Construction’s Long and Winding Road

TRAVEL THROUGH some development areas in Sydney, Brisbane or Melbourne, and you can observe evidence of pain in the construction sector for yourself – incomplete constructions that sit idle seem to underscore grim economic headlines about the sector.

This sector has struggled perhaps more than many other parts of the economy to ride out the pandemic hangover, with rates of external administration for related companies at dizzying levels over parts of the past year or two.

“Dwelling construction levels are stagnant or reducing due to a number of reasons, including supply costs, a higher interest rate environment, serviceability constraints and a number of large commercial and residential construction firms exiting, which will take time to reorganise,” says Blake Buchanan, general manager at Specialist Finance Group.

Statistics for the sector are a mixed bag. New loan commitments for commercial construction – a comparatively buoyant sub-sector – have been both positive and negative in the last few rounds. Data for the number of loans for the construction and purchase of new homes are hovering around their lowest levels in the past two decades, and the next set of data for this series, due later in April, will be closely watched.

But the low levels of building starts may also be a sign the market is adjusting to the tough conditions.

“The increase in building costs is driving these changes. There’s more focus on building contracts and due diligence, along with rising property prices and supply constraints, resulting in fewer building approvals nationwide,” says Ryan Gair, CEO and co-founder of Rate Money.

A negative feedback loop from insolvencies

Many observers say that while the rising pace may ease compared to 12 months ago, more insolvencies are pretty much baked in for the sector.

Triple-digit on-year percentage increases in monthly construction firm insolvencies look to be a thing of the past, but Australian Securities and Investments Commission insolvency statistics show that continuing increases for the series may bring total insolvencies for the current fiscal year to a level that nears or just exceeds the eye-watering numbers posted in the year to June 2023.

One effect of the reporting of these failures is to make buyers even more cautious about buying off the plan.

“There’s been a lot of media around insolvent builders, which can create a lot of uncertainty and distrust in the market,” says Royden D’Vaz, national head of sales and distribution at Assetline Capital. Another effect centres around insurance.

“When builders fall into administration, customers need to utilise their insurance cover to ensure that another builder will complete the required work,” says Darren McLeod, who is head of third party at Beyond Bank.

As a result, banks are now very careful to make sure all the required insurances are in place when the loan is established, including considering the effects for inflation.

“When a new builder is sought, the new building contract price can be more than the original building contract, which creates a shortfall to complete the build,” says McLeod.

This bind comes at a time when insurers themselves are reducing capacity and lifting premiums for the construction sector, particularly in areas prone to natural catastrophes. Additionally, the phenomenon of social inflation, alongside litigation funding, has contributed to pricing pressures for construction insurers.

Rising insurance costs are a big factor for small construction businesses in particular. Most construction-type businesses cannot operate without insurance, so they have no choice but to pay higher premiums – leaving some operating on a knife’s edge.

Construction risks that would have found insurance capacity in the past are now sometimes left unable to secure insurance either locally or globally.

Higher rates and an ongoing supply-demand mismatch

A recent global risk survey of the construction and real estate sector by insurance giant Aon cited economic slowdown or slow recovery as the top worry for the sector, largely on the basis that higher interest rates make it more expensive to obtain new project financing.

“Developers, especially now, need to put more equity into deals to make them work. Projects are becoming less profitable as interest costs have absorbed a lot of the margin for developers,” says D’Vaz. Greater delays, higher debt costs and build tender prices are causing feasibilities to not stack up, and when development activity slows, construction demand tends to follow suit.

Financing companies are striving to provide competitive rates by working closely with brokers and borrowers to mitigate the impact of rate increases, but there is an underlying supply-demand problem driven by record immigration numbers.

“There is a cost and that is inflated property prices – government bureaucracy, growth planning and land release are all issues that do not appear to have been addressed ahead of time,” says Buchanan.

Many of these concerns were set out in a recent Urban Development Institute of Australia (UDIA) report, warning that a continuation of the status quo would lead to a sustained housing supply shortage.

The inflation albatross

Higher interest rates, and the steps that the central banks worldwide are using to quell them – sticky inflation – are at the crux of many dynamics in the sector.

“For end buyers, higher rates can make it harder to qualify for finance. There’s limited ability to borrow from traditional banking, as serviceability buffers are higher, [resulting in] an increase in construction loan submissions in the non-bank lending sector,” says D’Vaz.

The costs of material and labour are forcing firms to raise their own prices just as consumers have less money on hand.

“The biggest issue for construction is their inability to build in the affordable brackets… these higher costs are imposed eventually on the consumer,” says Buchanan.

Cost blowouts and supply issues were one of the main causes of the rush of insolvencies in the sector last year. But the market is digesting these changes better in 2024.

“The shortage of construction materials has allowed builders to refine their estimates, ensuring more accurate project quotes. This adjustment has helped alleviate the financial burden compared to conditions experienced 12–18 months ago,” says Gair.

Producer Price Index (PPI) data shows that the cost of many construction materials continues to rise on a quarterly basis, although at a slower pace than double percentage point jumps seen in 2022.

Other indicators also suggest the long winter for construction costs may be on the verge of thawing. In the September quarter of last year, the CoreLogic Cordell Construction Costs Index saw the cost to build a typical new dwelling grow by 0.5%, the smallest increase since Q2 of 2019.

D’Vaz sees the easing of cost increases as a sign of normalisation for construction, a possible light at the end of the tunnel.

“The consistent deceleration hints at a sense of normality.”

While easing inflation gives some reason for hope, McLeod explains that the risks from a continuing inflationary environment will have knock-on effects far beyond higher prices.

