Construction

Construction is a cyclical sector, very sensitive to financial conditions and the interest rate level. This is the reason why the sector is in a challenging situation currently. For the time being, a backlog of work caused by the pandemic and subsequent supply chain issues are keeping activity somewhat stable – backlogs worth three quarters of work are observed both in the US and in Europe – but the outlook is more uncertain with restrained demand caused by high financial costs.

Timid demand is a constraint on the sector at the moment. Demand for residential construction is suffering due to high interest rates and housing affordability issues, commercial demand is strained by changing needs and financial constraints, while demand stemming from infrastructure is more stable and even strong in some parts of the world.Financial conditions are tightening with banks’ credit standards contracting along with interest rates having risen rapidly in much of the world due to successive hikes decided by significant central banks such as the Federal Reserve (Fed) and European Central Bank (ECB). As the construction sector is highly dependent on debt, operating in a high interest rate environment has a direct effect on both supply – the need to finance the actual construction – and demand as households, companies or governments need to finance the purchase of a house, office, plant or bridge.

In addition to rising financial costs, construction costs have been rising quickly in the US and Europe through consecutive waves: initially supply chain issues pushing up costs, followed by elevated commodity prices and lastly rising wage costs. This has resulted in construction costs being around 30% higher in 2023 than in 2019.

With an increased focus on environmental, social and governance (ESG) standards, one of the key issues faced by construction companies, particularly in advanced economies, is managing the decarbonisation of their activities and social challenges, such as improving working conditions, fighting corruption and dealing with undeclared employment. There is a necessity to reduce GHG emissions as the sector, including production of materials used in construction, is particularly energy intensive, but issues, such as water scarcity, also have to be addressed.

Residential demand is waning as housing affordability concerns are clear

The residential market has been facing a slowing demand from households due to a combination of lower real wages and high interest rates. This has reduced housing affordability even further in the US and Europe – house price-to-income ratios have worsened by more than 20% in the US since 2019. House prices have been receding slightly from their peak, but housing costs are still making up a large share of household income as interest rates and rents have risen sharply. Interest rates for new mortgages have increased by around 225 bps (more than doubling) in the Eurozone and the rate of a 30-year mortgage has risen from around 4% in 2019 to 6.6% by end-2023 in the US. The outlook is less bleak in the US than in Europe, with the market stabilizing slightly with tight supply (as many households sit with long mortgage fixed rates) leading to a slight resurgence in home sales.

The combination of high interest rates, high construction costs and worsened affordability will result in a weakened housing market – with fewer transactions and lower prices. There is clearly an increasing mismatch between what buyers can afford and what will be profitable for builders. This will continue to squeeze homebuilders’ profit margins.

Commercial is still adapting to a post-pandemic world

The commercial construction space has been going through a difficult and transformative time with seismic changes in habits and demand since the pandemic. The traditional office space, already challenged by the emergence of co-working spaces, is disrupted by the new normal of working from home. This has resulted in lower demand, and the entry of generation Z into the workforce is causing a change in demand for office amenities, i.e. more demand for environmentally friendly buildings, communal areas, gyms, etc. This will cause a further need to redesign office spaces and add additional costs.

Retail stores are suffering from consumers now shopping more online and generally falling demand. At the same time, parts of industrial construction are suffering from a sluggish manufacturing outlook, whereas warehousing facilities have a more benign outlook with online shopping and rising demand for extra inventory, meaning that demand has increased after the pandemic. The emergence of government industrial policies, such as the CHIPS Act in the US, is generating more activity in selected sectors within manufacturing construction.

Several commercial real estate companies are currently dealing with falling valuations of their properties (commercial property prices have fallen significantly, down roughly 25% in the US and Europe from their peaks in early 2022) which, alongside a high interest rate environment, high energy prices and wage costs, are challenging their profitability. This is happening at the same time as some companies need to rollover their debt. Given that demand has changed for office space and retail stores, real estate companies are having difficulties in passing on their higher costs to tenants, which is challenging their margins.

