Blog post
June 9, 2022

How is rising inflation impacting the UK construction industry?

by Robert Pritchard, Head of Funds Management and Alexandria Snee, Fund Services Associate

In our last analysis piece in February, we focused on the impact of rising interest rates on the UK residential housing market. It was considered how a potential reduction in mortgage affordability could slow (or reverse) the strong and stable price growth seen over the past decade, or if the chronic undersupply of housing in the UK was too strong a supporting force to prices. 

It was concluded that the rate rises forecast at the time were likely to prove more uncomfortable than unmanageable for home purchasers, with a material reduction in pricing unlikely – a view we still hold. 

Whilst this is clearly a situation that we will continue to monitor, in this note to investors we wanted to focus on the impact inflation – the force central banks around the world are attempting to control with interest rates –  is having on the UK construction industry.  

This is an important topic for us as, not only does the Real Estate Opportunity Fund provide a significant amount of funding to support the construction of new homes, factors influencing the construction industry have a direct impact on the supply and as a result pricing of housing. 

A Changing Inflationary Environment

Recent history has seen a period of relatively low and stable inflation. The Bank of England, along with the majority of their counterparts across the world, have been able to keep inflation within their official targets with relative ease. 

However, like many areas of the economy and society, Covid changed things. Despite the initial fall in inflation as the pandemic imposed lockdowns across much of the world, inflation has since soared. In the UK, headline inflation reached 9.0% in April and the Bank of England now expects it to peak at around 10% in October 2022.  

One of the immediate impacts of the pandemic was the major disturbance of supply chains both in the UK and beyond. Brexit and the end of the extended transition period at the end of 2021 added further disruption (although the extent of such an impact is difficult to determine given the aforementioned Covid induced havoc), as the movement of goods and labour moved less freely. 

Just as global demand returned, new headwinds to supply emerged, predominantly in the form of Chinese lockdowns and the Russia-Ukraine war. 

China’s multi-city mobility restrictions are leading to renewed shipping delays and potentially more supply bottlenecks, keeping transportation problematic and prices sticky. But it is perhaps the devastating war in Ukraine and the West’s sanction policy towards Russia that poses the greatest risk of a lasting shock, with the World Bank projecting energy prices, along with other commodity prices, to remain at historically high levels through to 2024 as a result of the conflict.

 

The construction industry is by no means insulated from this surge in inflation. Whilst many of the global inflationary pressures impact consumer goods, the main inputs to construction – labour and raw materials – have been some of the key areas experiencing significant price movements.  

Materials and Labour

The pause in construction activity globally due to government imposed lockdowns was relatively short and sharp. So whilst the demand for build materials to support this activity went unchanged (and in some sectors increased), the producers and manufacturers of construction materials were still running at reduced capacity. This demand and supply imbalance led to a sharp increase in prices across practically all materials, in particular timber and steel which rose 79% and 77% respectively between Q1 and Q3 2021.

Wages have also been on the up. Skilled construction workers were already in short supply in the UK, in part as a result of under investment by the sector and more recently due to Brexit and its impact on worker migration from Europe. 

Vacancies in the industry hit 48,000 on three occasions in the year to April 2022 – the highest figures since records began 21 years ago. This combined with general wage inflation across the UK, has led to significant wage increases. 

According to the Hays/BCIS Site Wage Cost Index, which tracks changes in the costs of UK construction labour, all-in site rates were 8% higher in Q4 2021 compared with a year earlier.

Impact on Construction Industry

In any sector, a company will always try to pass as much of an input cost increase onto its customer as possible. The construction industry is no different. As the below chart shows, the prices quoted by contractors (the “tender price”) has moved almost exactly inline with build costs.

Fortunately this period of tender price inflation has coincided with a significant growth in house prices. According to Nationwide, UK house prices have grown by 19.7% since the start of the pandemic (from Q1 2020 to Q1 2022). This has allowed many residential developers to maintain profit margins through this period. 

Should house price growth slow, margins are likely to be squeezed and in some cases schemes may become unviable unless there is a correction in land values. With an existing undersupplied market, any subsequent restriction in housing supply could act as a supporting force to prices in the UK. 

The ability of contractors to pass on cost increases on existing builds will however be limited. In the UK the majority of build contracts between main contractors and developers are placed on a fixed price basis, meaning the risk of cost inflation sits with the contractor.

