Insight

COVID building boom: who’s likely to be stung?

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Part 3 of our series on Going Bust in a Boom
Contents

In our previous articles in this series, we observed how the combination of continuing supply chain restrictions and a surge in demand across the developed world has resulted in the highest levels of material and labour cost inflation experienced in the building and construction industry for many decades, but also unprecedented delays in sourcing building materials. The surging demand has been fueled by cheap funding and pandemic related economic stimulus from major governments, along with the diversion of services/experience spending by consumers during lockdowns.

Despite the best intentions, most construction groups are subject to unprofitable jobs, which can be due to unforeseen budgeting, weather events or execution errors. Ordinarily, such projects can account for up to 20% of a builders’ project works in any year, however the broader business is generally supported by the performance on more profitable projects.

Construction margins are generally tight and major builders operate on extremely thin margins. The national average margin sits around 2.4% for commercial construction groups.

The double digit material price inflation we’ve seen, combined with extensive delays and wage price pressure, are a venomous mix for builders already operating on wafer thin margins.

In our final instalment in this series, we explore the different market segments in the construction industry to better understand the profile of industry participants most likely to feel the sting of continuing supply chain pressure.

Detached residential builds

Key standard features

Subject Segment Standard Comment
Contract Type Lump Sum (fixed price) Ordinarily executed on standard industry contracts with no protection for cost escalation and supply chain delays.
Build Time 7-12 months Industry commentary indicates that average build times for detached dwellings have blown out by six to eight weeks on average.
Benchmark Gross Profit Margin * 13%-17% Often rely heavily on subcontractors with only a small full time equivalent (FTE) workforce (as such, the liquidity boost provided by Jobkeeper was less than operators with larger workforces). 
Benchmark EBIT* 7.7% Source: Ibisworld (E3011 House Construction in Australia, Oct 2021)
Purchasing Power Limited / Price Taker Limited purchasing power can mean a higher risk of delays in delivery of critical materials (e.g. structural timber) which may protract building activity, delaying stage claims and potentially reducing revenue.
Borrowing Capacity Asset-backed Normally limited to equipment finance and cash/ real property supported bank guarantees. Overdraft facilities generally require real property security.   
Financial Capacity Limited Outside of project home builders, generally a fragmented industry segment. Smaller players usually family owned with small corporate balance sheets and businesses often rely upon Deeds of Covenant from Directors’ personal property (real estate) to support regulatory covenants of Net Tangible Assets (NTA).
Regulatory Risk Low - Medium NSW and QLD builders are subject to annual financial competency assessments by Icare and QBCC. Regulatory activity generally focused on larger builders.

*FY20 and FY21 numbers likely to be inflated due to impacts of Cashflow Boost and Jobkeeper.

Two key buyer profiles emerged in the initial demand surge that occurred in detached dwellings, driven by low interest rates and government stimulus packages:

  • First-home buyers (fueled by Early Access Super and HomeBuilder); and
  • Sea and tree changers (off the back of improved business conditions and excess liquidity accumulated courtesy of Jobkeeper and Cashflow Boost, closed borders and lock-downs demonstrating the ease of working remotely)

The Federal Government’s HomeBuilder incentive was introduced as part of the economic response to COVID, and offered $25k for new housing contracts or substantial renovations signed up before 31 December 2020 (with $10k less for those signed up after that date but before 31 March 2021). Unaware that the cost of delivering these commitments would drastically increase over the coming nine months, builders committed to these builds (approximately 135,000 in total).

While the majority of building contracts are lump sum (fixed price), in some cases, the profile of the building (bespoke mid to high end) and the homebuyer’s attributes (e.g. higher income with lower levels of debt leverage and a strong desire to occupy on time), is such that the builder can negotiate variations/amendments to the contract to recover these cost increases and maintain margin. Given the value caps placed on the HomeBuilder scheme, these were in the minority during this demand surge.

