The UK Construction Industry: Impact of the Recession

The UK Construction Industry: Impact of the Recession INTRODUCTION Chapter 1: Background Information According to the Department for Business Enterprise and Regulatory Reform (BERR), the UK construction industry has 250,000 firms employing 2.1 million people, and contributes 8.2 percent of the nations Gross Domestic Product (GDP). Construction companies provide employment for every skill level from labourers to architects as well as the opportunity to work for every size of firm from family run businesses, to major contractors. Its efficient operation and competitiveness is also essential to the fulfilment of the Governments commitment to improve public services and infrastructure. The delivery of new schools, hospitals, affordable housing, eco homes, all depend on the success of the construction sector to deliver. Key issues the construction industry is facing in 2009 With cut-backs, uncertainty and more red tape it looks as if 2009 will be a challenge. To say the year has been one of turmoil and change is an understatement. The reeling financial markets and the swelling sense of gloom overshadowing the general economic outlook have, naturally, a corollary in the construction industry always a lag barometer for the economic climate. And the uncertainty is far from over. If some experts are correct, we may be witnessing just the initial battering of the storm. Mervyn King, Governor of the Bank of England, has admitted it is likely that the country is heading for a â€Å"prolonged and painful recession†. In the last twelve months, the national and global situation has worsened. So in this light, below are the authors predictions for the biggest issues that UK construction will face. Skills The recession is forcing employers to look at restructuring and, ultimately, redundancies. For an industry that has enjoyed a boom for years, this is going to be a massive change of mindset employers need to be very careful they manage any redundancies properly or we will see an increase in litigation in this area. However, and perhaps perversely, the industry will continue to suffer major skills shortages, particularly in the South-east, where 2012 is a tremendous opportunity, but one which casts a skills shadow. This time, project management skills will be in short supply, due to lack of training facilities or lack of investment in education sponsoring from construction companies, rather than labour, where the situation regarding migrant workers who may be returning to their native countries will continue to remain unclear into 2009. Sectors like caring, which still needs a lot of people will attract all the labour force. Temporary workers Agency workers are soon to be given similar rights to permanent staff. It is proposed that the law will change in 2010. The new law will mean that after 12 weeks on assignment, an agency worker will be entitled to ‘equal treatment meaning the same basic working and employment conditions as a comparable permanent employee, including equal pay, notice and holiday entitlement. For an industry that employs a large volume of temporary workers, this is going to be an administrative and financial challenge that will really make itself felt in 2009. Health and safety The recent downward trend in construction-related injuries may well be over, and 2009 could see a significant increase since contractors will be looking to cut down costs on training and overlooking basic safety measures. There are suggestions that considerably different levels of adherence to health and safety rules are due to the rapid influx of migrant workers. Different people behave and act in different ways although all working for UK construction companies. There are some people who are very meticulous about their work and adhere to each and every smallest safety precautions while there are others who can consider petty measures as time wasting. If evidence of this emerges in 2009, we could expect the industry to experience a crackdown from the HSE. We expect to see increasing postponement of Local Authority maintenance work, which will hit small contractors and subcontractors the hardest. The Government is talking about major investment in new schemes. The consequence is that, even allowing for more lending, spend will have to be clawed back from somewhere. It seems inevitable that this will be from maintenance. This will be counter-productive, as maintenance work which puts money into the pockets of smaller contractors, quickly is usually the fastest way to stimulate the economy. House building For what seems like forever, the Government has been hugely vocal about its target for three million new homes by 2020 and 10 ecotowns by 2020. As Construction News reported, housing minister Margaret Beckett is already re-articulating these as â€Å"ambitions† and â€Å"hopes†, rather than firm commitments. (from www.cnplus.co.uk/story.aspx) It would seem inevitable that â€Å"ambitions† might be downplayed further and become â€Å"future aspirations† before long. This will provide more worry for subcontractors who rely on the house-building sector for some of their work. The