Shifting the construction goalposts

The price of construction materials has risen significantly. Steel prices, at last year’s peak, were up by 55% over 12 months; the ONS construction materials price index, for all work, is running 22% ahead of this time last year. Investors and developers need to understand, navigate, and predict both price rises and the availability of materials and labour to deliver viable projects to time. The situation is by no means clear cut.

Price increases in the construction sector are subject to many of the same forces driving global inflation. Supply-chain frictions have created delays in getting materials to their destination, creating a premium for materials that can be delivered quickly. Indeed, backwardation – where investors pay large premiums to secure immediate supply – has increased for many commodities.[1]

But there are other forces at work that are less linked to global factors. Margins have been eroding steadily, reducing contractors’ tolerance for absorbing pricing risk. As a result, in some cases, contactors are moving away from real estate towards infrastructure or public-sector frameworks, seeing a more dependable long-term book of business.

Labour within the sector is also traditionally footloose – workers have gone where the work is. The pandemic restricted this fluidity but the number of live projects outside London and the southeast has also increased due to growth in areas more likely to benefit from the ‘levelling up’ agenda. This has reduced the ability of projects in London and the southeast to suck in labour resource from elsewhere.

Brexit and the pandemic have further reduced labour availability, especially for London projects. The ONS estimates 18% of construction workers in London were from the European Economic Area in June 2021, compared with 29% as recently as March 2020.[2]

Tender price inflation – the all-in cost of placing a construction contract, which fell in 2020 – increased by an estimated 3% in 2021[3] and is set to rise further in 2022 to around 3.3%.[4] This may not sound high relative to some of the price rises reported, but different sectors have different sensitivities to materials and numbers are often camouflaged by movement in margins, transportation and wage costs.[5]

New bottlenecks

And now, of course, transport and wage costs are also rising. We see this as the next potential pinch point as base effects and a loosening global supply chain act as a brake on material price inflation. Contractors will, understandably, be reluctant to absorb further cost increases, which may mean more risk needs to be shared with investors, as well as higher prices and elongated lead times.

Construction bottlenecks are everywhere. There is too much retail stock and a significant proportion requires modernisation. Offices face the same challenge, amplified by the pandemic. Industrial stock is in short supply, and with not enough in the right places. The UK needs more homes across all tenures and much existing stock requires cladding replacement. Most importantly, tightening environmental standards and a requirement for all commercial real estate to be EPC B by 2030 (and EPC C by 2027) will drive retrofitting and refurbishment.[6]

The pandemic has amplified polarisation in market performance and arguably widened the definition of what constitutes poor-quality real estate, while narrowing the definition of what constitutes good quality. Potential rental premia, shorter voids and more attractive financing costs for sustainable and attractive stock – currently most evident in offices – may help mitigate construction cost increases.  But in a scenario where fewer buildings can be retrofitted due to construction challenges, despite best intentions, polarisation is likely to increase further.

Managers who navigate these challenges, whether through successful negotiation and perhaps risk sharing (either with their supply chain, or by embracing modern methods of construction), should be better placed to deliver the product needed to capture occupier demand and drive the financial performance their investors require. This was always the case, of course, but the pandemic – together with what we see as long-lasting challenges to resourcing construction – has, in our view, fundamentally shifted the goal posts.

[1] Financial Times, 14^th February 2022, Waning stockpiles drive widespread global commodity crunch

[2] ONS, Labour Force survey, November 2021

[3] BCIS, 2022

[4] LGIM Real Assets study of cost consultants undertaken in Q4 2021. Study covered six firms.

[5] Source: Arcadis, 2016

[6] It is estimated that up to 85% of the current UK building stock will still be in use in 2050. See, for instance, Faithful & Gould, 2017, UK Building Stock Carbon Reduction Commitments.

Unless otherwise stated, information is sourced from LGIM analysis as at 23 February 2022.