Managing challenging market conditions

John Cleaveley and Amber Wright explore the economic and market headwinds currently impacting the construction industry, with analysis of how living sector operators and developers can mitigate risk in a volatile environment.

The construction industry is operating in testing market conditions with economic uncertainty persisting into 2022.

Nevertheless, statistics published by the Office for National Statistics (ONS) show that construction output in March 2022 grew for the fifth consecutive month, increasing by 1.7%. This resulted from an increase in repair and maintenance, and new work. The monthly output in March 2022 was £14,994m which is the highest level since monthly records began. 

The outlook remains stormy. Indeed, the sector is still dealing with the disruption caused by Covid-19 and Brexit, with persisting challenges including the unavailability of materials and labour, and increased costs. This may lead to an increase in delays, claims and potential disputes on projects.

Skills and materials shortages

Statistics published by the ONS show that between February and April there were 49,000 job vacancies. These figures match the record high of vacancies set between December 2021 and February 2022. Material shortages also continue to impact the industry.

In a statement on 11 May 2022, the Construction Leadership Council’s Product Availability working group stated that, “ongoing challenges continue to affect bricks, aircrete blocks, concrete products, PIR insulation products and gas boilers all of which are on long lead times”.

The statement also referred to recent data published from Glenigan indicating a slowdown in starts on sites during the beginning of 2022, this suggests “that inflationary pressures are starting to influence client decisions in some sectors, continuing the trend seen with softening retail sales over the last few months”. The statement also points to price inflation as “a critical issue”.

The working group expects that energy price movements would remain “unpredictable” due to further restrictions on Russian gas and oil imports in Europe. Other challenges highlighted by the working group were the reported impact on the availability of products caused by the Covid-19 outbreak in China and the “wage inflation” required to secure labour.

The rising costs and long delivery lead in times is putting additional pressure on an industry that continues to deal with the effects of the pandemic, Brexit and is now contending with increased turbulence in the global market caused by Russia’s military invasion of Ukraine. The working group states that the “conflict in Ukraine continues to affect certain product areas” and they are considering “the likely extent of disruption particularly in relation to clay, ceramics, electrical products, and raw materials for steel and other production, as well as impact on energy costs”.

We are seeing that rising material costs and lead in times are causing some contracts to be abandoned due to affordability or timing issues. Concerns around fulfilling pre-let agreements for lease and development funding agreements is resulting in more conditionality, building cost conditions, funding conditions or viability conditions.

We are also seeing increased prominence in negotiations in relation to force majeure or equivalent extension of time provisions - addressing the risk of potential disruption to a contract because of Russia’s military invasion of Ukraine.

In recent years, war or hostility and the potential contractual disruption these may cause has not been considered as a high risk. The increased focus on these provisions is notable. It demonstrates that we are operating in a global marketplace, with the political climate causing market disruption and uncertainty.

Impact

Going forwards, increased material and labour costs are likely to be reflected in higher tender prices and fixed price contracts will represent a much riskier option for contractors.

For new contracts, we may see contractors increasingly looking to address risk by:

• taking on a more robust negotiating position to limit risks they may previously have accepted for fluctuations in material prices and delays in delivery of materials.
• requesting provisions to enable them to obtain an extension of time and additional costs for delays caused by the availability of certain materials and labour shortages.
• ordering materials well in advance. This may mitigate the risk of delivery delays and future price rises. Consequently, clients may see an increase in requests for advance payments.
• advance payments need to be considered carefully due to the solvency risk and security should be considered to protect against this risk such as advance payment bonds. This will add additional costs to the project. Ordering and receiving delivery of materials in advance also poses issues of storage and insurance that will need to be considered.
• an increased reliance on provisional sums to avoid committing to costs that are difficult to predict in the current market.

Ultimately, who takes on these risks will come down to the negotiations between parties and their relative bargaining strength.

Supply chains that have taken on the risk of fluctuation in material cost and delivery delays may be at risk of increased disputes and solvency issues. Statistics from the Insolvency Service show that construction insolvencies were up 85% in the 12 months ending Q1 2022 compared to the period ending Q1 2021.

In March 2022, there were 419 company insolvencies in the construction industry, which is the highest figure recorded in the previous two-year period.

Whilst supply chain insolvency is an inherent risk in construction projects, this risk is increased in the current climate. Therefore, to avoid future issues, risk should ideally fall on the party best placed to manage and bear it. However, there may be some debate as to which party this is. 

Increases in construction costs are easier to manage in a market where such assets are commanding record prices and yields, with forward funding and sales yet to be concluded - as the build price fluctuations can be offset against higher sales proceeds than was expected in the appraisal.

Where developers have prepared a pre-let or have already funded the development, these rising costs come off the bottom line, or require a renegotiation on rents or interest coupons.

Likewise, for owner and operators developing for their own use, the burden of increased build costs simply affects profits or, rather, the end user will have to pay a higher price for their living asset - be that an elderly person taking a care home bed, or a fresher pitching up to their university accommodation. These consequences ripple through the market.

Some contractors will argue that it is frequently the employer that can bear the risk in terms of financial consequences. Conversely, it may be argued that contractors are better at managing these risks in the first instance. 

It will be interesting to see how this is resolved in contract negotiations and whether fluctuation provisions will become more prevalent or at least some form of sharing the pain. Certainly, we are seeing that construction costs are part of a conversation around viability at an early stage.

This article features in Shoosmiths’ new report: Operating in living