Capacity constraints in construction sector driving 'massive' price escalation

Capacity constraints in Auckland's construction sector have been driving up building costs by more than four times the rate of inflation in recent years, eroding margins for companies locked into fixed-price contracts.

John Dakin, chief executive of industrial and commercial property investor Goodman Property Trust, says the cost per square metre to build the average warehouse in Auckland is about 50 percent more expensive today than it was five years ago and his understanding is that construction costs have been rising at an annual 8 percent a year for the past five years. In that time, the annual consumers price index hasn't risen by more than 2.2 percent.

Fletcher Building this week slashed $110 million from its guidance for full-year operating earnings before interest, tax and significant items after taking a deeper look at the building and interiors (B+I) unit of its construction arm, where losses on two major projects have been identified.

"In the last few years, construction pricing has been the biggest challenge," Dakin says. "We've seen massive construction price escalation".

That tallies with assessments from other property investors including Precinct Properties, which told analysts including Macquarie's Stephen Hudson last September that since it had signed the construction contract for its Commercial Bay development in Auckland with Fletcher Building in December 2015, construction costs for comparable Auckland CBD office projects had increased by 10 percent.

Fletcher said yesterday that Commercial Bay remained profitable although losses at another major project and a provision for expected losses at a second project meant its construction division would post a loss this year.

Dakin declined to comment specifically about Fletcher but said as a consumer of construction services, Goodman had faced "significant cost escalation" from the half dozen builders the company regularly used and his understanding was that it was capacity constraints among sub-contractors to major projects "because they are so flat-out" and it had become "a big issue for the country".

"At the moment there's a lot of price escalation around labour. There's some building material cost escalation," Dakin said. "We're probably going to see a bit of rental increase" as a result.

Fletcher shares dropped about 10 percent on yesterday's shock announcement, which came just four weeks after the company had affirmed its full-year guidance with its first-half results, which included a more modest one-time loss on a construction project. The stock gained 1.7 percent to $8.42 today as analysts reassessed the company in the wake of the downgrade and subsequent briefings to investors and analysts.

Hudson reiterated his 'underperform' rating on the company with a 12-month price target of $7.87. "It seemed in February that the market would not readily accept that the loss identified then was 'one-off'. We remain of this view," he said in a note yesterday, adding that the company's review of the B+I business should have extended to its residential and land development business.

By contrast, Credit Suisse upgraded Fletcher to 'outperform' from 'neutral', while cutting its price target by 3 percent to $9.80, and RBC Capital Markets lifted its rating to 'outperform' from 'sector perform'.

Fletcher didn't identify the problem contracts, although the $300 million Justice and Emergency Services precinct in Christchurch fits the bill of a complex project due for completion in the next few months, while Auckland's convention centre and Hobson Street hotel, a $700 million contract, would fit the bill of one that has a few years yet to run, with a completion date of 2019.

Chief executive Mark Adamson said yesterday that the loss-making project was complex - starting with "certain engineering issues that had not been resolved" and that "caused the initial delay" and that was "exacerbated" by changes to the design brief for the "unique" building.

Adamson said the critical thing with a major project was to stay on programme and if there was slippage in the timetable it was hard to get back and could have "almost an exponential multiplier effect". The nature of inflation in the industry was the "tightness of the market and the availability of sub-contractors."

Changes put in place as a result of the review included a "more stringent bidding process" and "a far more stringent filter on the nature of contracts and clients," Adamson said.

The New Zealand Shareholders Association yesterday questioned Adamson's performance, saying the downgrade left investors with a lack of detailed answers. A Fletcher spokesperson didn't respond today to a question on whether the Fletcher board still had confidence in Adamson.

(BusinessDesk)