21 Sep 2020
Construction equipments silhoutte on sunset

The looming construction cliff

Authors

Jo Masters

EY Oceania Chief Economist

Economist. Pundit. Keen tennis player. Referee to teenage girls. Paddle board lover.

Johnathan McMenamin

EY Oceania, Senior Economist

Macro Economist. Keen sportsman. Brewer.

21 Sep 2020

The construction sector is bracing for impact as the long-term effects of COVID-19 begin to be felt, and supporting this sector will remain a challenge for policy makers.

Unlike service industries such as accommodation, food and entertainment, the building industry has so far appeared to weather the fallout from coronavirus lockdowns relatively well to date. But that picture disguises the true impact the pandemic will have on the construction sector because the construction process is by its nature a long one and slow to respond to changing dynamics. While non-residential construction was at record highs earlier this year, residential building work had already been waning. It’s not a stretch to imagine that while the pipeline for non-residential construction is high now, corporate and industrial investors will suffer the same concerns about planning new work that the residential market has. Broadening recessionary conditions and the potential for rolling lockdowns for some time to come, have dampened investment risk appetite across the board. Building approvals for non-residential constructions have already fallen sharply.

There is a lot of discussion about the fiscal cliff, the productivity cliff, and the insolvency cliff, for example, but if a construction cliff forms it will have significant ramifications for the economy and the labour market. The construction sector – which includes residential and non-residential construction along with infrastructure projects - employs 1.1 million Australians and accounts for 7.8 per cent of economic activity. Furthermore, it has highly integrated into other parts of the economy through its’ supply chains. The public sector already plays a significant role in the construction sector – accounting for $50 billion worth of work over the last year (24 per cent of total construction work done) – but there is still an opportunity to smooth the cycle. Indeed, infrastructure spending is typically a mainstay for counter-cyclical fiscal stimulus, and an effective one at that. 

The government will need to expand its investment plans beyond what is already budgeted ideally to support a reasonably sized pipeline over the mid-term but, at a minimum, to try and cushion the decline that is coming in private activity.

The current pipeline of public investment is not enough to do that. Doing so will require governments to take on more debt, a prospect that is not ill-advised given debt is so cheap and is likely to remain so for some time. The key is to ensure debt is used for meaningful projects that fulfil existing and future needs, not just around transport but across social, environmental and digital infrastructure. Indeed, with debt cheap, we have the opportunity to build infrastructure that will support the future economy, not just address current concerns.

An elevated pipeline of work will support activity in the near term

As of March, there was over $150 billion worth of work under construction across Australia, a record high for the industry. The pipeline of work, which measures construction yet to be commenced and not yet complete, was sitting around $90 billion, which is only 10 per cent below its 2018 record high. Work underway will support the industry and its workers in the short term. For how long, though, depends on how much of the planned pipeline – projects approved but not commenced - eventuates and how much is deferred or cancelled. Importantly, there will be differing experience across the various sub-sectors. 

Residential construction – already under pressure and more to come

Residential construction had been winding down ahead of the COVID-19 pandemic. Residential building approvals peaked in mid-2016 although given the lags in approval and construction, this only flowed through to construction activity from mid-2018. The lengthy lag partly reflects the dominance of apartments in the most recent construction boom. Not surprisingly, apartments have a much longer construction cycle than detached houses. Indeed, according to data from the Australia Bureau of Statistics, the average time between approval and commencing construction for a detached house is just over 9 weeks, with completion of the house on average just under 7 months later. For apartments, the average time between approval and commencement is nearly 21 weeks, with completion just shy of 20 months later.

Residential construction has now fallen for eight consecutive quarters and the 6.8 per cent decline in the June quarter was the largest quarterly decline since the end of the Sydney Olympics building blitz, to be 11.2 per cent lower across the year. This reflects the historical decline in residential approvals finally feeding through to the construction cycle, as well as some anecdotal evidence that social distancing reduced productivity on some building sites, particularly high rises. The leading indicators – housing finance and building approvals - point to further contraction. Moreover, the devasting blow that border closures are having on population growth – a key driver of demand for new housing – will exacerbate the slowdown.

Commonwealth Treasury expects a fall in net overseas migration to lead to population growth roughly halving in 2021, to 0.6 per cent, which will be the slowest pace in over one hundred years.

Developers and builders are facing testing conditions and elevated uncertainty. There is $79 billion of work already under construction, which is equal to roughly 13 months of activity at the current completion rate. However, beyond that, annual building approvals are close to a 7-year low, and there is a reasonable question-mark over how much of the $11 billion worth of work yet to be commenced, particularly for high rise apartments, will actually begin. The Home Builder Scheme may cushion the blow, but it will flow mostly to detached houses. The residential construction sector has already lost 8,600 jobs in the June quarter, and with that likely to extend, there is a reasonable question about whether public spending can create new job opportunities. 

Non-residential construction is faring better but far from good

The non-residential construction industry is faring better. The value of work under construction and pipeline of work both reached record highs in the March quarter 2020. That’s on top of record high value of annual private building approvals seen over the past two and a half years in commercial, industrial and services sectors. In the June quarter, non-residential construction fell by only 2.3 per cent and remains only 5.5 per cent below a record high for the sector seen in the September quarter 2019. Because of lengthy construction timelines, building activity is expected to remain solid for some time, but will begin to fall, if new approvals aren’t added to the pipeline. 