However, home buyers at the lower end of the market can’t be as flexible and are working to tight lending limits. Here builders have a limited number of options:

  • Complete the building at a loss
  • Defer commencing or continuing works in the hope that economic conditions correct in the near term
  • Broker a settlement with the home buyer (putting their brand at risk if not resolved to the satisfaction of the buyer)

In this respect, reports abound of larger project builders (large and small) paying owners to ‘walk away’ from these burdensome contracts, presumably as they see this as a better outcome than the alternatives and indicates the extent of cost increases expected.

The last of the Phase 1 HomeBuilder Grant homes must be commenced by 30 June 2022, and the balance (phase 2) by 30 September 2022 at the latest. In recognition of the delays brought about from supply chain restraints, in April 2021 the Government was forced to extend the initial six month commencement requirement by a further 12 months from the date of signing the contract.

The wind down of activity from the HomeBuilder scheme, mixed with the lack of international migration expected in the medium term, along with the fact that a large number of recent completions may have been ‘brought forward’ due to the federal and state government incentives on offer, will likely mean a reduced level of demand over the coming years. This may lead to intensely competitive conditions from 2022-23 when builders who have expanded to meet the current demand are looking to maintain that pipeline.

Multi-unit residential

Subject Industry Standard Comment
Contract Type Lump Sum (fixed price) Lump-sum contracts still preferred by developers/ financiers due to certainty of timing and cost.
As such generally no contractual protection for cost escalation and supply chain delays.
Build Time Dependent on scale of project Larger unit towers may take 3-4 years to complete. Extensive lag between tender and build particularly on Design and Construct contracts. Clients may request extensions due to delays in awarding contracts.
Benchmark Gross Profit Margin * 15%-19% Exposed on fixed workforce/overhead. Continuing financial exposure to labour costs where jobs do not commence or continue subject to productivity restraints (e.g. social distancing limitations, material delays). 
Benchmark EBIT* 5% Source: Ibisworld (E3019 Multi-Unit Apartment and Townhouse Construction, Oct 2021)
Purchasing Power Medium Advanced ordering, larger volumes and industry presence provide a greater level of buying power and prioritized delivery.
Borrowing Capacity Primarily
Asset-backed
Core debt is normally limited to equipment finance. Depending on the size and consistency of performance, bank guarantees may be offered without full cash/ real property support.   
Financial Capacity Medium-Significant While generally large and often supported by related party funding arrangements, the period of sector underperformance pre-COVID may have depleted some balance sheets.
Regulatory Risk Medium-High QLD builders are subject to annual financial competency assessments by QBCC, other State regulators have less focus on financial ratios. Regulatory activity generally focused on larger builders with substantive networks of subcontractors.

*FY20 and FY21 numbers likely to be inflated due to impacts of Cashflow Boost and Jobkeeper

Pre-COVID, building approvals in this sector had been forecast to slide by approximately 30% relative to FY19. As such, tenders submitted during mid-2020 were likely at aggressive prices seeking to firm up pipeline and support overheads.

Sharp declines in large-scale apartment commencements in recent years (partially due to weak pricing growth and oversupply in some unit markets) and falling residential development margin were impacting profitability for many apartment builders. Industry participation has also been deteriorating over the past five years, as a result of the sharp decline in demand conditions (particularly foreign buyers) from 2017-18. The average profit margin fell from 9% in 2020, to around 5% in mid-2021 (noting that apartment and townhouse builders are reporting the lowest profit margin amid the sectors we report here).

While the current building boom was initially focused on detached dwellings, it has now spread to multi-unit dwellings. This is likely a result of affordability, particularly with the eligibility pricing caps in place for the Government stimulus and the lack of land supply. The turn in the cycle took many by surprise and builders may now face the combined problems of delivering projects tendered at 2020 prices; and funding growth off of a low base.

Unfortunately, the capacity of developers to support builders through this period of cost increases and growing pains may be limited - particularly where the project is predominantly pre-sold and the realization value is capped at yesterday’s prices. Ironically, those developers with low levels of pre-sale commitments on projects seem better positioned to manage the current phase of the pandemic where demand has been high. That said, the current speculation around a rise in interest rates could soon shift things back into natural order.

