April 23, 2009

Hospital project prices falling, but it is still buyer beware

  • With low bids and corner-cutting designs, you get what you pay for.
    Rider Levett Bucknall



    Until recently, the construction industry has seen significant price increases of around 7 percent to 12 percent per year, driven by both increasing demand for construction and speculation in base metals and oil. This trend of rapidly rising costs, which began in 2003, ended in the last quarter of 2008.

    With new construction starts slowing dramatically, we are now reminded of introductory economics courses and the importance of the laws of supply and demand. Demand for construction has slumped while the supply of labor and material has remained relatively static, and therefore construction costs should fall.

    The recent reversal of pricing has seen construction costs fall back to pricing levels of early 2007. From the last quarter of 2008 through the first quarter of 2009, bid prices would appear on average to have fallen by around 10 percent. We don't anticipate a return to 2008 pricing until after 2010.

    Health care not immune

    At first, health care projects appeared to be immune to the industry downturn. However, it appears this niche market is now falling in step with the rest of the economic market. Like other sectors, health care owners are looking to strategically focus expenditures towards facilities that increase and grow revenue. Planned projects that are not expected to contribute to the bottom line are starting to be put on hold.

    Owners are also paring down their overhead by eliminating non-income-producing staff and have begun outsourcing their construction planning to outside project management companies and developers.

    Source: Rider Levett Bucknall
    Construction costs in Seattle rose dramatically between 2003 and 2008, but have fallen sharply since then.

    A positive effect of the current market is more aggressive pricing. The cost of a hospital in 2008 was around $375 to $550 per square foot. We are now seeing projects coming in around $340 to $480 per square foot. While the reduction in pricing does sound attractive, it may come with increased risk.

    Competitive bidding

    A review of the market indicates that not only has the supply price of building materials come down, but contractors and subcontractors are also shrinking their margins in an attempt to win the quickly evaporating pool of available projects. In recent months, bidding has become so competitive that projects that would have received little interest in 2008 are now receiving 10 or more bids.

    In some cases, the low bidders may be taking on projects with a negligible margin in order to keep their business open. In situations like these, there is increased likelihood that low bidders are aggressively searching for ways to generate change orders throughout the course of the project.

    The low bidder may also be underestimating the cost of the work, resulting in insufficient cash flow. Without available credit to supplement the cash flow, they cannot pay their subcontractors and suppliers.

    If the low bidder is unable to continue on the project and is forced to leave, it will delay the project while a replacement is obtained. This could result in additional costs and delays to the owner.

    Low-price design

    In a down economy, owners may be tempted to "price-shop" designers. By price-shopping the designer you tend to get what you pay for.

    An adequately funded design will enable all aspects of the process to be studied. Conversely, lower design fees generally encourage shortcuts or skipped steps in the design and planning process, the by-product of which may be an incomplete set of construction documents.

    This not only leaves the door open for the bidder to underprice the construction documents from the start, it also assists the low bidder in generating change orders during construction. The money an owner saves on design can quickly be eaten away by a crafty low bidder, but a well-thought-out design can provide an excellent return on investment.

    With current construction prices not likely to rebound to 2008 prices until after 2010, some owners are electing to wait the market out and reenter when they feel the time is right.

    This strategy does create an opportunity to develop a thorough set of design documents; however, timing is the key. Projects that are "shovel ready" will be able to take advantage of the lowest pricing.

    As momentum in the market increases, projects that are only kicking off the design process will be at a disadvantage.

    Simon Squire is the principal and Christopher Burris is an associate in the Seattle office of Rider Levett Bucknall, a global property and construction consulting practice.

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