While the initial chorus of gloomy predictions for property and construction didn’t come to pass over the last two years, there challenging times ahead for the sector.
Businesses will continue to experience persistent material and wage price inflation, ongoing supply frustrations set against the current backdrop of tightening monetary policy, rising interest rates, the cooling of property prices, and access to credit.
Is your business at risk?
The extent of labour and material price inflation experienced by builders varies between operators. Larger businesses may be cushioned by purchasing power, forward orders, hedging instruments and attractive career opportunities. Smaller operators may be more exposed due to less material purchasing power, limited human and financial resources to retain employees, and their contractors being lured away to more lucrative projects.
This is reflected in the anecdotal feedback we receive from industry professionals who say larger players are enjoying lower cost increases than smaller residential builders who often experience a much larger exposure.
With inflation continuing to climb, builders who tendered aggressively to secure pipeline revenue during 2020 and early 2021 are most at risk of incurring significant losses as they now have to deliver these projects in this current cycle.
Those with a strong balance sheet and a pipeline of existing profitable projects will be in a solid position. By comparison, marginal operators seduced by the prospects of rapid turnover growth, may soon realise their financial resources are insufficient to fund either the top-line growth, or the unexpected bottom-line losses from projects now subject to inflationary price hikes and constant delays due to staff covid isolation protocols.
Our clients are telling us the average build period for detached dwellings continues to rise compared to pre-pandemic levels due to delays in the supply chain. Assuming workers cannot be readily deployed onto other productive projects during wait periods, this could translate to a reduction in monthly turnover. The risk of material delays when combined with the cost pressures, hardly make for ideal business conditions.
Steps you can take to weather the storm
A single source of truth: The first step to identifying and mitigating risks
Operators with unsophisticated financial reporting functions which only provide historical information are worst placed to deal with the complexity of rapid escalation in material 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.
Even if your organisation has invested in Enterprise Resource Planning systems and more timely forecasting, implementation is often incomplete and relies on prompt and quality input from multiple operators, leaving project managers to rely upon their own stand-alone spreadsheets. This leaves the business without a single source of truth to help identify and mitigate risks.
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.
Allocate potential risks in your contracts
For builders with pricing fixed by the black letter of the building contract, and a balance sheet insufficient to survive a substantive operating loss on the project, the level of discretionary support you can extract from the project principal will be critical to your company’s survival.
On the development side, we have seen higher instances of these companies exercising ‘sun set clauses’ to drive through price increases whilst demand has been high. The current shortage in building capacity has empowered developers to take a more collaborative approach to managing completion of projects and allocating risk in new contracts. Though the extent of developer cost flexibility depends on the circumstances of each project, in some cases, developers’ primary motivation will be timeliness, so they may be prepared to support costs escalation requests, provided these are accompanied with detailed supporting documentation.
That said, with the recent rise in interest rates and cooling of property prices we could soon see a shift in these trends.
Use scenario modelling to mitigate damage on existing commitments
The impact of delays and cost escalation on materials over the last six months is likely to render many projects as loss generators. The challenge is how these losses can be minimised while still delivering on the project.
Quantifying the likely financial impact of delays in terms of lost margin, burnt overhead and people costs, along with the risk of potential damages is also a common challenge.
However, organisations that operate scenario models have better supported strategies to:
- update project delivery plans so key materials (for example, high demand resources like framing) are ordered sufficiently in advance
- assume responsibility for key material supplies from subcontractors if there are capacity concerns about delivering on time
- encourage transparent dialogue with key subcontractors and suppliers so that emerging issues are dealt with proactively rather than reactively
- ensure risk points are raised during Project Control Group meetings
- negotiate variations of contract terms, and consider reasonable delay buffers where external factors persist
- bulk order materials in short supply – when available and if funding allows
- engage with financiers to ensure continuity of existing facilities critical to future operations (eg, bank guarantees and equipment finance)
- maintain liquidity including securing fresh debt or equity funding
- ensure the business remains compliant with regulations.
How can you protect your business on new projects
We’re currently advising our clients to:
- provide shorter turnaround time on the validity of quotations given the rapid movement in commodity prices
- explore options to contract on a cost-plus basis / schedule of rates wherever possible
- nominate at-risk materials to be subject to a cost-escalation clause
- incorporate further protections in contracts; areas to consider can be extensions of time and a contingent start date based on availability of materials
- ensure that either project milestones documented in the contract are set conservatively, or the contract ‘protection’ is available to the builder to accommodate continuing experiences of supply chain disruption.
While the price volatility and tightened resources risk presents a major challenge for builders, developers and financiers alike, the exploding lead times and delays of materials contribute to further headaches. It will be vital to map out the potential impact on your projects, so you can act in time and preserve the longer-term sustainability of your business.
The contrasting outcomes for businesses that manage these risks reactively rather than proactively is stark.