RECENTLY in Australia we have seen what may amount to a new pandemic forming in the construction industry. A pandemic of high costs, building delays, depleted workforces, and all-around general distress.
This new pandemic is having an impact on all new Australians seeking to enter the property market, whether it be a young couple looking to build their first home, or a new coming family, looking to upsize.
There are a couple of key triggers that have brought on the current state of the property market, which both can be linked to the lingering effects of COVID-19. The trends we are seeing are ultimately due to the combined pressures of a hot property market and rising construction costs.
During the COVID-19 pandemic, to stimulate spending, the government slashed interest rates to record lows, inadvertently leading to a boom in the property market as buyers looked to take advantage. Additionally, in anticipation of stagnation in the property market, the government also began providing more financial support to home buyers. This only added to the increased disposable income available to Australians that was already on the rise due to the closure of most leisure activities and the domestic & international travel restrictions. Many renters also assumed the option to forego their rent over this period, which also contributed to the outsized savings.
Social distancing procedures and lockdowns created global supply chain issues across the globe as companies became unable to operate at full capacity, or even operate at all. This led to a rise in cost for key construction materials such as Steel and Lumber, which have been up 50% and 300%+ respectively over the past 2 years. These types of price surges have not been seen since 2005.
The spike in demand combined with hot property markets & rising construction costs led to a perfect storm of issues which has created the debacle that we are currently in.
Troubles for the building industry as fixed contract come back to bite
We are now seeing a huge swell in the backlogs of building companies, but a major shortfall in workers, and available funds to complete these builds.
The dilemma for builders lies in the nature of the contracts that have become a staple in the industry. These contracts lock in the prices agreed to upon signing, stripping builders of the ability to raise them to accommodate for build cost volatility, which is dangerous for an industry with thin margins. Therefore, many of the contracts signed pre-pandemic are simply no longer profitable to complete.
“The current practice of monthly price increases to market (from 5% to 10%), is leading to the demise of the fixed price contract and the rise of the provisional sum,” Ben Robinson, Academic Director for APD Institute.
This forces builders to either conduct builds they know are unprofitable, or to simply delay projects, upsetting the end customer. For the builders that do choose to go ahead with builds, they in turn face difficulties paying the workers that they have employed to complete the job, due to the lack of profit. This forces builders to choose between using any sales proceeds to pay for the high price of materials or the cost of labour.
Paying the price of materials leads to a distressed workforce, and paying the workforce leads to unpaid suppliers, leaving builders between a rock and a hard place.
There are many notable builders/developers in Australia that have faced financial difficulties due to this issue, such as Metricon, Probuild and ABD Group. Many of these larger companies are relying on capital injections from shareholders to sustain themselves during this period, but companies who lack access to this kind of funding, are facing the very real prospect of bankruptcy.
Developers who are selling and building in the same market will be ok
“Pricing to stabilise in 2023 with lack of work for builders following a reduction of shovel ready developments that are funded, combined with more labour resources as immigration comes back and less government infrastructure projects,,” Illan Samuel, Managing Director, Samuel Property.
Asked about his views on how the current builder crisis is going to affect property developers over the next 6-18 months, Samuel Property’s Managing Director, Illan Samuel is optimistic, believing that market corrections lie just around the corner.
“I expect pricing to stabilise in 2023 with a lack of work for builders following a reduction of shovel ready developments that are funded, combined with more labour resources as immigration comes back and less government infrastructure projects”. Much of the view that selling and building in the same market allows developers to be covering rising costs with rising revenues, he adds “developers need to keep one eye on sales rates and the other in building rates, ensuring they have developments that can sustain price adjustments to reflect construction costs, together with a strong relationship with a preferred builder.”
Cost overrun the greatest risk
Ben Robinson, Academic Director for APD Institute (www.APDInstitute.com), believes that developers need to look at their feasibility model assumptions during this time. “Whilst the conventional approach to repricing construction inputs has been annually to CPI, the current practice of monthly price increases to market (from 5% to 10% p.m.), is leading to the demise of the fixed price contract and the rise of the Provisional Sum [contract], depending on the materials required.” He believes that “Certainty on construction cost overruns has become the greatest risk of them all, and will be until equilibrium in supply has returned.”
More builder insolvencies inevitable
Although, there is a possibility that the government steps in to cover the funding shortfall that many of our Australian builders have as a short-term solution, the government prefers to use long term strategies to fight the issue. To curb demand, it is likely that the government will opt to raise interest rates, in order to stifle some of the overwhelming demand created over the pandemic and relieve some of the pressure off of the industry, however in the near term – the solvency of many Australian builders is still at risk.
By Buka Njoku & Chris Wolfe, Wolfe Advisory Group.*
Chris Wolfe is the founder of Wolfe Advisory Group with over 20 years’ experience consulting to the Australian property development industry in financial modelling, feasibilities, strategic advisory and investment analysis.
