
“But you are a high volume work provider, don’t contractors fight for your business?” No, they absolutely do not. Especially in heady times like this where work is plentiful either at the corporate level or even with so many investors massively renovating old homes, would you be surprised to find that many don’t jump at the chance to fix toilets all day every day? That’s just a bit of the problem. Many vendors we call will not even speak to us because they have had so many headaches and huge delays from other managers. Our company pays huge amounts of invoices ourselves each month specifically to avoid asking our prized vendors to go months without pay, but in this business that would otherwise be very necessary. We try hard to use local small outfits because they give us the best prices and service, but financing and administration are not their strong suit. For many going months without a big check means closing up and going to work for GloboCorp Inc. Or perhaps one of the massive apartment REITs that have sprung up everywhere you look. Consequently, our approach to paying vendors so quickly via company funds is a major contributor to lower prices that you don’t see firsthand, but it’s minimal compared to the huge forces at play on the other side. The bottom line is that it is extremely difficult, especially these days, for us to find great handymen/women. In our case it’s by far the hardest part of the job.
We also must use insured, reliable, and consistent vendors. Owners often point out that their buddy had the same job done for 30% less. Well, if that vendor wasn’t insured that pretty much accounts for the 30% savings right there, as insurance in this industry is a major cost. Of course if they make a mistake you can sue them (rarely an effective solution anyway) but they’ll already have dissolved their company and gone to work for GloboCorp, and you’ll be footing a huge bill. Many cheap contractors are good sometimes, but inconsistent to the point a legitimate company like ours obviously could never use them. They also have to keep appointments, and not alienate good tenants.
Bottom line, finding good, reasonably priced vendors to do the thankless tasks that dominate our workload is extremely difficult. With that said, we can and will do better. This year came fast and furious and our top priority for 2019 will be normalizing costs as best as possible. We’re even seriously weighing the merits of an inhouse repair staff. This is no panacea as we’d have been in a lot of trouble after hurricane Florence if that was our only option, and the concern for conflicts of interest arise then as well. These challenges can be minimized though, and in general we’re weighing a lot of options.
One other issue is the new regulations regarding HVAC freon. The former chemical is no longer manufactured and the new chemical will not work in old systems. This was known well in advance so huge amounts have been stockpiled, but storage has a cost also, and as supplies are depleted the costs keep rising. Since freon leaks are the single most common repair that we deal with, it’s a major issue to say the least. Freon has never been cheap, but now the fix / replace question is harder than ever. Or, in my opinion perhaps easier than ever as continuing to refill a badly leaking system is simply paying a huge amount to delay the inevitable. Even a leak search to determine severity is $300+, so when in doubt you might as well take the leap. In years past repairing a rough system was a viable option, now it rarely is and that means $5K+ investments are becoming commonplace. If you haven’t upgraded yet, get ready. “But I got my last HVAC for $3500!” you say? Welcome to inflation… We haven’t seen a full install for that price in 5+ years.