After high levels of activity over the past three years, there was an expectation – before COVID-19 hit – that the non-residential construction cycle would peak in 2020 and slow from there. However, as with the residential sector, COVID-19 and the deep recession will have lasting impact on the non-residential construction cycle. While the $50 billion worth of projects already underway will get completed, the pipeline is expected to weaken substantially.

Getting a lot of press is the rigorous debate about demand for office space as the great ‘work from home’ experiment put the trend on warp speed. Indeed, an ABS survey taken in June showed over a third of all Australians worked from home in the month. In a survey a month later, 25 per cent of Australians reported they would like to work or study more from home going forward.  This is particularly relevant in Sydney and Melbourne, which are not only Australia’s largest cities but have already seen a rise in office supply and still have a number of large projects getting closer to completion. While the debate about how much office space businesses will demand rages, one thing is clear, the office will need to look different and demand at least somewhat lower. Interestingly, there is little discussion about the increased demand for warehousing and logistics as COVID-19 has also accelerated online shopping, for example.

Perhaps most striking for this segment is that given non-residential investment tends to focus on large, expensive projects, extreme uncertainty is outweighing cheap and available credit. Or in other words, the hurdle rate on which projects are assessed may have risen as the risk premia shot up and business interest rates only edged lower. In short, there is little appetite for increased debt in an uncertain world. 

Can the public sector fill the gap?

The public sector is always active with construction, building the needs of a nation. However, it is also a very effective counter-cycle tool, to support economic activity and jobs when times are tough but also boosting the capital stock and drives productivity gains. A 2009 report by the Organisation for Economic Co-operation and Development (OECD) estimated that an increase in public investment of $1 billion boosts GDP by around $1.1–$1.3 billion after two years. The use of public – private partnerships and sub-contractors means that public spending also has spill over benefits to the private sector. There is a catch, though. It is the change in the level of activity that generates economic growth, and the pipeline of public investment is already high. In fact, the large number of projects has led to certain parts of the country experiencing a shortage of specialist resources and to cost and time overruns on some major projects.

The amount of public sector work underway and yet to be completed prior to COVID-19 was already substantial – work yet to be done rose to $42 billion in the March quarter 2020, equivalent to 29 per cent of total work yet to be done – and there are already reports of capacity constraints on specific projects. In June, public sector investment rose by 1.0 per cent to be 1.8 per cent higher through the year. However, these projects have even longer lead times than non-residential construction, running into decades in some cases. Importantly, analysis of the General Government budgets (who are mostly responsible for this type of spending) shows that the peak infrastructure spend occurred in 2019-20. While the level of activity is set to remain high, counter-cyclical support for the economy will require a lift in the pipeline. To get spending above 2019-20 levels for 2020-21 and 2021-22 would require additional $8.5 billion of spending over two years, and even more if the aim is to offset the slowdown in the private sector.

Governments at all levels are already looking at this, and there has been a focus on smaller, labour intensive shovel readyprojects. Encouragingly, while these projects will need to be debt financed, Australia is a relatively strong position. Government debt as a per cent of GDP is low on a global comparison, credit ratings are high (and will remain attractive even in the event of downgrade), and most importantly, debt is cheap with plenty of demand for sovereign bonds. That doesn’t mean anything goes, even though the economy is in dire need of support for aggregate demand. It is important the government aims to ensure that investment focusses on projects that deliver an economic or social benefit, or in other words, improve productivity or fulfil a future need. Given the cyclical need for increased spending, there is also an opportunity to expand how we shape our economy through public spending. Broadening beyond what has typically been transport focussed projects, to include social, environmental and digital infrastructure.

Boosting investment in construction, or rather reducing the decline, will be important because of how integrated the industry is across the economy. For example, $1 billion invested in social infrastructure across the country could directly support up to 1,800 full-time equivalents (FTEs), as well as indirectly, through supply chains, support a further 3,400 FTEs. The industries across the supply chain that would receive the greatest benefit include manufacturing, professional, scientific & technical services and transport services. There are already calls to build social housing, which not only serves a social needs but is labour intensive and has a strong skills match with residential construction, where job losses are already occurring. There may, of course, be a need to assist in the deployment of workers from the housing sector to the major projects sector, and in getting them to go where the work is. That is something that governments could usefully facilitate.

Beyond direct investment, governments should also do all they can to support business confidence in the industry. That’s not easy, and there is no silver bullet, but certainly policymakers can try to provide a roadmap or plan in these uncertain times or by make it easier to operate through red tape, tax and regulatory reform. Business confidence in the construction sector is even more depressed than across the broader economy, reaching a record low in April of -71 index points and as of July still 27 index points below its average outcome since the 1990s, the worst result of any industry surveyed. If confidence remains low, then businesses won’t invest or hire. 

As it currently stands, with international borders unlikely to open for some time, the work from home trend on hyperdrive and a high level of uncertainty persisting across the sector, it seems unlikely the construction industry will see any noticeable growth for some time to come. Supporting this industry will remain a challenge for policy makers for some time to come and we expect the 6 October Federal Budget to contain some measures to assist.

Summary

Unlike service industries such as accommodation, food and entertainment, the building industry has so far appeared to weather the fallout from coronavirus lockdowns relatively well to date. But that picture disguises the true impact the pandemic will have on the construction sector because the construction process is by its nature a long one and slow to respond to changing dynamics. 

About this article

Authors

Jo Masters

EY Oceania Chief Economist

Economist. Pundit. Keen tennis player. Referee to teenage girls. Paddle board lover.

Johnathan McMenamin

EY Oceania, Senior Economist

Macro Economist. Keen sportsman. Brewer.