Deconstructing Construction Costs

Labor and the materials typically make up the biggest costs of single-family home construction, and those costs increased significantly during the COVID-19 pandemic. Cost increases tend to be reflected in higher sales prices, making homes less affordable.

Before the pandemic, the Producer Price Index, or PPI (see sidebar), for construction services and goods (in other words, labor and materials) increased steadily, with services facing more upward pressure than goods (Figure 1).

After a brief downturn in the initial stages of the pandemic, the PPI for construction goods increased rapidly starting in early 2021, reaching double digit year-over-year (YOY) growth in March 2021 (Figure 2). While growth moderated in the latter half of 2022, falling to single digits in December 2022, the index remains well above its long-term average.

The PPI for construction services moderated in the initial stages of the pandemic, then increased sharply in the first half of 2021 before declining. It increased again in the first half of 2022, then fell. YOY PPI growth for services peaked at over 36 percent in June 2021. The deviation between the PPI for construction services and the PPI for construction goods moderated considerably by the second half of 2022.

How Higher PPI Impacts Home Prices

Table 1 shows the percent increase in home sales price by the PPI and the proportion of construction costs to sales price. For example, if the PPI increased by 10 percent and construction costs equaled 60 percent of the sales price, the home’s sales price would increase 6 percent.

Using the same parameters, a new home that otherwise would have sold for $250,000 would sell for an additional $10,500, for a total of $260,500 (Table 2); a $350,000 new home would sell for an additional $21,000, for a total of $371,000 (Table 3); and a $450,000 new home would sell for an additional $31,500, for a total of $481,500 (Table 4).

Implications on Long-Term Affordability

All else being equal, every increase in the PPI reduces the proportion of homeowners who could afford the new home sales price. Tables 5, 6, and 7 estimate how much PPI increases would reduce the proportion of Texas homeowners who could afford a $250,000, $350,000, or $450,000 home, respectively, in 2022.

For example, assuming the PPI increased by 10 percent and construction costs made up 60 percent of the sales price, 53.1 percent of Texas homeowners could have afforded a new home with a $250,000 base price in 2022. If the PPI measured 25 percent, 49.2 percent could have afforded that home. (This analysis assumes the average 30-year fixed mortgage rate in 2022 of 5.34 percent.)

The substantial increase in construction costs over the past several years has significant implications on the long-term affordability of new single-family homes. Generally speaking, as the PPI for single-family residential construction increases, so does the sales price for a new home. This reduces the proportion of homeowners who can afford these homes. Coupled with higher mortgage rates, the rise in construction costs adds yet another affordability constraint.

Construction Costs and Sales Prices

An analysis conducted by the
National Association of Home Builders found that, on average, slightly over 60 percent of the sales price of a new home can be attributed to construction costs. The remaining 40 percent or so of the sales price is accounted for by components such as finished lot cost, financing cost, overhead and general expenses, marketing cost, sales commission, and profit. Construction costs as a proportion of the sales price of a new home varies by multiple factors, including geography, the size of the home, and the quality of materials and finishings.

This article assumes changes in construction costs do not affect other components of the sales price. However, that’s not always the case, so the calculations in this article likely underestimate the effect of changes in construction costs on the sales price of a new home.

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Dr. Losey ([email protected]) is a former assistant research economist with the Texas Real Estate Research Center at Texas A&M University. She is now a housing economist with the Austin Board of Realtors.