Predicting the trajectory of building material prices is never an exact science, but this time around the numbers are even harder to divine. Volatile fuel prices, shortages of essentials such as concrete and plastics, and signs of a building slowdown are all conspiring to complicate economists' efforts at getting a good read on where the numbers are headed for 2006. As 2005 ended, price spikes on materials that use natural gas or crude oil in processing—such as PVC, gypsum, and asphalt shingles—reflected the impact of Hurricanes Katrina and Rita on petroleum plants and factories in the Gulf of Mexico, a situation that analysts believe will ease by the second half the year. Until then, escalating material prices and uncertainty about what's in store have big builders scrambling to sustain profit levels.

“We're getting hit with 5- to 10-percent increases on a quarterly basis from most of our suppliers—anything that uses fuel for transport or fabrication,” says Alec Stetzer, director of national accounts at Kimball Hill Homes in Rolling Meadows, Ill. Natural gas prices are up 60 percent from a year ago, and the company is on allocation for supplies of carpet and wallboard—petroleum-based products that were already in short supply before Katrina came along.

Lennar Corp. is also sitting tight. Mark Shevory, regional president for Lennar in West Palm Beach, Fla., says his company is most concerned about cost fluctuations in lumber, concrete, and drywall. The price of cement and concrete products is headed up as much as 10 percent to 15 percent this year, according to an NAHB report. “If the market slows a little, we probably won't see as large of an increase in these materials as we've seen in the last two years,” Shevory says. “We're closely monitoring them.”

For Ken Simonson, chief economist at the Associated General Contractors of America in Arlington, Va., cement is the dark cloud on the horizon. “We're still quite worried about the cement supply,” he says. “Construction demand for concrete keeps growing and domestic production does not. Nobody wants a cement plant in their back yard, and charter rates for the ships bringing it to us have gotten expensive.” The volatility of concrete and steel prices portends another year of double-digit material increases for the nonresidential and multifamily sector, Simonson says. And he speculates that natural gas shortages and a cold winter could raise the cost of insulation and roofing materials by 20 percent to 50 percent in 2006, with brick and glass prices up by 5 percent to 10 percent.

The good news? After a year or two of price hikes for lumber, plywood, oriented strand board, and gypsum, those costs should flatten out or sink 10 percent, he says, as the result of more production capacity and a reduction in demand as the market cools.

HOME BUYER PASS-THROUGH Material price increases alone, which represent 30 percent of a house's cost, will add about $7,000 to the cost of building a typical $300,000 home this year, says NAHB economist Michael Carliner. Tack on today's steeper costs of transporting materials to the site and a widespread shortage of labor, and the National Association of Realtors predicts that even if the housing market slows in 2006, new-home prices will rise 7.3 percent, compared with 5.5 percent in 2005 and 3.9 percent in 2004. “Higher building costs are the single biggest reason we expect the appreciation of new homes to rise,” says Walter Molony, public relations director at the NAR. He notes that those figures are skewed downward because the highest concentration of construction activity is in the lower-cost markets of the Midwest and South.

Yet as rising costs converge with a flattening real estate market, something's got to give. At least in price-sensitive markets, it's likely to be gross margin. “In Houston, a pretty competitive area, everyone's margins are going down,” Stetzer says. By contrast, “In Sacramento, Las Vegas, Florida, and Chicago, you can almost name the price. We can mark up a little to absorb rising costs, but in tighter markets it's very difficult.”

Despite Florida's booming housing industry, Doug Guy, president of Morrison Homes' Jacksonville division, expects profits will slip as costs creep up. “The pricing relief on materials that builders in slower parts of the country will get won't be seen in Florida,” he says. “Our average home went up about 8 percent in cost last year, so we're expecting at least that for 2006. We're going to feed off the competition and demand. We'll look at what type of margin we're willing to accept on price. I'd say we're looking at basically a 2 percent erosion.”

Construction costs are pressuring big builders to leverage their size and efficiencies more than ever. With 80 home building divisions, Lennar occasionally uses commodities price indexing to lock in the cost of lumber for months at a time. This year the builder is also stepping up efforts to reduce the building cycle by maximizing field efficiencies and reducing the number of house plans it offers. “We're hoping that through a combination of market conditions and profit improvements, we can maintain our cost structure and even perhaps drive it down in 2006,” says Shevory.

COUNTERBALANCING FORCES Another variable in home buyer tolerance to price increases is mortgage rates. A rise in rates this year would create all the more headwind for home prices—particularly for first-time buyers who don't have equity to trade in. However, Eric Belsky, executive director of the Joint Center for Housing Studies of Harvard University, says home prices are rising roughly on par with consumer income, and that builders will still have pricing power. “In some markets, such as Boston, pricing power will be curtailed significantly,” he says. “But even though the net income builders earn will be reduced because they have to absorb additional materials costs, they'll still be able to benefit from the rising value of the land they locked into at an earlier date.”