fact that the UK is still suffering a major shortage of housing particularly affordable housing, regardless of falling house prices does mean, however, that this semantic juggling will only be a 2009 phenomenon. Top 20 Construction Companies Q2 2009 The Top 20 construction companies league table, by construction news, ranks the UKs 20 biggest construction companies by turnover and profit, as follows. The table is updated quarterly, and was last updated inJune 2009. New Infrastructure New infrastructure output in the 12 months to the first quarter of 2009 was 7 per cent higher compared with the previous 12 months and the first quarter of 2009 was 2 per cent higher compared with the previous quarter. The outlook is becoming increasingly gloomy as the worsening economy hits the capital. London escaped the worst of the construction slowdown for much of 2008. Indeed, the value of underlying work starting on site fell by just 3 per cent in 2008. But construction starts in London fell sharply in the fourth quarter of 2008 as the worsening economic conditions took hold. The value of underlying construction starts has continued to slide during the opening months of 2009, with starts during the three months to February 35 per cent down on a year earlier. With financial and property related firms reducing their workforces, many developers have put planned construction projects on hold. The value of underlying office starts, which accounted for about a quarter of the value of underlying construction starts during 2007, fell 21 per cent last year. That said, some developers are still pressing forward with major office projects. Tighter mortgage conditions and sustained pessimism in the residential housing market are now severely impacting private housing construction in London. Having held up well during the first half of 2008, sector starts in the capital are now following a similar trend to the rest of the country. The value of underlying construction starts was  £150 million in the fourth quarter 2008, down 73 per cent on a year earlier. Construction prospects in London are becoming increasingly gloomy. The value of projects in the pre-construction pipeline has fallen away sharply, with underlying planning approvals falling by 36 per cent in value during the fourth quarter of 2008. Large projects are a significant feature of construction activity in London. At first glance the preconstruction pipeline for large projects looks promising. However, given the current economic climate, there is likely to be a higher than normal proportion of planned large projects to be either delayed or abandoned. This is due to the fact that the government is planning to spread its restricted allowable budget across several other vital sectors such as education and health. Nonetheless we should breathe a sign of relief when looking at big projects such Cross rail where preliminary works have begun this year and construction starting in 2010. We should also be looking at temporary relief projects such as the Olympics which need to be completed by mid 2012. These important projects are acting like a lifeline for major construction companies, while waiting for the bad economic climate to change a bit. Overall, construction starts has significantly deteriorated in 2009, which has affe cted small contractors a lot but there is still a glimmer of hope for major firms with very few massive projects. Chapter 2: History of recession The word recession has several meanings. The simplest one could be, a recession happens when our neighbour losses his or her job, and it is a depression when we are made redundant. Economic textbooks tell that a recession is what happens when the economy shrinks for six months on the trot. GDP is used to measure the size of the economy, and when the figures go negative for two successive three months periods (or quarters) the technical definition is met (from http://business.timesonline.co.uk/tol/business/economics/article5753844.ece). When recessions are prolonged past several months, they become depressions. Unlike recession there is no widely accepted textbook definition of a depression, although some say it comes when GDP shrinks by a total of 10 per cent. It will feel distinctly like a depression if a recession goes on for more than a year. After two years, talk of recessions is sure to be replaced by ultra-glum references to depression. Credit crunch timetable Year 2007 In February HSBC gives an early sign of the crisis to come when it warns of higher than expected mortgage defaults in its US business. In August BNP Paribas suspends three funds exposed to sub-prime mortgages. European Central Bank pumps â‚ ¬95 billion into the markets. In September Northern Rock seeks emergency funding. First run on a UK bank for more than 140 years. In October UBS, of Switzerland, is the worlds first major bank to announce losses from sub-prime-related investments, totalling $3.4 billion. Year 2008 In February Northern Rock is nationalised. In March Bear Stearns, the US investment bank, seeks emergency funding and is sold to JP Morgan in a cut-price deal, sparking week of turmoil in stock markets. In April Nationwide