Property development has been thriving over the past 12 to 24 months. Low interest rates and insatiable demand for housing (from investors and owner-occupiers alike) has spurred one of the most significant construction booms since the 1970s.
The industry that was hit hard during the GFC appears to have now fully recovered with a strong pipeline of projects continuing to work their way through the system. The annual number of new homes consented has been setting new records each month since March 2021. The previous high (last set in February 1974) of 40,025 was surpassed for the first time. While not all newly consented dwellings will get built, it is commonly accepted that a high level of new consents is usually followed by high levels of building activity.
Operating at the coal face of the property development and construction finance market, we can attest to the significant increase in demand for project funding. ASAP Finance has funded over 800 new dwellings year to date, a 57% increase from 2020 when we funded 507 houses. Almost all of our clients have been huge benefactors of the construction boom, and while we expect demand for housing to remain strong into 2022, headwinds are building, and developers need to be mindful of the changing conditions.
It is well established that construction is a cyclical sector of the economy, and one prone to overshooting. Economic cycles are to be expected and can be planned for — it is the extreme or rapid pace of change that so often catches people off-guard.
Characteristics of boom-and-bust cycles within the construction sector are well studied—rapid increases in construction activity can cause inflated construction prices, reduced competition among builders, and result in increased lead times (due to capacity constraints). In contrast, downward moves can result in competitive cost-cutting, a reduced margin, and pressure on quality.
With the above in mind, it is hard to ignore some of the characteristics on display in the current market, creating challenging conditions for property developers and contractors alike. Let’s look at some of these challenges in more detail:
Industry-Wide Capacity Constraints
The industry is facing significant capacity constraints. All sectors of the market appear to be affected by shortages of raw materials, essential products, and skilled labour. The unemployment rate is sitting at a historic low of 3.4% (a rate not seen since December 2007) and issues with sourcing and retaining skilled staff are now commonplace resulting in extended deadlines. This is evident across the development lifecycle from planning to construction.
Local councils, who are essential to project planning, are consistently missing the self-imposed statutory deadlines to process consent applications. Recently, Auckland Council wrote to one of our clients advising them that resource consents are taking 6 weeks to be simply ‘assigned’ to an assessor due to ‘unprecedented demand’ and ‘under-resourced teams’. We have not witnessed a single resource or building consent issued within the 20-working day statutory deadline, with most taking between two to three months to process.
Construction companies are facing similar constraints. With most contractors booking ‘back-to-back’ jobs, the consequences of missing pre-arranged ‘window’ for a sub-trade to undertake specified works is now dire. For example, if you have your slab-pour booked for Wednesday, and for some reason the slab is not ready on that day (say because you had previously failed a pre-pour inspection that required remediation), it is not a simple process of re-booking the sub-contractor for an alternate date. Often, the next available date may be weeks, if not months away from the prior date, significantly pushing out your completion date.
Supply Chain Disruptions
In addition to capacity constraints, importers continue to face considerable disruption to their supply chain resulting from Covid-19. Freight and shipping costs have surged, with the latter reported to have increased as much as 400% since the start of the Covid-19 pandemic in 2019. Limited availability of freight and increased lead times (including increased processing times to clear NZ ports) are only further contributing to price increases across essential products in the construction sectors. The above is of note given an estimated 90% of all (building) products sold in NZ are either imported or contain imported components not easily replaced by domestic supply.
What does this mean? We are hearing of delays on framing, weatherboard, cavity batons, insulation, concrete… the list goes on. While some materials are easily replaceable, others are not with alternate products often only available at a significantly increased cost (if at all). Most recent anecdotes from our clients include 4–6-month delays on frames, 2-month delays on concrete, and other issues.
Escalating Construction Costs
Surging demand and limited supply are leading to rapidly rising construction costs—ANZ reported in Q2 and Q3 2021 an increase in construction costs of 4.5% on a quarterly basis. However, these numbers do not appear to represent the extent of the cost increase prevalent in the industry.
At ASAP, we have witnessed contracted construction rates (from independent builders’) for affordable terraced product skyrocket from $1,900-2,100/sqm in 2019, to $2,500-2,800/sqm today. Developers who have engaged builders on fixed-price contracts need to consider whether their contractor will still be able to perform/complete the project within the agreed budget. Opting for the cheapest contractor in this market (or any market) is not the right strategy — you can expect an increase in variation claims (VO’s) as they try to recoup or pass on the cost for mispricing the job. Worse still, some of the so-called “affordable” builders may not have the cash flow or planning foresight to overcome the pressures brought about by cost escalation and may become insolvent themselves.
The rate at which prices are rising is forcing builders to move away from the traditional fixed-price contract—with a preference to opt for cost-plus-margin or other forms of contract. We are also seeing an increase in contractors seeking upfront payments and deposits to guarantee the supply of materials. The above has flow-on affects when obtaining funding—most banks are unwilling to fund projects without fixed-price contracts.
Furthermore, there are very few lenders who will allow upfront payments that do not reflect work completed on the site to date (as these payments are affectively unsecured). Looking ahead into 2022, relationships with funders who understand such complexities and who are willing to be flexible with the funding mechanics will be paramount.
Funding Market Struggling to Meet Demand
Main banks have tightened considerably over the past 6 months, in response to the mounting headwinds within the sector. We are hearing of banks requiring up to 130% presales cover ratio (vs. the previously accepted 100%) and increased contingencies of up to 20% of the construction budget (previously 7%-10%). In addition, there has been many changes to the regulatory environment in the retail market, making funding generally harder to obtain. These changes include amendment of the CCCFA (responsible lending code), reduction of LVR speed limits, the introduction of tighter debt-to-income ratios, and changes to test interest rates.
As the banks retreated, non-banks stepped up to fill the void (as best they can), however, liquidity appears to be a common issue. Anecdotally, most the major non-bank development lenders have had to pause or limit lending at some point during FY2021—a market characteristic that used to be commonplace but has not been prevalent for several years. Even at ASAP, we were forced to limit the onboarding of new clients in November and December due to unprecedented demand, despite having increases to our funding lines approved earlier in the year. In this environment it’s important to be wary of irresponsible lenders who over-trade—we are already hearing of lenders who are unable to meet settlement obligations or make progress payments under the existing facilities. At ASAP we operate with a margin of safety that ensures we can meet obligations to existing clients.
Limited funding is having flow-on effects regarding loan processing times and credit criteria. Applications are taking longer to process, as non-bank lenders wait to match up new lending with repayments. Expect low-risk transactions and existing relationships to be prioritised ahead of high-risk transactions or ‘new-to-bank’ clients. Developers should expect enhanced due diligence, tougher conditions, higher interest rates and fees, and greater equity contribution. This trend can already be witnessed industry-wide to varying extents; for example, one lender who previously provided development funding without a QS is now insisting on having a QS appointed to every project. To avoid being caught out—engage with your lender as early as possible and take time to work through any conditions up front.
The Path Forward: Consult with ASAP Finance Today
While the issues at play are complicated, they are in essence textbook characteristics of a booming construction market. Partnering with experienced and well capitalised lenders will be key to navigating a path to success. We encourage our clients to engage with us early and get a good understanding of the funding that would be available and also get clarity on the likely terms and conditions. Get in touch with ASAP Finance for property finance in New Zealand today.