Rise in construction costs 0 comments

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Anything that looks too good to be true will eventually show its bad side. This law of nature manifests itself in economics through the laws of supply and demand; where demand rises strongly, supply experiences a tightening which eventually leads to higher prices crimping the margins.

Singapore's construction industry is poised to enter a boom period. Value of contruction works for 2007 is estimated to be ~S$19B, up strongly from previous years of sub-$15B. Demand is strong from the private sector due to upcoming condominium and commercial developments especially in the prime areas, the IR developments extending all the way to 2009-10, as well as oil and gas infrastructure construction on Jurong Island and selected industrial facilities construction (especially semiconductor and disk drive facilities). Those interested in the dynamics leading up to the current construction boom can refer to a previous writeup a year and a half back: Recovery of Singapore construction industry.

Yet, as mentioned earlier, it is important to look at the feedback of strong demand into rising factor costs.

The Indonesian sand ban is the most widely-talked about issue this past week and has allegedly been responsible for the market crash on Thursday. Sand is an important component of concrete, comprising 1/3 of the total (as "fine aggregate"), with the rest comprising granite ("coarse aggregate"; 40-45%) and cement (15%). It is unwise to just laugh this off; the ban is likely to be revoked but with readjustment to higher selling prices (already there is talk of sand prices rising 100% or more). There have been sand bans in the past from Indonesia in the late 1990s-early 2000s which were then reversed; it is worth noting that Sembcorp Construction ran into the red because of such bans. It is also worth noting that such building materials price hikes are not confined to Singapore: in December 2006 the Malaysian government also raised its ceiling price for cement by 10% though due to different dynamics (higher production costs eg. energy, transportation).

The sand ban is a precursor of things to come. It may or may not have strong cost impact (our government insists it will not) but it is a symptom of imminent rising building materials costs.

Building materials are not the only factor costs to see potentially strong inflation. Given the industry's labour-intensive nature, the issue of lack of skilled labour for the high number of construction projects coming up has also been highlighted several times by the government, leading to relaxation of labour laws to allow contractors to hire more foreign labour. The reason is the lack of local supply as most Singaporeans shun the construction industry. 50,000 new foreign workers are expected to join the Singapore job market in the next few years as major construction projects get underway. Such a high influx of foreign labour, while alleviating the labour supply shortage, might destabilise margins because foreign labour is typically lower-educated, implying high training costs; and less adaptable, meaning any switches to alternative and better building methods may be difficult (such as switching to the steel-based dry construction method from cement-based wet construction due to the sand ban).

It is instructive to look at the most recent gross margins of some locally-listed construction companies for a view of how important direct costs (ie. raw materials, direct labour) are. Gross margins are typically <10% for companies like Chip Eng Seng and Lian Beng, suggesting direct costs form >90% of total revenue. And these are the better construction companies.

The incidence of rising materials and labour costs, however, is not likely to fall strongly on builders, given the strong demand for their services and the tight supply given that many poorly-managed builders have dropped out over the lean years. Any rising costs will be shared by the property developers, who will be trying to launch their developments ASAP in the current boom market before it falters (as it inevitably will) and therefore will be willing to pay higher prices for construction works. Hence, any rise in factor prices will filter its way downwards through the entire value chain and affect both builders and property developers. It is worth noting that the property index on the SGX has fallen more substantially than the construction index since the announcement of the Indonesia sand ban.

A trend in recent years has been for construction companies to venture into property development, making them integrated property developers, where they integrate their core competence in construction with the very closely related field of property development. This enables them to undertake design-and-build projects, and pass construction costs directly to consumers (property buyers) through higher selling prices that factor in higher construction costs. This business model shields these companies partially from rising construction costs.

Companies to avoid must be poorly-financed construction companies with thin margins. Why buy into companies with loss-making or unstable track records which have basically shown their inability to manage costs well (albeit in the lean years)? A rise in material costs could easily put them into the red given the incumbent thinness of their gross margins as it is; poor finances will exacerbate the situation through lack of working capital to deal with rising costs. This is what caused smaller construction companies to collapse in the years following the last mini-construction boom of 1998-99.

References:
(1) Channelnewsasia Jan 25 2007: 50,000 more foreign workers needed in construction sector