Infrastructure plans are ambitious but affected by high interest rates as well

Several governments have embarked on large infrastructure plans. This is partly to support the construction sector and domestic growth but is also caused by energy concerns. Several plans have been implemented to facilitate the energy transition, but also to ensure energy security – especially in Europe propelled by Russia’s invasion of Ukraine last year.

In the US, the Bipartisan Infrastructure Law will help construction companies and their suppliers in the materials and machinery sector. This law, and the Inflation Reduction Act (IRA) will support both the building of transport and energy infrastructure in the US, as well as aiding upgrades in equipment in the domestic manufacturing base. It is expected that USD 1.2 trillion will be added over the next five years to finance these projects, thereby boosting the companies operating in the non-residential and infrastructure (public work) segments.

The European equivalent, The Renovation Wave, is estimated to be worth EUR 900 billion and aims at promoting building renovations over ten years, until 2030. However, the current financial environment might limit the impact given that required improvements will be more difficult to finance for property owners due to the high interest level. Additionally, the owner incentive part of the scheme is contingent on owners’ willingness to borrow large sums to improve their property’s environmental performance.

Chinese government intervention to support the sector might be insufficient to overcome its difficulties in the short-term

The construction sector remains important in the Chinese economy, representing roughly 7% of GDP (however, together with the real estate sector, they amount to around a quarter of GDP combined). It rose by 4.1% in 2023 compared to a year prior, but growth was ebbing out throughout the year and the latest construction PMI figures are indicating fewer new orders. The zero-Covid policy impacted the whole construction sector since severe lockdowns and quarantine policies reduced the ability to make home purchases and to operate construction sites. This happened as the sector was adjusting to the Chinese government’s newly introduced “three red lines” rule (centred around three different debt metrics) to limit over-indebtedness in the sector, which seriously challenged the pre-existing business model.

As a result, the business climate in the Chinese construction sector is in the worst state that it has been in for roughly a decade – China’s Real Estate Climate Index is indeed at its lowest level since 2014. This has also had tangible consequences for large Chinese real estate companies that have defaulted on their debt since 2021 – the value of offshore corporate bond defaults rose fivefold between 2020 and 2022 (roughly two-thirds of private real estate developers have defaulted since 2021).

Despite some intervention from the Chinese government, the construction sector is still in disarray and the bankruptcy process of Evergrande and the uncertainty around other developers (like Country Garden) only confirm that government intervention has been insufficient to stabilise the sector so far. The government intervention – such as lowering interest rates and loan relief for developers among other measures – underlines that the Government will do a lot to avoid an actual crash in land prices. While the intervention will have an effect, it might still not be enough to overcome the fundamental problem that confidence, and thereby demand, in the sector is very low. The current situation is bleak with new home sales still weak, and local governments will have a difficult time to compensate for lingering demand as they too are struggling with high indebtedness. With demand low, the sector’s high debt level, and the current economic outlook for China, the Chinese construction sector will remain in a tough space for a while and the recovery will be slow.

Construction material companies are feeling the pinch

Construction material companies, such as cement and other materials, are energy intensive industries. Therefore, they are very affected by current elevated energy prices, particularly in Europe, Japan, and South Korea, and to a lesser extent in the United States, which along with other high costs will affect their bottom line. They have also seen new orders dwindle for almost two years as the construction sector has slowed.

Construction material companies are also facing challenges to decarbonize their activities. There will be a lot of potential for first movers in the decarbonisation process, where there is much government support. For example, concrete makers that are able to reduce their environmental footprint, through electricity decarbonisation for instance, will benefit from Infrastructure Investment and Jobs Act’s grants and the IRA tax credits. These acts will also support construction material demand with further infrastructure development. Activity stemming from infrastructure projects in the US, Europe and Asia could somewhat compensate for difficulties faced by companies in the sector (such as high costs and low demand).