Commercial (office/retail/industrial)

Subject Industry Standard Comment
Contract Type Lump Sum (fixed price) Lump-sum contracts are still preferred by developers/ financiers due to certainty of timing and cost. Variations are hard fought.
As such generally no contractual protection for cost escalation and supply chain delays.
Build Time Dependent on scale of project Major builds (e.g. multiple towers) may take up to five years to get to the completion stage. Extensive time lags can exist between tender and build, particularly on Design and Construct contracts. Clients may request extensions due to delays in awarding contracts.
Benchmark Gross Profit Margin * 16%-19% Exposed on fixed workforce/overhead - continuing financial exposure to labour costs where jobs do not commence or continue subject to productivity restraints (e.g. Social distancing limitations, material delays).
Benchmark EBIT* 7.2% Source: Ibisworld (E3021 Commercial and Industrial Building Construction, Oct 2021).
Purchasing Power Medium Advanced ordering, larger volumes and industry presence provide greater level of buying power and prioritized delivery.
Borrowing Capacity Primarily Asset-backed Core debt normally limited to equipment finance. Depending on size and consistency of performance, bank guarantees may be offered without full cash/ real property support. Larger end of town may have internal treasury functions with access to diversified income streams. .   
Financial Capacity Medium-Significant While generally large and often supported by related party funding arrangements, sector underperformance pre-COVID may have depleted some balance sheets.
Regulatory Risk Medium-High QLD builders are subject to annual financial competency assessments by QBCC while other State regulators have less focus on financial ratios. Regulatory activity generally focused on larger builders with substantive networks of subcontractors.

*FY20 and FY21 numbers likely to be inflated due to impacts of Cashflow Boost and Jobkeeper

The profit margins for commercial and industrial construction fluctuate widely in response to volatile demand conditions. Industrial property had already been growing in popularity and has outperformed throughout the pandemic with the emphasis on logistics and autonomy. The positive investment trends in commercial and industrial building markets over the past five years have allowed contractors specializing in the sector to raise contract prices and attracted new participants.

Market uncertainty in the early stages of the pandemic delayed commencement of many commercial projects, particularly in those states dealing with larger outbreaks (Victoria and NSW) and commercial builders have had to bear the cost of that. As market confidence improves, these commercial builders will also face the problems of funding growth from a low base and delivering projects tendered at 2020 prices.

With larger projects, senior subcontractors may be exposed where supplier prices are either not locked in, or provisions for rate escalation are insufficient. Even where cost exposure can be contained, subcontractors may still be exposed for delays in delivery under ‘back to back’ contracting arrangements.

Despite that, the current shortage in building capacity has empowered contractors. Developers, well aware of this shift, are generally taking a more collaborative approach to managing completion of projects and allocating risk in new contracts. Though the extent of developer cost flexibility is dependent on the circumstances of each project, in some cases, the developers’ primary motivation will be timeliness and may be prepared to support costs escalation requests, provided these are accompanied with detailed supporting documentation. Anecdotal reports of developers accepting (supported) 10-15% cost escalations in these circumstances are not uncommon. If the overall demand has increased the developers potential realization on the project overall, they may be happy to share in some of this to get the product to market and maintain relationships for future projects.

Infrastructure/Civil

Subject Industry Standard Comment
Contract Type Varies Lump-sum, Schedule of Rates, Alliancing, Pain/ Gain are all common at the head-contractor level. Many have been burned by the Lump sum design and construct a model and will seek out alternative contract models (preferably cost plus) wherever possible. Subcontractors are more likely to be engaged on lump sum basis and arguably more exposed.
Build Time Dependent on scale of project Between 12 months to more than 5 years. Governments are being encouraged to break down major infrastructure projects into separate phases to give Contractors other than the top tier or internationals the opportunity to compete.
Many can be subject to Government delays and bureaucratic process.
Benchmark Gross Profit Margin * 9% to 15% Exposed on fixed workforce/overhead - continuing financial exposure to labour costs where jobs do not commence, weather event delays. Less impacted by social distancing limitations, but significant exposure to material delays e.g. concrete piping.
Benchmark EBIT* <5% Source: Ibisworld (E3011 House Construction in Australia, Oct 2021).
Purchasing Power Medium Advanced ordering, larger volumes and industry presence provide greater level of buying power and prioritized delivery. Many are opting to place orders at time of tender to decrease delivery delay risk.
Borrowing Capacity Primarily Asset-backed Generally significant equipment finance. Depending on size and consistency of performance, bank guarantees and bonding arrangements may be offered without full cash/ real property support.  
Financial Capacity Medium-Significant While generally large and often supported by related party funding arrangements, years of underperformance pre-COVID may have depleted some.
Regulatory Risk Medium to High Generally subject to annual reviews of financial and operational competency by state governments in order to maintain prequalified contractor status (PQC).

