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Could high construction costs affect your clients' property finance plans?

Higher costs on development projects could well result in lower margins and reduced return on investment (ROI).

Mike Cass Aug 26, 2021

The property and construction sectors have seen a number of highs and lows over the course of the pandemic. So it’s excellent news to see that construction output growth hit a 24-year high in June of this year, with both house-building and commercial construction on the rise.

But this rapid growth and building activity is a double-edged sword. After the Covid disruption of the past 18 months, it’s great to see construction businesses getting back to full output and getting new projects off the ground. However, the current high costs of building supplies and construction materials is making it difficult to complete these new building projects.

Higher costs on development projects could well result in lower margins and reduced return on investment (ROI). So, how could this affect the outlook for your property clients?

Positive growth in the construction sector

The Covid pandemic had a very clear and disruptive impact on construction – as seen in the most recent ONS data below. Many sites were shut down completely during the first lockdown, and work has taken considerable time to return to normal levels. As such, the newly reported growth in output will remove some of the worries and concerns that have been holding back further expansion and project planning.

Despite the two-month dip in ONS figures leading up to May 2021, the June figures from the IHS Markit/CIPS UK Construction PMI® Total Activity Index signalled the strongest rate of output growth since 1997. This is positive news and likely to drive renewed confidence in the sector, given the rises in both domestic and commercial building projects. 

On the whole, the outlook is positive:

  • House-building on the rise – house-building is the biggest growth area, especially in the suburbs outside of big cities. With the move to remote and hybrid working, what the market needs is more suburban houses and fewer large-scale office spaces.
  • Commercial projects growing but also evolving – commercial projects are also growing but there are question marks over the long-term future of commercial office space. 54% of employees spend more than half their week working elsewhere than their company HQ, according to research by Regus. So, we’re likely to see a shift away from large commercial office space developments and more focus on warehouses, factories and smaller local community office spaces.
  • Developers are still cautious following Brexit and the pandemic – builders and developers are still testing the post-Brexit, post-Covid waters at present. Bank of England figures do predict significant economic growth, but many companies and developers are still hesitant about jumping into any large-scale development projects in the current climate. 

Significant increases in the cost of materials

Concern around rising costs are echoing around the whole UK construction industry, despite the jump in construction output. Construction News reported on higher than normal costs increases over the course of spring and summer 2021, based on recent data released from the Office for National Statistics (ONS).

Michael Cass, ​​Head of Secured & Structured Finance at Capitalise, works with clients on a number of property financing projects and has seen the effect that high costs are having:
 

"The impact of these rising costs in construction has been borne out in two recent development projects we have worked on. One is a big residential deal in London, where the contractor’s costs have risen by £400k in the period since the initial quote was given, due on the whole to rising prices for raw materials and a lack of capacity in the supply chain. The second example was a firm of quantity surveyors, where the cost of their commercial build contract has recently gone up by 8%. 

Developers will be working to very specific budgets, so any upwards movement on costs will put pressure on margins and profits. If a deal has legs then it has to be a 15%-20% profit margin at least, so a rise in costs can really put pressure on that."


The impact on the financing of building and development projects

With high costs presenting such a clear threat to margins, knowing how to finance new deals and ongoing projects becomes more complex and more unpredictable. It’s very difficult to fully predict the outcome of these spiralling supply costs, as Michael Cass outlines:
 

"These unexpected jumps in supply costs really do decrease your profit level in a significant way. So it will be interesting to see the short and medium-term impact on the market. Will high costs have an impact on land prices? Will deals grind to a halt? Will smaller developers/ contractors with less buying power be forced out of the market temporarily? 

For now, the residential market is buoyant, with demand and prices continuing to remain high, but once that dissipates things could get tough. There’s a maelstrom of different forces to think about, for lenders, developers and contractors alike. It feels like everything is in flux in the sector at present and that will affect both buyers' behaviour and lenders’ behaviour over the coming months."


Talk to our property finance specialists

At Capitalise, our property finance specialists are working hard to support and advise our accounting partners and their clients in these times of much-needed recovery.

We can offer a range of different routes to property finance, including bridging finance, commercial investment finance, portfolio refinancing and development finance.

If you’d like to talk through how property finance can be a key part of your practice’s Capital Advisory offering, please do reach out to your Partnership Manager or book a consultation if you're new to Capitalise. 

 

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