Lessons we’ve learned from hurricane Florence – Flo wasn’t our first experience with major storms, but it was dramatically worse than all others. We touched on those challenges in an update that we sent to our Wilmington area owners shortly afterward. In that notice we mentioned that home damage was certainly a problem, but the real challenge was the damage to infrastructure. It was easy to see at that point how recovery can easily seize up, how prices are forced to rise even when dealing with good people, and generally how an event like that can cause normally level-headed people to suddenly fly off the rails in a myriad of ways. We had long time great vendors do terrible work for surprisingly high prices (pricing during a storm though is not as simple as many seemed to think), good tenants became utterly unreasonable, and a lot of people started to act like the world owed them, and it was payback time. Something as simple as updating us on the status of their home / when they’d be returning was ignored by most of our tenants and it was unbelievably frustrating during such a critical period. Just days after explaining how brutally tough the conditions were, we were fielding a number of calls from owners who decided it was a great time to scrutinize extremely minor issues. “I understand you have an accounting question about this $30 charge, but I’m currently standing in 3 feet of water in a house, and a bit light headed due to the anemia caused by thousands of hyper-aggressive mosquitos everywhere…” I joke with that example to point out that it’s been a tough time for us all. Every little thing imaginable was hard at that point. Charging phones, getting internet service, finding working computers, driving, finding fuel, decent food, printing, you name it. The cost of everything imaginable shot up. Not outright gouging, but simple supply and demand, and also conditions. We were lucky to find housing for our vendors at all, and when we did it was for $200 a night. When supplies are snapped up the second they hit the floor, costs go up no matter what. So while we kept a laser eye on what was going on, we accepted the fact that brutal conditions mean higher prices. Everything was more difficult than usual, and as a result more costly as well. Another huge issue is the increased danger after a major storm like that. Of course increased danger also increases prices, and there were few places in the US at that time that were more dangerous than the streets of Wilmington. Luckily the people were pretty well subdued, but power lines were down, trees and debris were hanging everywhere, flooding and surging water covered huge portions of the area, and staples such as medicine and access to treatment were very hard to come by. With all manners of wildlife running rampant, especially mosquitos, and huge amounts of spilled waste from various sources, infections and disease became an unbelievably dangerous risk. During this time I was also reminded of my own personal experience cleaning up after hurricane Fran where the bucket of a small tractor fell on my back and I was simply lucky that it didn’t kill or permanently injure me. When people are risking their lives they are going to charge a lot more, it’s that simple and I assume common sense that most view as reasonable. This is not hyperbole, many people did die from infection, disease, and flooding weeks after the storm. This storm in fact took many more lives than the cat 4 that hit Florida just a few weeks later. To sum up the major lessons we learned from this event, the most frustrating was that you can’t rely on others to keep level heads during an experience like that, so you had better have several back up plans, and nerves of steel. The worse a situation is, the less you can count on people to do as asked. Some will say that’s common sense but frankly I expected the opposite. Don’t expect much sympathy from anyone. While home damage is our top concern, the real problem in the immediate aftermath is a barely functioning infrastructure that makes even the simplest of tasks immensely difficult. Past experiences with people can no longer be counted on when making current assumptions. Costs and general problems can get out of hand shockingly fast and in areas you’d least expect it.
Rents also rise dramatically after a major storm like this. Even a month and a half later housing inventory is almost non-existent and that drives prices higher. While we were adamant about not gouging storm victims, we did stick to our decade-old approach of beginning our marketing 10-15% higher than where we expect to end up (pre-storm expectations), and reducing systematically from there. We however haven’t had to do many reductions lately. We’ve also seen research that shows rents after a major storm like this remain higher for at least a year. While great for landlords and will help alleviate the storm costs, it’s another very tough burden on already thinly stretched renters that is likely to lead to problems somewhere, either in the form of higher crime or simply a lower standard of living for the area. One caveat is that we’re likely to see a significant lull and we may be hitting that now. Most who needed to be placed are, many are returning to their original homes thereby boosting inventory, and things were so feverish you’d expect a cooling off for a bit.
The good news? As we mentioned these issues are not new for our industry. It’s entirely possible we’ve paid the inflation piper and now things will level off, though I doubt the same can be said for the rest of your financial world. We also mentioned in our annual update that rentals, while far from perfect are still one of the absolute safest investments you could ever make if you’re truly in it for the long-term and can handle the occasional large expense such as HVAC replacement. Rising interest rates and potential general inflation are by far the biggest non-political threats to our economy right now, and almost no investment is better suited to handle those two (again, only if you’re in it for the long term) than rental real estate. Rising rates means it’s harder than ever to own a home, and that is good news for landlords (albeit horrible news for non-owners). While inflation has driven up repair costs significantly over the past 5 years or so, we of course cannot forget that this has been a fraction (usually 5-10%) of the increase in rental income that we’ve also enjoyed as a result. So while inflation does bite on the expense side, it usually juices the far more important income side just as much.
By: Victory Property Management