records first annual house price fall for 12 years. In September Lehman Brothers, the US investment bank, goes bust. Bradford Bingley is nationalised. In October The Icelandic banking system collapses. Royal Bank of Scotland, Lloyds TSB and HBOS are partly nationalised. Year 2009 In January UK officially enters recession. In March Base rate cut to 0.5 per cent. The credit crunch refers to a sudden shortage of funds for lending, leading to a resulting decline in loans available. A Credit Crunch can occur for various reasons: Sudden increase in interest rates (e.g. in 1992, UK government increased rates to 15%) Direct money controls by the government (rarely used by Western Governments these days) A lack of liquidity in the capital markets The recent credit crunch was driven by a sharp rise in defaults on subprime mortgages. These mortgages were mainly in America but the resulting shortage of funds spread throughout the rest of the world. Steps to 2007 / 08 Credit Crunch US mortgage lenders sell many inappropriate mortgages to customers with low income and poor credit. It is hoped with a booming housing market, the mortgages will remain affordable. Often there was lack of controls in the sale of mortgage products. Mortgage brokers got paid for selling a mortgage, so there was an incentive to sell mortgages even if they were too expensive and high chance of default. To sell more profitable subprime mortgages, mortgage companies bundled the debt into consolidation packages and sold the debt on to other finance companies. In other words, mortgage companies borrowed to be able to lend mortgages. The lending was not financed out of saving accounts, for example. These mortgage debts were bought by financial intermediaries. The idea was to spread the risk, but, actually it just spread the problem. Usually subprime mortgages would have a high risk assessment rating. But, when the mortgage bundles got passed onto other lenders, rating agencies gave these risky subprime mortgages a low risk rating. Therefore, the financial system denied the extent of risk in their balance sheets. Many of these mortgages had an introductory period of 1-2 years of very low interest rates. At the end of this period, interest rates increased. In 2007, the US had to increase interest rates because of inflation. This made mortgage payments more expensive. Furthermore, many homeowners who had taken out mortgages 2 years earlier now faced ballooning mortgage payments as their introductory period ended. Homeowners also faced lower disposable income because of rising health care costs, rising petrol prices and rising food prices. This caused a rise in mortgage defaults, as many new homeowners could not afford mortgage payments. These defaults also signalled the end of the US housing boom. US house prices started to fall and this caused more mortgage problems. For example, people with 100% mortgages now faced negative equity. It also meant that the loans were no longer secured. If people did default, the bank couldnt guarantee to recoup the initial loan. The number of defaults caused many medium sized US mortgage companies to go bankrupt. However, the losses werent confined to mortgage lenders, many banks also lost billions of pounds in the bad mortgage debt they had bought off US mortgage companies. Banks had to write off large losses and this made them reluctant to make any further lending, especially in the now dangerous subprime sector. The result was that all around the world, it became very difficult to raise funds and borrow money. The cost of interbank lending has increased significantly. Often it was very difficult to borrow any money at all. The markets dried up. This affected many firms who had been exposed to the subprime lending. It also affected a wide variety of firms who now have difficulty borrowing money. For example, biotech companies rely on ‘high risk investment and are now struggling to get enough funds. The slow down in borrowing has contributed to a slowing economy with the possibility of recession in the US a real problem. Credit Crunch in the UK UK mortgage lenders did not lend so many bad mortgages. Although mortgage lending became more relaxed in the past few years, it still had more controls in place than the US. However, it caused very serious problems for Northern Rock. Northern rock had a high percentage of risky loans, but, also had the highest percentage of loans financed through reselling in the capital markets. When the subprime crisis hit, Northern Rock could no longer raise enough funds in the usual capital market. It was left with a shortfall and eventually had to make the humiliating step to asking the Bank of England for emergency funds. Because the Bank asked for emergency funds, this caused its customers to worry and start to withdraw savings (even though savings werent directly affected) As a result of the credit crunch, the UK has seen a change in the mortgage market. Mortgages have become more expensive. Risky mortgage products- like 125% mortgages have been removed from the market. UK Banks continue to face problems. HBOS (Owner of Halifax) struggled to finance its balance sheet. Like Northern