Construction Prices are Making BRRRR Investments (and The Home Depot) Deeply Unprofitable

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It’s not just you: The cost of construction—be it on rehabs or new builds—has gone through the proverbial roof. 

Early in my career, I was consistently making the same mistake that just about every new real estate investor (and many seasoned ones) makes: budgeting too little for rehab. Then, after I had finally got that (mostly) under control, material and labor costs started skyrocketing faster than I was keeping pace, and once again, I had to reorient my construction budgets. 

And this time around, it’s not like the spike in lumber costs during the middle of 2021. This rise is across the board (pun sort of intended).

Further, it’s much worse than inflation has been in general. Inflation, at least according to the CPI, peaked at 9.1% in June 2022 and is back down to 3.7% as of August 2023. Unfortunately for us in real estate, construction-related expenses have gone up much more than that.

According to Ed Zarenski, the Final Demand PPI, which “represents contractors’ bid price to client [and] includes labor, material, equipment, overhead, and profit,” increased an astronomical 19.9% on nonresidential buildings in 2022.

For residential buildings, it was 16.1% in 2022. Both have trended down since then, but overall, prices are much higher than they were in 2021 despite the shocks in the supply of lumber that year. Furthermore, construction prices have gone up much more than other goods during that same time period. 

Market Ramifications

As your Econ 101 textbook will tell you, all things being equal, when prices go up, demand goes down. Thus, it should not be surprising that Home Depot had the most disastrous quarter in its history at the beginning of this year. 

As Retail Brew notes, “The Home Depot last month missed revenue expectations in historic fashion—it was the worst quarter for the company in 20 years as consumers did away with large home improvement projects.”

In Q1, revenue dropped 4.2% year over year.

Lowe’s—Home Depot’s primary competitor—did better. Even still, according to the article, “the company lowered its outlook for the rest of the financial year.”

What may be more concerning for the economy, on the whole, is how many homeowners intend to delay or scale back home improvement projects they were planning to do. According to a survey by Discover Home Loans earlier this year, ”Inflation is significantly impacting homeowners’ desire to undertake home improvement projects, with 59% of survey respondents choosing to postpone their projects and 26% saying they will reduce the scope of their projects in the face of increased costs.”

I suspect a survey of real estate investors might find a similar result.

We can definitely see this with regard to new construction, which is down. As the Census Bureau notes, “Privately-owned housing units authorized by building permits in August were at a seasonally adjusted annual rate of 1,543,000. This is 6.9% above the revised July rate of 1,443,000, but is 2.7% below the August 2022 rate of 1,586,000.”

This is actually quite a bit better than it was in January of this year (and better than I personally expected it to be). Still, it’s significantly below where it was when COVID hit and way below where it was before the Great Recession of 2008.

Given new construction is down and we had a housing shortage going into COVID, we still have a housing shortage. This is the main reason why there was (and will be) no housing crash. The lack of supply is buoying prices that would otherwise dip due to high interest rates and construction costs. 

While this is mostly good news, given how expensive it is to buy and rehab a property, relatively stable prices make it all that much harder to find a good deal and for it to still be a good deal after having rehabbed it.

What Does This Mean for Real Estate Investors?

Delinquencies and foreclosures have ticked up slightly since their trough in mid-2022 but are still way below historical norms. And both sales prices and inventory are starting to stabilize. 

The real estate market overall looks relatively healthy. There are still major issues in the U.S. economy that could lead to a recession or continued stagnation (high interest rates, low savings, massive federal debt), but at least the real estate market looks substantially more stable than it did six months ago.

That being said, interest rates are about as high as they’ve been in my lifetime. The average rate on a five-year ARM went over 8% last month for the first time in my career. With rates so high, real estate prices only slightly below where they were in 2022, and, as we’ve discussed, construction expenses being much higher than they were in 2021, it’s very hard to see how the BRRRR strategy can work consistently in this market.

Yes, we’re still buying some holds here and there, but they’re only the exceptional deals and, admittedly, mostly on the bet that rates will come down eventually. For that reason, as well as a general concern about the health of the American economy, we aren’t buying aggressively to hold right now.

On the other hand, there are more distressed properties than there were a year ago. And while higher construction prices make rehabs more difficult, there are still plenty of buyers out there. 

Therefore, flipping definitely works in this market. That said, I would shy away from large projects, given where construction prices are at.

For holds, though, you’re going to have to bring cash to the table. Equity deals and syndications are doable, but the no- or low-money down BRRRR deals aren’t easy to come by—and likely won’t be for the foreseeable future.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.