*FY20 and FY21 numbers likely to be inflated due to impacts of Cashflow Boost and Jobkeeper

As principals, Government bodies are more likely to adopt hybrid contracting models that provide a greater degree of flexibility to support contractors experiencing supply chain disruption. While an industry shift toward New Engineering Contracting (“NEC”) (e.g. Sydney Water) is still in its infancy, the contract options provided under this model are reflective of a more collaborative approach to risk allocation and management:

1. Priced contract with activity schedule
2. Priced contract with bill of quantities
3. Target contract with activity schedule
4. Target contract with bill of quantities
5. Cost-reimbursable contract
6. Management contract

In recent years, with the advent of large global contractors entering the Australian market, the contractor associations have been calling on Governments to ensure the delivery of large scale infrastructure projects can be achieved in a phased or segmented approach rather than awarding as one major contract. This provides the mid-tier (often privately owned) Australian contractors the opportunity to compete with the limited number of tier one contractors, who have the balance sheet backing to take on projects of that size.

In summary

With the construction sector employing almost 10% of the working population and the significant investment by Government into this sector to stimulate the broader economy, it is imperative that the financial stability of the sector is carefully managed.

Construction businesses bear significant risk on projects and work with narrow margins, but in most cases have difficulties securing contingencies for rising input prices and project delays.

The first step to mitigating any risk is identifying and measuring it. To this end, smaller operators often have unsophisticated financial reporting functions providing historical information only and are worst placed to deal with the complexity of rapid escalation in materials prices and uncertain supply timeframes. Intense competition for human resources on projects further magnifies execution risk when the bulk of information relating to project progress sits with an individual project manager rather than being centrally accessible.

Mid-sized operators are not immune to these risks, as despite generally having invested in Enterprise Resource Planning systems (e.g. Viewpoint), and more timely forecasting, implementation is often incomplete and relies on the integrity of input from multiple operators and timeliness, leaving project managers to rely upon their own stand-alone spreadsheets. Where bills of materials are used for project costing and management, the current challenge is ensuring the data is updated frequently enough to capture and forecast cost increases that continue to flow through the industry.

Where the builder’s price is fixed by the black letter of the building contract, and the balance sheet is insufficient to weather a substantive operating loss on the project, the level of discretionary support able to be extracted from the project principal may be critical to the builder’s survival.

If things weren’t tough enough, Queensland based builders face the additional problem of having their working capital locked up in Project Trust Accounts and Retention Trust Accounts from 1 January 2021 (initially for projects >$10m but expanding to all projects >$1m in 2022). Accurate cash flow forecasts for the coming festive season have never been more important.

How can we help?

The team at Grant Thornton Australia can offer its expertise in various ways to assist builders, developers, financiers or other key stakeholders identify early and navigate distress, in various ways:

  • Quantifying the financial impact of these market factors on business cash flow;
  • Connecting data provided by quality surveyors to create dynamic cash flow forecasts, specified to contract terms and the pipeline of specific businesses;
  • Assisting in securing finance to improve working capital, via debtor financiers, alternate debt or extension of existing bank facilities;
  • Assisting in negotiations with key counterparties, such as the ATO, contract principals or sub-contractors; and
  • Managing regulatory compliance with bodies like the QBCC or State Government pre-qualifications.


Supply chain risk management in the COVID building boom

Watch this webinar on-demand as we host a panel discussion on the ways businesses are responding to supply chain challenges and when supply/demand may return to normal – if at all.

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