Rock, it financed an expansion of lending by borrowing. Now money markets have frozen up, they couldnt raise enough money to maintain liquidity. Falling House prices. Now that mortgages are difficult to get, demand for houses has slumped. Therefore, house prices have fallen. Lower house prices mean many face negative equity. Therefore, mortgage defaults now cost banks even more (because they cant get back the initial loan. Bradford Bingley was nationalised because it couldnt raise enough finance. The BB had specialised in buy to let loans, which are particularly susceptible to falling house prices. How long will the Credit Crunch Last? The credit crunch could last a long time. This is because: House prices are still falling in the US, reducing the value of mortgage loans Many homeowners still face rising interest rates, when their introductory periods come to an end It can be difficult to regain confidence in the financial markets A recession in the US and global downturn could cause a further rise in bad loans The cheerfully named Profile of Depression shows the fall in UK economic growth, as measured by GDP, following some ofthe key slumps of the past century. It compares these to todays crisis. It illustrates the level of fear among experts about the financial hurricane that has disabled Britain -the ‘Noughties bust had, until very recently, actually been worse than the Great Depression of the 1930s (although it was less ‘Great in Britain than it was in the US, where GDP shrank by more than 25%). LITERATURE REVIEW Chapter 3: Effects of recession on UK construction Industry First of all, some uncomfortable facts and figures: 4,500,000 people on council house waiting lists 300,000 construction jobs in danger across the sector 90,000 predicted job losses for Small and Medium Enterprise (SME) builders 71 percent fall in workload for the Federation of Master Builders (FMB) private house builders 61 percent FMB companies expecting lower workloads in 2009 quarter one 60 percent FMB companies reporting fall in workloads for fourth consecutive quarter 52 percent FMB builders warning they will be making staff cuts over the coming months 16 percent house price fall to date 8 construction companies going into insolvency every day 7.5 percent fall in building prices in the last quarter of 2008. The construction industry has been particularly badly hit as a result of the credit crunch and the down turn in the housing market. The industry is facing its biggest challenge for many years. The indicators are that many will struggle to survive in the current market, with the Royal Institution of Chartered Surveyors (RICS) predicting the loss of over 300,000 jobs within the industry and with 52 percent of FMB members warning that they will be making staff redundant over the coming months. There is currently a crisis in the housing market with many first time buyers unable to get a mortgage let alone afford a first home. Alongside this there are more than 90,000 families living in temporary accommodation and 1.6 million families on council house waiting lists; the case for building new homes is therefore very clear. However, news from the National House Building Council shows new home starts being at their lowest level since 1924. The authors feel that current proposals to deal with this desperate situation dont go far enough in tackling the real problems affecting the UK construction industry and the wider housing sector. If the UK construction industry is to have any realistic chance of surviving this recession, these 10 key issues need to be addressed to kick start the building industry. The effects of the recession are affecting all aspects of the UK national economy. In December 2008, the construction sector shrank at its fastest pace since records began. The most considerable decline was registered in house building, while the civil engineering and commercial sub-sectors also fell at record rates during that month. As well as the decline in the housing construction sector, the housing market has also slumped. According to the Halifax, house prices fell 16.2% in 2008, the biggest annual decline since it began keeping records in 1983. This has made buying a home more affordable when set against earnings than at any time since April 2003. However, getting a mortgage is difficult for many. Data from the Bank of England showed the number of mortgage approvals fell to 27,000 in November 2008, representing at least a nine-year low (from BBC News, 2 January 2009, www.news.bbc.co.uk). Roy Ayliffe, Director of Professional Practice at the Chartered Institute of Purchasing and Supply, said: Once again, the housing sector bore the brunt of the crisis as purchasing managers reported significant reductions in new business. Amidst a climate of doom and gloom, firms were forced to axe more jobs in preparation for what is set to be another year of trouble and turmoil. (from Times Online, 5 January 2009, www.timesonline.co.uk) The UK government has plans for public spending and it is hoped that these will include major construction projects, such as roads, schools and other public buildings. This would help the construction