Asset Class Analysis, Market Analysis

The MYTH of Surging Construction Costs & Home Prices

2021 has been an interesting year so far. The economy has rebounded better than expectations (although with heavy government assistance). One consequence of this rebounding economy is that the demand for goods, services, and materials has spiked faster than supply can catch up. The result is shortages of everything: labor, homes, lumber, cars, etc.

Those shortages are causing spikes in prices. That’s how the free market works. If demand exceeds supply, prices go up. And that surge in prices is causing some pretty high levels of inflation over the last several months. Particularly in the construction and home building industries.

Surging construction costs are causing many to declare that 1) high Home Price appreciation is justified and will continue and 2) that Builders aren’t building as many new homes a result of these increases.

Yet, like with almost every mainstream narrative about the real estate market right now, both of these assumptions are dead wrong.

Find out why in the text and graphs below.

Surging Construction Costs? Not Really

As with almost anything related to real estate in 2021 it’s extremely important to establish historical context. Just how much are construction costs increasing over the last several months? And how do these increases compare to previous ones?

To answer these questions we will consult Engineering News-Record (“ENR”), a news periodical established in 1917 that tracks the construction industry. Since then they have been measuring changes in construction costs based on shifts in labor, lumber, steel, and cement prices. Since 1991 they have been quoting this data monthly in a data set called the ENR Construction Cost Index (“CCI”).

Construction costs (including the cost of Home, Commercial, and Infrastructure) have increased by +5.9% YoY in June 2021 according to ENR's CCI.
Construction Costs increased by +5.9% YoY through June 2021 according to ENR’s Construction Cost Index.

To be sure – the CCI does a show big increase in construction costs through June 2021, measuring at +5.9% year-over-year. That’s by far the largest increase over the last decade.

However, this increase is by no means unprecedented. Construction Cost Inflation measured a whopping +7.2% YoY in October 2008. Going back further to September 2004 we see +8.0%. And digging back even further we find a +6.0% reading in May 1993.

ENR’s data shows that the cost increases in 2021 are high, but within the range of historical norms. The other thing this historical data shows is that cost spikes typically don’t last for long, and come back down to the long-term range of +3.0% fairly quickly. We will likely see a similar retrenchment in cost increases over the next couple months as lumber and steel prices continue to crash.

Home Price v. Building Cost Relationship

The issue for the US Housing Market in 2021 is that, while the cost of building is within historical norms, the cost of homes is anything but. Home Prices in America in mid-2021 are at their highest level ever in nominal terms and second highest level compared to building costs.

This is where historical context is important. For most of the 20th century home prices and the cost of building matched each other. But starting in the late 1990s and continuing through the 2000s home prices escalated way above costs.

We all know what happened next. Home prices in America had a brutal collapse from 2007 to 2012, bottoming out back to the the fundamental level of building costs.

US Home Prices in 2021 are approaching record highs compared to building costs. The last time prices were this higher compared to costs was in 2006 before the last Housing Crash.
Home Prices are back near record highs relative to the Cost of Building. (Source: Zillow / ENR)

Since the mid-2010s a very similar surge in Home Prices has taken place, with the blue line in the graph above once again surging well above the green line. The price of a home in America today is roughly 43% higher than the indexed level of building costs.

Clearly something other than building costs has been propelling home prices higher in America over the last half-decade.

Home Builders Aren’t Building?

The other common argument regarding construction cost and home prices is that home builders have stopped building new houses because of the higher costs. And if new homes aren’t being built, that creates a shortage of houses and could push prices up.

But once again, the narrative doesn’t match up with reality. In fact, the exact opposite thing is occurring. Over the previous 12 months builders in America have started construction on over 1.6 million housing units. That’s the highest level experienced since 2007.

Housing Starts in the US measure 1.6 million for previous 12 months in May 2021. That's the highest level since 2007.
Housing Starts in America are back above the long-term trend line for the first time in years (Source: US Census Bureau)

While it’s possible that some builders have put certain “started” projects on hold due to labor shortages and higher materials cost, it is likely that these paused projects will be resumed soon. After all, home prices are at all time highs while materials cost of lumber and steel is dropping like a rock.

Astute observers will look at the graph above and notice the steep decline in Housing Starts that occurred from 2008 through 2014. Some argue that this decline in building – which was the largest in US history – created a systemic housing shortage that is leading to the high prices experienced today.

Like the construction cost argument, the shortage argument is also a MYTH. I covered this in a previous post and will be diving more into the shortage MYTH in future ones.

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