The Problem with Construction is Actually the Solution
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The past few months can be best described as average economic conditions, with regular news of companies in the building construction industry either flashing red or announcing bankruptcy.
Stable economic growth and a tight labor market, which is benefiting most sectors in the broader property industry, hasn’t as readily materialised in the construction industry..
Rising market interest rates are having a negative impact on capital market conditions across various asset classes. Private credit opportunities, while resilient, must compete in an incrementally (albeit gradually) shrinking pool of residential lending projects. The wider commercial sector isn’t doing any better either, with capitalisation rates showing signs of softening and discount rates moving in an upward direction. So, across the space we’re looking at a smaller pool of profitable opportunities.
The construction industry is a substantial part of the Australian economy, contributing 7.5% to the nation’s GDP and employing over 1.2 million people. While there is still a considerable amount of work in progress, approvals for new dwellings have dropped significantly, partly due to the conclusion of the Home Builder program and the rise in mortgage rates.
A surge of 30 percent in residential construction costs over the past two years has led developers to put their projects on hold. Given the construction sector’s size and its extensive supply chains, this slowdown in construction activity will have a noticeable impact on the overall pace of economic growth. The extent of this downturn will depend on the scale and pace of future interest rate increases.
This brings me to the consumer, during the previous quarter, the total number of employed individuals in the nation rose by 106,000, reaching a total of 13.9 million people employed as of March 2023. Remarkably, the unemployment rate continues to hover near historically low levels at 3.5%. This signals a stable and flourishing economy, which bodes well for the continued strength and growth of the residential housing/rental sector.
The construction industry also faces challenges such as supply chain disruptions, increased costs, rising borrowing expenses, financial stress, and the persistent issue of stagnant productivity.
The (recent) series of well-publicised insolvencies within the sector has reduced both the quality of projects available and the ability to deliver ongoing projects. However, positively, the nimble and agile nature of private credit opportunities has offered investors access to opportunities which have proven to be stable and resilient – despite all the challenges.
The opportunity is to identify and fund projects that are best positioned to flourish in the aforementioned commercial and supply chain environment. Projects that are less construction intensive give added assurance to both the lender and the developer, with fixed price contracts that are easier to agree on. A less construction-intensive project also leaves a smaller footprint, likely facilitating a faster pre-sale and attracting the kind of clientele who requires financial unencumberment.
Private credit is now utilising its “dry powder” more effectively. Opportunities lie not only in enabling project completion but identifying sectors and lending opportunities that are less construction-intensive and are backed by resilient market demand.