Problems of the construction market – tools to overcome them
The construction industry’s boom is cyclical; after a good 2021, in 2022 we saw a gradual reduction in the dynamics of investments entitling us even to speak of a slowdown (e.g., in Q3 2022, 63% less construction was started than a year earlier). However, the construction industry is not homogeneous – both specialization and size of construction companies matter, and because of this, some companies face a decline in orders and declining margins, while others at the same time have a full portfolio and are able to raise said margins. One thing is certain: the market is tougher than before due to a lack of funds for investment – fewer orders in some areas, the extension of investments already underway (and therefore guarantees on them), higher financing costs, and labor and material price inflation (albeit gradually slowing down). Where there are problems, there are also solutions – in this text I want to discuss how to overcome the problems of financing investments, especially the release of funds from the security of their contract guarantees.
Attention is drawn to investments (or lack thereof), and the profitability of their contractors is also important
Sales of new apartments in 2022 fell by about 40% y/y and followed by a comparable decline in new investments by residential developers. Residential construction accounts for 15 to 20% of the market – more than 50% of the market is made up of public investments, mainly infrastructure. Funding for road investments is assured, but funding for rail and energy investments is a problem. This is due to the inflow of funds from the current EU budget perspective only in 2024, and the release of funds from the NIP, which could bridge the gap, is still being delayed. The lack of funds and, as a result, the stagnation in investing, in addition to railroads and energy, is also felt by local governments, facing higher overall costs (energy prices, new obligations), but also an increase in the cost of investments already underway.
In this situation, the condition of individual contractors is important – not least because of their specialization: the warehouse market, distribution centers and logistics are in good shape, while companies dependent on residential construction are losing. The size of the company also matters: the construction market changed during the pandemic, with the result, for example, that all the big players (the top 15) reported record profits. They are the ones who are swamped with contracts and will be disguised as subcontractors, unable to rein in the numerous local government or private investments as before. Hence the reversal of the trend – a decline in the margins of small and medium-sized companies and an increase in those of large companies, a trend toward their equalization.
The real problem – financial security for investments, including guarantees
All indications are that in some areas of construction, the previous increase in the price of construction materials has already begun to slow down from Q3 2022. On a year-over-year basis, cost pressures were a significant problem: in a broad generalization, shuttering materials became 70% more expensive, electricity 60% more expensive, and wages increased by 20%. At its peak, the price of steel more than tripled – but this is no longer a problem, there has been a repricing of steel as demand declined, and sales (and over time prices) of shell-related items – such as windows – similarly declined by a third.
The slowdown in cost growth is not associated with a dramatic improvement in the situation of smaller and medium-sized contractors. With a limited number of orders, we are dealing with a situation like in 2015 – the market of the main contractor. While it used to be the smaller and medium-sized contractors that had higher margins than the main contractors (quoting around 1.5%), it is now the large companies that are increasing their margins, while the smaller ones are falling. Financing institutions are taking this into account – the aforementioned uncertainty of a rapid influx of public funds into the market also contributes to their risk aversion. But also the expected accumulation of works once they are released due to the very high demand for works in the energy sector and on the railroads, which will result in higher costs and problems with their valorization (roads – currently it’s 10% max) and also problems with timeliness.
The latter are occurring even now, among other things, many investments are being delayed due to a shortage of workers. Demands are also being made to extend, along with this, the extra-premium quality guarantee periods from 10 to 15 years. With banks’ conservative, cautious assessment of financial risks in the construction sector, this raises the problem of the lack of limits on such long guarantees.
The solution – share the risk with the insurer
In order to relieve the burden on the credit limits of construction companies in banks, guarantees can and should be shifted to the insurance sector – this is what customers who have limits and in banks and insurers can do after all. In this way they will free up financing in banks, while not bypassing them, but with their participation. Allianz Trade offers an MRPA program for this purpose, i.e. Master Risk Participation Agreement – its premise is to participate in the guarantee issued by the bank, thus relieving the limit of the guarantee customer at the bank. This is possible thanks to the high rating of our capital group – in effect, capital relief allows you to get off the limit at the bank. This is important especially in large upcoming investments, not only in roads (PLN 28.6 billion for 2023 in the plans of the General Directorate for National Roads and Motorways), but also, for example, in the power industry, i.e. in key investments of huge amounts. The bank, by not increasing its exposure, can keep its client – it does not have to look for a limit and financing elsewhere, and an insurer like us is not a competitor for the bank, we do not offer direct financing to the client and only take over the necessary part of the guarantee risk in agreement with the bank.
This is also in the interest of construction companies, because it provides them with the level of financing they need, so they themselves can propose to banks that they share the guarantee risk and free up limits for financing. This is important for CFOs – in ongoing projects they need both guarantees and financing. In some situations, regulations make the investor not accept fully insured guarantees, and then MRPA also comes out ahead – the bank is the lead guarantor, and we, as an insurer, double-insure it, assume part of the risk.
In the long run – better use of domestic capital
It is worth rethinking PPP (public-private partnership) – there is still a lack of use of this form effectively and on a large scale, which is why we are so dependent on the next tranches of funds from the EU. To make it work, the source of money cannot be standard financial products like bonds. Private investors’ savings need to be mobilized – in the shape of “bricks,” as in the Second Republic. Someone would have to issue guarantees (BGK, some government-appointed fund), this could jump-start the market for both savings and investment. From our perspective, from the side of the institution guaranteeing investments, a dispersed source of financing would not be a problem, and could become a stimulus for the market. By the way, it would be an interesting form of investment for private investors, and we would all benefit from new investments.
Andrzej Puta, Director of the Guarantee Bureau at Allianz Trade
Last Updated on April 3, 2023 by Anastazja