In a market where contracts are typically fixed and contractors with strong balance sheets and high profit margins are rare, it is perhaps of little surprise that the combination of rising input costs and supply constraints has led to an increase in contractor insolvencies – up 85% in the year to Q1 2022. Although it should be noted that government support measures during the pandemic delayed the insolvency of many contractors that were doomed to fail, pandemic or not. 

The failure of main and sub-contractors does pose a risk to developers and their funders. A failed contractor mid-way through a scheme can add delay and costs to a project, and the problem in seeking a replacement contractor at a comparable pricing is exacerbated in the current market.

Not all impacts on the construction sector are negative however. Contractors and developers alike have been incentivised to improve efficiency in the sector, with cost inflation shining a light on the historically poor productivity of the sector. The improvement of on-site practices and employment of new methods of construction, including off-site manufacturing, have all gained renewed focus in the high cost environment. Should this continue, we could see the sector come through this period in a better, more productive, shape than it went into.

Outlook

Whilst challenging to make predictions in this environment, looking forward it is difficult to see how the current rate of cost and wage inflation within the construction industry will continue. Energy prices are likely to remain high and this will affect those materials that are energy intensive in their manufacture, however, many of the disruptions to supply-lines impacting construction materials are easing. The potential for further covid lockdowns in China is unlikely to disrupt imported construction materials destined for the UK, and may in fact weigh on global material prices as Chinese construction activity is subdued.

The outlook for wages is less clear due to the variety of factors that determine their growth. The impact of Brexit has already been felt and the drivers for both demand and supply in the construction industry should settle in the coming months. Looking at the wider market, wage inflation across all sectors is set to fall from 5.3% in 2022 to 2.89% and 2.6% in the two years that follow.  

Reacting to the uncertain cost environment some developers, predominantly in commercial (non-residential) sectors, have already delayed planned schemes. Should this continue the reduction in construction activity should help alleviate some of the pressure on both labour and material prices. 

Furthermore, wider contingencies are also now being included in build contracts to reflect cost uncertainty. Whilst this increases tender prices, it should mean that contractors are better placed to weather inflation, make profit and ultimately stay solvent. 

All of the above, whilst not certain, do point to an improving picture on inflation within the construction industry. 

In Context of the Real Estate Opportunity Fund

At LendInvest, we are very aware of the strains inflation is placing on the construction industry and our borrowers. Fortunately, our development loan positions have been relatively insulated to-date. 

Firstly, we lend to developers rather than contractors, with fixed price contracts between our borrowers and contractors helping to mitigate cost risk. For those developments where our borrower is dealing directly with subcontractors, the additional contingency we included on underwrite of the loan has allowed for the absorption of cost increases. 

Lending to good quality sponsors with established track records has also helped mitigate the impact of cost inflation as they are able to obtain best value in their builds and have the resources to meet cost increases should they arise. 

That said, with risk mitigation being key to the performance of the fund, we have taken a number of steps to help further protect the fund from potential risks related to cost inflation. 

  • Including a greater level of contingency in appraisals so that cost increases can be met
  • Reduced appetite for larger development schemes
  • Targeting a lower overall leverage level for our portfolio of development loans
  • Greater focus on the financials of main contractors 
  • Moving our development product to floating rates to benefit from a rising rate environment.

With the above measures and our continued focus on supporting high quality developers and schemes, we feel that the fund is well positioned in this environment of inflationary uncertainty. 

Capital at risk – The value of investments (and income) may fall as well as rise and you may get back less than invested. Past performance is not a reliable indicator of future results. Learn more about our approach to managing risk.

Income and capital repayments are not guaranteed. Investors cannot liquidate investments, but the underlying borrowers may repay early, late or not at all. Your capital is at risk. Past performance is not a reliable indicator of future results. 

The information we provide can help you make your own informed decisions, but it is not investment advice or a personal recommendation. You should seek independent financial advice if you are not sure a product or investment is right for you, or you do not fully understand the risks.

Issued by LendInvest Funds Management Limited (the Investment Advisor) on behalf of the LendInvest S.C.A SICAV-SIF S.A. – The LendInvest Real Estate Opportunity Fund which is authorised by the Commission de Surveillance du Secteur Financier.

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