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Record inflation levels caused by the combined impacts of COVID-19, supply chain hold-ups and the Russia-Ukraine conflict have driven the Reserve Bank of Australia to increase interest rates on lending and banks have passed on these higher rates to consumer and business borrowers. The combined effects of prolonged external factors with this rate rise has put the property market into reverse, with financial institutions applying greater scrutiny to loans and debtors' ability to meet their repayments.

The increased costs and declining availability of construction project finance

Construction developers and projects are also affected by the higher cost of finance. Against a background of construction business insolvencies there has also been a significant decline in construction lending, according to the 2022 Stamford Capital survey. Some projects waiting on financing no longer qualify under more stringent standards, resulting in those projects either being cancelled or postponed while developers add more equity to the project.

The Australian Bureau of Statistics reports a 17.2% annual decline in building approvals, preliminary construction works falling 3.8% and the value of total building work done decreasing by -0.5% , which represents millions if not billions of lost revenues.

Cost of materials is constraining construction activity

Perhaps the biggest threat to continued growth in the construction industry are the extraordinary cost increases that contractors and insurers have experienced over the last several years. Almost every category of building materials has become more expensive. Steel products almost doubled in the year ending March 2022, followed by timber products at over 20%, other metal products (16%+), insulation (14%), electrical components (13%+) and plumbing products (11%+), the Sydney Morning Herald reports.

Supply shortages have led many contractors to obtain materials from non-traditional suppliers but some have proved to be defective and failed to meet quality standards. Poor quality materials also raise the likelihood of increases in liability claims.

Contractors are asking for price increases because they're unable to obtain steel and other materials at the price cited in their bids. In some cases, contractors are walking away from projects due to the losses they expect to incur. In others some prime contractors are finding that sub-contractors who bid the work at one price are no longer willing to honour that quote at a later date.

Construction sector skills shortage, labour shortfall

Compounding the increase in material prices, contractors are having a very difficult time finding qualified workers. Construction vacancies have risen by 80 per cent since late 2019, according to the 2022 Arcadis Construction Costs Index Report. The report forecasts that by 2023 there will be more than 100,000 unfilled roles in the sector.

Other industry sector research conducted by Kennards Hire has found industry leaders remain concerned about negative pressures such as the rising cost of materials, supply chain difficulties impacting the ability to deliver projects on time and on budget and a shortage of skilled, qualified labour. In spite of this more than 80% of the 259 industry leaders canvassed expressed confidence in the future of the sector, based on growth in residential and commercial buildings over the next five years.

In the meantime many businesses are in difficulties, with the Association of Professional Builders reporting that more than half of Australia's 12,000 construction companies are trading at a loss, with at least 50% showing negative equity.

The net result is to raise the risk that the actual price of construction will be greater than the contract amount. To address the risk of increased costs during construction lenders may opt to raise credit standards by increasing the loan to value (LTV) or loan to cost (LTC) ratio when underwriting the loan. Then if the project needs additional financing the higher LTV or LTC ratio gives the bank some room to add to the loan while keeping ratios in place that will meet regulatory scrutiny.

Measures for construction project owners and contractors to consider adopting

All the parties involved in a construction project, from owners to the financing parties and insurers, need to take a unified approach in addressing current construction market conditions, since any single issue can jeopardise the entire project.

The following points are possible measures developers and contractors can take to counter rising rates and tightening credit ‒ but market conditions must be carefully considered.

  1. Contractors performing preconstruction work should assume that tightening standards and rising rates will impact project financing. Accordingly they should expect extended pre-con durations and make sure their fees are not tied to the project closing.
  2. Build escalation contingencies into the contract price, to be triggered if prices go up by a specified percentage. Alternatively they can apply to the first 5% or 10% of the price increase, but there needs to be a mechanism in place to add funding strategically when necessary.
  3. Contractors should consider ascertaining that there is financing is in place to pay any contingencies. This means sighting the documentation showing that financing is in place and also verifying that the project owner has the financial resources and credit to put additional money into the project if needed.
  4. Add generous payment terms when purchasing materials stored off-site. If it isn't needed for 6 to 12 months you can either hope prices go down or you can lock prices in by ordering the materials for early delivery to avoid not having necessary materials at the start of the project.
  5. Ensure that the lender understands your approach to managing these risks and will fund loan draws for materials stored off site and include greater contingencies in the loan. Building these costs into the loan at origination may allow the lender to make an exception to requirements for higher LTC and LTV ratios.
  6. Watch the schedule. Even on a fixed-price contract a delay caused by the project owner may lead to a claim for price escalation, but the claim has to be supported by a contemporaneously updated schedule.
  7. Contractors should take a stronger stance against no-damage-for-delay clauses as extra time will result in increased cost in an inflationary environment.

Insurance impacts for construction

An annual or project-specific insurance policy is usually adjustable on final contract value, meaning that if it costs more to build the project or you have higher construction turnover at the end of the policy than estimated at commencement, an adjustment premium is due — typically pro rata. Due allowance should be made in your project budget for this.

Additionally, contract works policies usually have a maximum limit payable under the policy, which is aligned to either project value for a project-specific policy or the highest contract value likely to be entered into for an annual policy. There will be escalation clause in the policy that escalates this limit typically between 10% and 20% for increases in this limit over the policy period.

However, with the level of escalation in key materials and labour we have seen recently this escalation allowance in the policy limit may not be sufficient to cover a rebuild in the event of a total loss. On the positive side, unlike other property insurances construction policies do not have an underinsurance provision and therefore a claim payout will not be reduced proportionately to the amount of under-insurances as provided under an industrial special risks or business package-type policy.

Benefit from broker expertise in construction insurance

It's recommended that all construction business owners review their current insurance cover with the help of an industry specialist broker who can help you ensure you have the right protections for your situation. Gallagher has many construction clients, from major works to smaller projects, and construction insurance specialists to advise on key covers tailored to each construction business and project.

Disclaimer

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