Why forecasts of a steep decline in building prices may be overstated

Expect spooked investors and developers to hold onto cash, says CPC’s Mark Cleverly

Following the immediate disruption to construction sites and business caused by the covid-19 pandemic, debate and discussion has turned to what is the long-term outlook for the construction industry and tender prices.

CPC’s conversations with clients and contractors indicate that prices have not fallen yet – in most cases, labour and subcontractors have simply returned to site on the same day rates as before the crisis. With no exit strategy from covid-19 in sight, many parties across the UK are faced with higher costs to complete construction projects caused by +20% reductions in productivity, delayed programmes, higher expenditure against precautionary measures and dislocation to materials supply.

The prolongation of live projects and government support to the labour market will hold up prices throughout the summer and the autumn as contractors and clients work through the problems.

But CPC is expecting a slowdown in the pipeline for new work as developers and investors hold onto cash, resulting in lower confidence dragging on tender prices before the end of 2020. CPC forecasts prices in London / South East will fall by 3.5%, while we also anticipate input prices will follow a weaker market downwards 6% by the middle of 2021.

The abrupt shock caused by covid-19 has seen demand vanish temporarily from some real estate sectors but we foresee that changing working practices and behaviours by clients and structural/capacity constraints within the industry will act as a break on a larger slide in tender prices for the following reasons:

1. Flight to safety by client organisations – the fear of weaker balance sheets and future contractor insolvencies impacting projects, together with concerns to adopt safe working practices on site will increasingly drive risk aversion in client organisations who will be wary about risk, reputation and covenant resilience. This will manifest itself in a preference by clients to negotiate work and solve the challenges to programme, site productivity and sourcing in an informed way through collaborative initiatives with subcontractors and main contractors, as opposed to a blind race to the bottom by competitive tendering at lowest price. While input prices may soften over the next 12-15 months, this will be offset by the ‘measured mile’ of work on site taking longer under safe working practices adding to time related costs.

2. Stagflation in the supply chain – factory orders are down across Europe by 15.6% and 10 million workers have been furloughed. Remobilised factories will face both a backlog of incomplete work and a build-up of new orders and the possibility of a competitive struggle for prioritisation holding up prices, possibly at a premium in acute areas where business failures may reduce the total number of suppliers. Concerns over reduced productivity and output in factories may also translate into higher unit prices as overheads are spread over a lower volume of work.

3. Tighter labour market – for many UK contractors, 50% of their tradesmen come from Eastern Europe, many of whom left the UK before lockdown. Fully remobilising this labour force will take time and previous recessions have shown that some damage to labour capacity will be permanent. While less new work will eventually exert pressure on labour rates, there will be a time lag and government support via furlough schemes may ironically cause some degree of cost push inflation within the labour pool remaining in employment thus tempering a deeper fall.

4. Unprecedented government stimulus will lead to longer term inflation – this time around, boosting growth and reflation looks to be the only way out of the economic crisis as austerity cuts and tax rises alone will be insufficient to pay off the mountain of debt. Paying back all the UK sovereign debt over time will require kick starting inflation so that it rises over and above interest rates and historically the construction industry has been a vehicle to achieve this. The government will need to get Britain building again and may have to fund growth using instruments similar to the ‘Build America Bonds’ adopted in the US after the 2009 crash.

5. Reversal of globalisation/UK reshoring – the covid-19 pandemic has brought into sharp focus the level of risk and resilience associated with long and sophisticated supply chains. It’s likely that we will see increased efforts to shorten supply chains overtime with clients looking at how to reshore activities within the UK or Ireland and engage more vertically integrated contractors to hedge the risks, even if this involves paying a premium. Brexit and volatility in the relationships and trading outlook for the EU as whole may also introduce some counter balancing inflation.

6. Attraction of comparable investment returns – while industry confidence has been severely dented by the covid 19 pandemic, the UK real estate market still has many of the same strong underlying fundamentals to attract investors as before and, in some cases, those market needs are now actually more acute than ever, or new needs are rising. Against a backdrop of negative bond yields, rock-bottom interest rates and suspended share dividends, investors will gradually see through this crisis recognising the long-term opportunities in the UK property sector, many of which offer inflation proof returns that may cushion a soft landing whichever way construction prices move.

Date: 20/05/2020
Category: Insight