industry and those companies that supply the construction industry to ensure continued employment for many. Businesses in the construction industry therefore need to ensure they remain competitive during this difficult economic climate. At the same time, they need to prepare the business to be able to take advantage of any future upturn in the market. Everyone knows the downturn has hit the industry badly. But research commissioned by The Construction News from Emap Glenigan shows the true extent of the contraction, how it breaks down by sector and region, and what the likely outcome for the rest of the year will be. Parts of the industry private housing, offices and industrial are badly affected by the deteriorating economic conditions and the credit crunch. The situation is brighter for those with jobs in infrastructure and the Olympics, although neither of these will be enough to sustain overall industry activity. Historically, economic growth below two per cent has been associated with falls in construction output. Last month, GDP growth for the second quarter was revised down to zero. Consensus forecasts suggest prospects for growth will slow even further in 2009. The gloomy economic conditions have led to a sharp fall in the flow of new projects in the pre-construction pipeline. Glenigan expects construction starts in the UK will fall by five per cent in value during 2009. Private housing has been most affected by the credit crunch. The reappraisal of risk by the banking sector has arguably led to more appropriate criteria for accessing credit. However, as a result the asset price bubble in the housing market has burst. This is causing a long-term contraction in demand since prospective buyers can no longer borrow as much to finance house purchases. Inevitably, those in private housing construction will have to find a way to either cut per unit costs or, more likely, adjust to a new, much lower, level of housing demand. The impact of the credit crunch on other private sector parts of construction industrial, offices, retail and hotels is different. These sectors have not suffered from the asset price bubble evident in private housing. However, investment in each of these sectors is affected by the prevailing economic conditions. As such, the immediate outlook is bleak but, with the Olympics on the horizon, construction prospects for the sector should start to improve in the latter half of 2009, when all major works will need to be started in order to be ready for 2012. The Government has had an ambitious construction-related spending programme across a number of sectors. Education and health in particular will benefit from an increase in the value of construction projects this year. But the Government is not immune to the economic slowdown. The absorption of Northern Rock has already put the Governments finances under pressure. Falling retail sales, rising unemployment and a decline in the profitability of UK firms will reduce tax receipts and add to its difficulties. Looking forward, the poor state of Government finances may jeopardise some of its proposed construction schemes. Major infrastructure projects will continue to help buoy the UK construction industry. Projects such as the widening of the M25 motorway and Crossrail are set to provide a boost to the sector. Ongoing projects such as Thameslink and the Edinburgh tram line will continue to contribute to the sectors workload for some time yet. Outside transport, the sector should also benefit from increased capital expenditure by water and electricity utilities. At present, the macroeconomic and sector-specific conditions are having a much bigger impact on the UK construction outlook than regional factors. Regional variations Differences in the composition of construction sectors within each region explain much of the variation in the regions respective prospects. For instance, regions where industrial construction is relatively significant, such as the West Midlands and Yorkshire and Humberside, will see the value of construction starts contract this year. The North-east, which has relatively less exposure to private housing than other regions, is faring better. Construction orders down 9% as property market slumps New orders in the British construction industry have continued to plunge as building firms are battered by the credit crunch. The Office for National Statistics said that orders fell by 9% in the three months to November, compared with the previous three months. They were 27% down on a year-on-year basis. The figures showed that new construction orders were particularly weak in November itself, diving 38.6% year-on-year. The private housing sector was a major casualty, with new orders down by 55% compared with a year ago. All the UK house builders have dramatically reined in their activity and cut jobs as the housing market has slumped. Howard Archer, chief UK and European economist at IHS Global Insight, said the data showed that the construction sectors recession deepened markedly in the fourth quarter of 2008. He sees little prospect of conditions improving soon. â€Å"With housing market activity and prices likely to remain