“Long extensions to build projects due to high demand for resources and cost of materials [is a risk], as the time frames that builds are taking … may impact customers if they have not locked in for fixed prices,” he says.

Difficult choices for some in current market

Inflation, combined with higher rates, is now leading to difficult choices for people who purchased land when loans were being offered with historically low interest.

“It is not uncommon to hear stories of consumers who purchased land with the intention to build that now cannot service the costs of a loan for the construction component in a higher rate environment,” says Buchanan.

Gair sees the same phenomenon at work in the market.

“With interest rates currently at a 12-year high, many individuals find themselves grappling with the challenge of balancing a construction loan and a mortgage, alongside the added expense of securing temporary accommodation during the building process.”

The outcome can be consumers opting for a more cost-effective build such as a smaller dwelling, or a move to offload the land altogether.

Higher rents are also creating drag on the market as it takes longer to save for a deposit to start construction, and the costs of maintaining any existing loans are higher.

“While building loans are typically interest-only, if you already have a mortgage you might find you’re having to pay a lot more while you’re building. Increasing interest rates impact on your current house as well as the loan for your building,” says McLeod.

The quick pace of rent increases also motivates people with higher liquidity to opt for something that is immediately available rather than a new build to be finished at some unknown point in the future.

“With the current housing crisis, a lot of buyers are looking for a house ‘right now’, so building may not be as attractive,” McLeod explains.

Making life easier where possible

Financial companies are trying to ease the burden for borrowers while the market remains in its current tight spot.

“Our system workflows make the process of these loan types easy to transact on, and when this is combined with good lender policies and appetites, brokers can confidently transact with their clients,” says Buchanan.

In some cases, this includes new products to match the volatile conditions still working through the system.

“Faced with market dynamics that are still changing, it’s more important than ever for us to keep rolling out products that are adaptable and competitive,” says D’Vaz. “That’s where our new Alt Doc Construction product comes in. It provides a tailored solution for the ground-up construction of houses, duplexes, townhouses and structural renovations… the product is tailor-made for developers, investors and borrowers seeking development options.”

Rate Money is also introducing a new product in response to the tough market conditions. It recently launched a low-doc construction product tailored to self-employed individuals.

“Additionally, we offer a reduced interest rate for those constructing a 7-star rated property. It’s a leg-up for borrowers who have solid credit but may not have their business financials up to date,” says Gair.

The product is designed to address the current limitations in construction finance and provide a competitive advantage for brokers.

Workarounds and fast reactions to market changes are key

At Beyond Bank, customers have the ability to fix construction loans from day one.

“They don’t have to wait until the construction period is finished,” says McLeod. Many funders are also willing to look at workarounds when time frames blow out.

“We are exploring the build period for contracts as we know that these can extend past 12 months, and we currently try and work with borrowers who are having this issue,” says McLeod.

Banks are also supporting the construction firms themselves as much as possible.

“We have a dedicated progress payment team that deals with builders and aims to pay their invoices within 48 hours of receiving each claim,” says McLeod.

But it is sometimes non-banks that can react more quickly to sudden changes as the market is pulled in various directions at once.

“As a non-bank lender, we’re able to consistently innovate as the industry changes, unlike larger institutions. Thanks to our agile approach, we’re the first to see these changes, and the first to adapt,” says D’Vaz.

“We not only provide flexible financing options but also hands-on support through each project, development and deal. The focus is on proactive problem-solving.

“We have also recently introduced a customisable and integrated software platform for our construction projects to enhance our service to brokers. This platform allows for early identification of issues in the project, keeps the client updated on the construction progress and gives us the ability to foresee any potential issues.”

Rate Money also emphasises the adaptability of non-banks in helping the construction market emerge from its funk.

“The primary opportunity lies in supporting creditworthy self-employed borrowers overlooked by major lenders,” says Gair.

Better times ahead, but when?

A tug of war among complex factors provides evidence for both an optimistic and pessimistic outlook for construction. The market will turn at some point, but the key will be timing.

The near-term outlook looks tough to some lenders as the slow pace of new dwelling units commenced will drag on the sector for a while yet.

“As construction takes time, this will play out in the forward 6–12 months when they are completed and is well shy of what is needed from a demand perspective,” says Buchanan.

A recent sector report from Oxford Economics Australia predicted that the number of total attached dwelling builds would continue to slump until FY25, with the strong mismatch between pent-up demand and supply not easing until after then.

Commodity price risk, talent retention, workforce shortage and cash flow/liquidity risks are just a few of the risks in play, and all of these are interlinked and exacerbated by factors such as energy volatility, natural catastrophes and the ongoing shift to a greener economy, including new regulations around efficiency.

Rapidly rising climate-related costs also mean that getting inflation back into its pre-pandemic band is that much harder, which may stay the hand of central banks contemplating more liquidity in the system.

More optimistically, some economists are hoping that weaker conditions will help prompt the Reserve Bank of Australia to cut interest rates earlier than previous predictions for late 2024 or early 2025. The hope is that such expectations may underpin borrower confidence and perhaps reduce the amount of time that it takes to sell properties.

“Rates have likely peaked and with reductions on the way, there will be more confidence,” says Buchanan.

Lenders are ready to come the party if the stars align for projects – poised for growth, if not yet growing.

“Being well-informed and confident is crucial. As long as you’ve done your homework and feel confident in your loan being approved, you can navigate market fluctuations. It’s about seizing the right opportunities with a sharp focus on market trends,” says Gair.

Federal government targets to build 1.2 million homes over five years from July 2024 also provide a clear opportunity for brokers, even if there are questions about how the current market can boost its capacity to deliver at this pace.

“We anticipate a more stable market ahead – there’s scope for increased demand and reduced build times,” says Gair.

It’s just a matter of when.