‘It Will Get Worse Before It Gets Better.’ Real Estate Developers Keep Close Eye On Surging Energy Costs

Energy prices are swelling to new highs in the wake of the Russia-Ukraine war, and real estate developers are taking notice.

While the industry is somewhat insulated by the long timelines for commercial development, for those developers who have yet to kick off construction, delays or cancellations may be in the cards. That's especially true for the harder-hit sectors over the past two years. 

A lengthy bout of energy inflation will put the squeeze on real estate development, experts note.

"If energy costs don't stabilize pretty soon, development will start seeing an impact," Citiventure Associates President Marilee Utter said. 

That impact will not be equal, according to Utter, who is also chair of the Counselors of Real Estate.

"On the commercial development side, the impact will probably be felt more among smaller developers, who don't have the capital resources and staying power of larger firms with longer-term perspectives," she said. "Local development will start being impacted first, at risk of having to delay or cancel projects later this year."

That will especially be the case for projects that were already on shaky footing as a result of the pandemic or other market volatility, Utter said. Office projects, for example, might not pencil in a high-cost energy environment, while the robust industrial sector is expected to sustain those higher development costs. 

Still, even secure developers are wary of the uncertainty caused by volatile energy prices.

"We continue to monitor energy prices closely," Duke Realty Executive Vice President-Real Estate Operations Chris Burns said. "However, with our long lead times on developments, it's very difficult to predict how this will impact our projects."

During the fourth quarter of 2021, Duke started nine speculative development projects totaling about 2.4M SF, which brought full-year 2021 development starts to 7.7M SF, which is the highest annual volume of developments the company has ever started, responding to intense demand.

As of January, the company anticipated another robust development year in 2022, fueled in large part by land the company already owns or controls, much of which it carries or has under contract at well below market prices.

The global uncertainty — caused by the Russia-Ukraine war, the pandemic and labor shortages, to name a few factors — has disrupted supply chains and thrown a wild card into the equation. 

"What's happening in the world’s economies and its direct impact to the energy sector is unpredictable, and can change daily making it difficult to predict how long these price increases will last," Burns said.

For their part, residential developers will likely be more nimble in the face of higher energy costs, Utter said, as shorter timelines mean they can adjust the scope of their projects more readily. 

Residential development is less immune from the impact of higher energy costs in the longer term, especially if those costs affect consumer decisions about where to live.

"Consumers will be quite responsive about where they want to live," Utter said, noting that long-lasting energy inflation will probably favor some markets, and some parts of the country, over others. 

"Energy prices could apply pressure to people to go to warmer climates, which they already have been doing, and to go to more walkable places, even though they spread out during the pandemic," Utter said. "Energy will be only one factor, but it will be an important one for residential development, along with rising interest rates and other kinds of inflation."

The most recent inflation data paints a stark picture for energy prices, especially if elevated levels are sustained. Construction input prices for natural gas and unprocessed energy materials surged a whopping 65% and 32%, respectively, in February compared with the month prior, according to the Associated Builders and Contractors analysis of the Bureau of Labor Statistics' Producer Price Index data.

Crude petroleum prices increased most modestly for the month, but are still up a notable 13.7%. All three energy subcategories are up significantly on a year-over-year basis.

“It will get worse before it gets better,” ABC Chief Economist Anirban Basu said in a statement. 

“Not only has Russia’s assault on democratic Ukraine created supply challenges in a number of categories, including oil and natural gas, but the reemergence of Covid-19 in parts of Asia and Europe is also poised to produce additional impacts," Basu said. "While many still expect commodity prices to decline later this year, the wait has been meaningfully extended."

The war only exacerbated rising energy costs, which were seeing increases as lockdowns ended and demand rose. 

In late February, the BLS reported the PPI for energy was up 29% in January 2022 compared with a year earlier. 

Prices in the energy sector are now proving to be even more volatile than before. Brent crude, a major metric for the price of oil, touched $139 per barrel in early March, and analysts warned prices could touch $185 or even $200 as traders avoided Russian oil, CNN reported.

Yet by Tuesday, the price of a barrel of oil dropped below $100 for the first time in March. Various factors were cited, such as the prospect of higher production by other oil-producing countries, and the renewed outbreak of Covid-19 in China, which stands to dampen that country's demand for oil. Yet other experts weren't so sure the drop won't reverse itself.

"I wouldn't rule out $200 a barrel just yet," Bjørnar Tonhaugen, head of oil markets at Rystad Energy, told CNN. "It's too soon." 

Besides driving up the cost of development in the mid- or long-term, and possibly delaying projects, energy cost volatility will push real estate development even further toward sustainable projects. 

That might, in fact, be the longest-lasting impact of the current energy crisis on real estate development, according to Sara Neff, head of sustainability at Lendlease Americas.

"The upshot is that building developers will need to learn how to play more effectively in the energy space," Neff said. "For savvy real estate owners and developers, there are paths to sustainability that protect themselves and tenants from energy-price volatility, especially through renewables and energy-purchase agreements." 

Another change coming to commercial development will be the wider adoption of energy storage batteries, which will allow properties to store energy, either from the grid or renewable sources, Neff said.

Building design will need to accommodate these systems, and some developers are already doing so. Neff said that Lendlease hasn't incorporated batteries into its developments yet, but is seriously considering doing so.

Perhaps the most important change among developers when it comes to energy will be a shift in thinking, Neff said.

"Developers need to be proactive when it comes to energy," she said. "The discussion has to begin as early as possible in the development process. It used to be, let's finish the building and we'll figure out the renewables later. Now the energy market is too volatile for that approach."