depressed for some considerable time to come and the commercial property sector in dire straits, the construction sector looks set for extended weakness, despite some support from the government bringing forward some public construction activity and infrastructure spending as part of its fiscal stimulus package,† Archer said. Accountants Grant Thornton said that the construction and property sector was set to be the worst casualty of the economic downturn in 2009, plummeting by 75% in profitability and 71% in turnover from the same period last year. Clare Hartnell, head of property and construction at Grant Thornton, said: â€Å"Profitability and turnover within the construction and property sector are significantly driven by sales and market value; 2008 was a turbulent year as credit dried up and confidence plummeted, causing house prices and the number of properties sold to fall sharply. The decline in the residential market consequently has had a knock-on-effect on the construction sector, where problems have been exacerbated by huge debts as many proposed developments have been put on hold.† http://spreadsheets.google.com/pub?key=tnuPqsRPvjute_-qBacPptQoid=4output=image The year 2009 is set to be a trying year to say the least. Part of the reason for this is the current state of the economy. Lack of available credit will have an adverse effect on the ailing construction and property sector. http://spreadsheets.google.com/pub?key=tnuPqsRPvjute_-qBacPptQoid=6output=image The June Glenigan Index reveals that promised government funding has finally begun to filtering through to project starts. In particular a rise in educational, health and social housing projects starting on site have helped steady the Index, cutting the year-on-year decline to 20%. Workload trends: Infrastructure Infrastructure saw the value of underlying planning approvals (covering schemes under  £100M) fall sharply last year. Whilst the fall appears to have dampened the flow of project starts, with the value of underlying project starts during the first five months of 2009, 13% down on a year earlier, the overall prospects for the sector are bright. With the help of the new infrastructure planning commission, it is hoped that new planning consents for key projects can be accelerated. Impact of the recession on supply chain The construction industry has got the largest supply chain, compared with other industries. It ranges from mere nails to large modular constructions. It has been a major contributor since the dawn of this industry and has risen in vigour and strength over the years. Its integration with our industry has created a revolution that triggered the rise of new technologies powered by their contribution. This general introduction, gives us a fair knowledge of the value of supply chain to the construction industry. When this unexpected recession struck the markets with tremendous force, the construction industry felt the tremor, and its repercussions were felt throughout its branches. As the properties and developments went down, demand dropped, which in-turn left the developers with no option but to suspend majority of their works. The great â€Å"feeders† supply chain took its toll. Demand for their products vanished. Then the only rule of law that applies is â€Å"Survival of the fittest†, i.e. the one who could bring best deals could survive (both in price and Quality) and others would go bust. By and large the prices soured. Illustration with an example would clearly explain what the authors are trying to convey. Major components of our industry are cement, ready-mix, rebar and structural steel. Their price variation could indicate the trail recession took. http://spreadsheets.google.com/pub?key=tnuPqsRPvjute_-qBacPptQoid=2output=image All major supply resources have dropped in price dramatically one or the other time, to merely survive this recession rather than making profit. One of the major suppliers, now are for the ODA. Even they are experiencing the crunch. All the pre-allocated works, which assured definite return, are re-examined to align with the new prices. This has created friction, and even few of them moved on for adjudication. ODA has awarded contracts to around 1036 suppliers, most of which are small to medium sized businesses. This is a government initiative to prop up the middle class players, and there-by securing best deal contracts. Similar public investments could be seen in the health and education sectors, which form large part of the construction order-book and keep the pressure off. The main issue here is the growing trend of irresponsible pricing to win the scarce bids. That is, pricing below the cost. Many experts have warned of the return of industrial dispute culture of the 1980. This could ruin the objective. Recessionary impact was clearly felt when private investments dried up and forced the government twice to dip into the contingency budget. Due to this ill demand, there has been deterioration in construction product manufacturing. All heavy side manufacturers and 91% of light side manufacturers reported that sales had fallen; unprecedented results have been collected, research shows