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“The ‘Inflation’ Tide may not raise all ‘Cost’ Boats”

  • Material inflation and tight labor markets suggest construction costs should be rising.
  • However, the anecdotal evidence of our borrowers is that construction tenders in the apartment sector are coming in below expectations
  • It appears the 70%+ decline in new apartment developments is leading builders and sub-contractors to compress margins to win business.
  • This is good news for developers and underpins the significant discount to replacement cost reflected in our loan attachments points (LVRs).
  • It does introduce some construction risk as builders have no margin and could face rising material costs during the life of a build contract.

Inflationary concerns continue to dominate market sentiment. Earlier this week, for example, higher than expected headline CPI inflation in the US (including the highest annual increase since September 2008 of 4.2%) caused the S&P500 index to fall 2.1% and the US 10-year bond yield to rise 8 basis points to 1.70% during the session. US Treasury Secretary Janet Yellen’s comment that “It may be that interest rates will have to rise somewhat” caused similar market volatility before she remembered how to “FedSpeak” and calmed market nerves with a smooth back-pedal.

Previous weekly reports have also considered the record prices of various commodities and the potential impact on the Partners Fund. Traded commodities such as lumbar, iron ore, copper and corn are at multi-year record highs, while in the “real world” the boom in home renovations, global timber shortages and strong domestic demand have seen timber prices rise up to 15%.

Interestingly, however, Rider Levett Bucknall (RLB) notes in its 1Q “Construction Market Intelligence” report that whilst there have been price increases across the country for structural steel, façades concrete, reinforcement and brick supply, actual tender prices have not yet reflected these material increases to their full extent.

The RLB Tender Price Index represents the annual rate of change of tendered construction costs across the industry (except single dwelling housing). RLB says that the pressure of pricing has eased in 2021 following on from 2020 and all states have seen a substantial reduction in escalation uplifts that were forecast 12 months ago compared to those forecasted now. In Sydney and Melbourne, for example, the estimates of escalation costs have been reduced from 3.8% and 3.3% respectively at Q42019 to 1.2% and 1.5% respectively currently.

This analysis is consistent with our experience on several ongoing Partners Fund Investments, particularly in the apartment construction sector. Reducing construction volumes have led to increased competition and margin compression, resulting in tendering outcomes consistently in line with or even below previously budgeted levels as contractors attempt to build their future work pipeline.

Looking ahead, RLB notes there are opposing factors affecting construction costs. Downward pressure from margin compression will compete with the upside risks from volatile exchange rates, supply chain reliability and changing work practices which may result in lower productivity and increasing program duration.

There is no evidence of this pressure in the Partners Fund portfolio, and our projects are progressing in line with (or better than) initial cost projections. The resulting containment of construction costs and delivery of projects within budget parameters, despite rising commodity prices and input costs, is a welcome outcome for investors that will ensure the continuing strong performance of our construction investments.

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