Rising Building Material Costs Could Crimp Construction Gains

Demand is heating up for newly built homes, but headwinds could dampen gains in the industry.

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It would seem the winds of fortune have finally changed for the better when it comes to the construction industry.

Builder confidence edged up to a five-year high in August and permits—an indicator of future construction—rose almost 7 percent in July to their highest level since August 2008, helping cement the notion that the homebuilding industry will be a major contributor to the nation's economic growth in coming months.

Although builders broke ground on slightly fewer homes last month—starts fell by more than 1 percent according to a report released Thursday by the Commerce Department—the pullback doesn't worry economists.

"The housing market is continuing its comeback," Joel Naroff, president and chief economist at Naroff Economic Advisors, wrote in a note to clients. "These data do bounce around and the total number of houses under construction continues to rise."

With rents rising by double-digits in some markets and the fallout from the foreclosure crisis still ongoing, Naroff is particularly confident the apartment/multi-family construction sector will continue to be strong. Single-family construction is also poised for a comeback, he says, given the sharp uptick in permits.

[Read: Average Closing Costs Dip Nationwide.]

"Developers are taking out permits only if they expect to put the shovel into the ground in the immediate future," he says. "They are not doing a whole lot of speculation."

But there is at least one thing that could rain on the industry's parade: rising costs for key materials that go into building single- and multi-family homes.

"This is something that hasn't surfaced in some time," says Robert Rulla, director and lead building materials analyst for Fitch Ratings. "[Builders] are starting to feel some cost pressures from the materials side and also selectively from the labor side."

While cost pressures on the labor side are much more specific to a certain area—for instance Phoenix, he says, which has seen a recent resurgence in its housing market—cost increases in materials are much more broad-based and affect all builders.

The building materials component in the Producer Price Index released by the Bureau of Labor Statistics rose almost 2 percent year-over-year in July, and builders are already starting to see their costs rise for construction essentials such as gypsum, lumber, and insulation. Somewhat offsetting those jumps have been declines in some commodities used in building such as copper, brass, and steel.

Another obstacle builders have found themselves bumping up against in certain areas is the availability of land, in particular, developed land with streets, sidewalks, and access to sewers and other utilities.

"Land is very specific, and you can't talk about it on a generalized basis, but there are some pressures for land prices to go up, depending on the status of the land—whether it's developed, partially developed, or raw," says Robert Curran, managing director and lead homebuilding analyst for Fitch Ratings.

Thanks to the building boom mid-last decade, the supply of ready-to-go lots is depleted, he says, which means land in desirable locations is being bid up. That's only added more pressure to builders' bottom lines.

[Read: Home Remodeling on the Rise.]

In a more normal market, builders would simply raise prices to manage rising building materials and land costs. However, getting an accurate appraisal of a home's value has been a consistent thorn in the side of builders and would-be buyers alike.

Thanks to a relatively small supply of newly built homes over that past few years as the nation's construction industry ground to a halt, there isn't much for appraisers to compare to newly built homes today. Instead, they have to rely on comps in the surrounding area, which in many cases are distressed properties. That in turn lowers the appraised value of the home and would-be buyers aren't able to get the financing they need to meet the builder's asking price and the sale falls through.

"Appraisers who took a lot of heat supposedly appraising homes at higher values than was correct during the upside of the cycle have been pretty conservative if not reluctant to adjust for the current tone of market," Curran says. "The way that manifests is you come to closing and last minute [the bank] requires that you put more money down, and for people in general that's not something easy to come by especially for entry level buyers. So often the deal falls through unless the seller drops his price."

Still, with many good indicators coming out of the housing and construction industries, Curran is confident the market will finally find its footing, especially as "fence-sitters" begin to trickle in thanks to rising home prices.

Meg Handley is a business reporter for U.S. News & World Report. You can reach her at mhandley@usnews.com and follow her on Twitter at @mmhandley.