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Sunday, 23 March 2014

9 reasons developer costs jumped...and what they're planning to do about it

Rising construction costs

Last year, the Reserve Bank of Australia (RBA) released independent analysis which determined that the overwhelming share of costs relating to greenfield and particularly infill property development sites relate to construction and financing rather than the respective land value per dwelling.

As you'd expect, rising land values have certainly played a part in increasing dwelling prices as the capital city populations increase rapidly. But in mature capital cities elevated developer construction costs on infill sites have contributed disproportionately to the expensive nature of new multistorey apartment developments, as the RBA's research concluded:

"If land availability were the problem, we'd expect land costs to dominate the costs of producing a new home at the city fringe. But that's not what we see. Neither do government charges dominate total costs. Rather, it turns out that construction costs are the largest contributor to the total costs of production, and they seem quite high compared with the total cost of a newly built home in some other developed countries."

Today, I'll consider in some detail why that has happened, but will also explore what Australia's major developers are now planning to do in order to combat expensive construction costs.

Supply response

I put forward the opinion some years ago when Australia's residential property markets were soft that I did not believe that dwelling prices would continue to fall over a prolonged period of time in a mature capital city with booming population growth such as Sydney, since housing supply would collapse until such point in time when upwards pressure returned on dwelling prices. 

The clearest evidence in support of this is how quickly and dramatically dwelling approvals dived in the New South Wales capital after dwelling prices peaked in early 2004. 

It is important to recognise that the executives of Australia's major property development companies are responsible for representing shareholder interests and thus where developments can be completed profitably, so they will be. 

From 2005-2011, however, unit dwelling approvals in Sydney essentially died a death despite the rapid growth in the city's population. 

Source: RP Data

In this context, it was critical that dwelling prices rose in order to stimulate supply, and with median prices having jumped by more than 20% in Sydney since 2012 in concert with a material easing in financing costs, this has resulted in a strong supply response presently unfolding, which is clearly visible across the harbour city. 

This will please the Reserve Bank, since last year it mused:

"It takes longer to build a block of apartments on a brownfield site than the same number of dwellings as detached houses at the fringe. Dwelling investment has already become less cyclical in the past 10 years than it was in the previous 20 years. It might well be that construction lags – and concerns about supply – will become even more acute."

Developer gouging?

Contrary to what some folk believe, there is scant evidence of price gouging by developers. If there was then this would very quickly show itself in the reams of publicly available information of the major development companies available on our securities exchange.

This is important, since tight profit margins add weight to the argument that a prolonged easing in prices would quickly kill off supply.

The large Mirvac (ASX: MGR) property group has a ROIC hitting at ~10%, and its residential developments have been recording extremely weak average gross margins of only 18%. 

You certainly don't require a master's degree in accounting to know that there is not a shred of evidence of price gouging on residential developments happening there.

Land developer Stockland's (SGP) underlying profit in FY13 was hampered by weak housing conditions, with that financial period encompassing the period from 1 July 2012 when sentiment was still in the process of picking up. 

Stockland's Australian residential development division secured an operating profit of only $60m in FY13 due to what the company termed "the prolonged downturn in the Australian residential land market" (Source: Stockland Annual Report 2013) recording an EBIT of  only 19.9% and a ROA of just 5.5%. 

The residential results of Stockland had been propped up in FY12 by sales in Victoria where a very strong uplift in Melbourne dwelling prices from 2006 resulted in respectable margins to the company's residential division. 

Meanwhile Lend Lease's (LLC) Australian geographical segment is recording EBITDA of only $500-$600m and NPAT of around only $400-$500m from colossal annual revenue streams of  $7.5 billion+. 

However, Lend Lease's FY14 H1 results for its Australian geographical segment have disappointed as development and construction profits have once again slipped.

One could continue analysing developer's financial data until kingdom come, but the conclusions would remain the same. Developers are making satisfactory margins in the current environment - particularly now that prices have picked up and financing costs been cut to near record lows - but no more than that. 

The implication of that is this in the face of a drawn out downturn in dwelling prices (or significant rises in the cost of financing) multistorey apartment construction would quickly dry up.

9 reasons construction costs have increased (and what developers plan to do about it)

Construction costs have leapt dramatically in Australia over the years. I could list 90 reasons why this has been the case, but here are just 9 of them:

1 - Good and Sales Tax (GST)

The GST value added tax of 10% was introduced in Australia on 1 July 2000, and since "developers are price takers not price makers", the additional GST costs levied on materials, insurance, consultancy fact, practically everything...were duly passed on to the end consumer, a once-off increase in dwelling prices

2 - Land remediation

It's important to note than rising developer costs are not merely related to the cost of materials - the relatively shallow increase in the cost of project homes is proof enough of that. Moreover, reflective of what we have seen in London and elsewhere, as our cities mature the cost of preparing infill or brownfield sites for construction and subsequently developing them has escalated. 

Challenges facing developers today's infill and brownfield sites include anything from heavy metal or lead contamination, to pesticides, hydrocarbon spillages, the removal of asbestos...even uranium contamination on Sydney's north shore. 

One could perm any one of a thousand examples, but let's take the new Barangaroo South project as a case study for today. 

The main sources of contamination on the Barangaroo site are waste tar and underground structures including gas tanks (due to the Hungry Mile area being the former home of the famous Millers Point gasworks), not to mention the unwelcome presence of "polycyclic aromatic hydrocarbons (PAHs); benzene, toluene, ethylbenzene and xylenes (BTEX); total petroleum hydrocarbons (TPHs); ammonia; phenol and cyanide.". 

The city desperately needs more major developments to come online, yet there will be "no cost to taxpayers for remediation. Barangaroo South developer payments will cover any state liability for remediation.". 

Although the figure won't require disclosure, you can read this as meaning that Lend Lease will be required to pay very substantial fees to the government. Who'd be a developer?

3 - Environmental ratings

In 2003, the Green Building Council of Australia introduced its environmental rating system for buildings in Australia. 

Lend Lease's new Barangaroo South project will be awarded a full 6 Star Green Rating: it will have lower greenhouse emissions, use significantly less potable water, far less electricity and will recycle almost 100% of its construction demolition waste. 

All incontrovertibly great news for the environment. And expensive. 

4 - Durability and sustainability

Today's developments must be durable. To again perm one of a thousand examples, typically in Millers Point developments are of high density and retain storm drainage facilities built to withstand only a 1 in 5 year event. 

Approval for Barangaroo, on the other hand, was dependent on the provision of a wide area public space in the guise of a headland park, to be developed with the site requiring stringent drainage and other durability requirements of 100 years.

The benefits will surely be realised over the long term, but in the short term this comes with a cost premium attached.

5 - Insurance, health and safety, training

In today's increasingly litigious society insurance premiums continue to increase, but disproportionately so in the world of construction.

Actuarial calculations of employment risk unsurprisingly showed that construction worker compensation have increased more quickly than industry norms. Consequently, construction premiums jumped yet again in July 2013.

The costs of health and safety compliance and training for Australian construction firms have also increased dramatically, which is perhaps not altogether unexpected given where construction workers and tradespeople tend to feature on the lists of serious incident claims.

6 - Design

Almost everything about today's project design has become more expensive, from complex planning, architect and legal fees, to expensive European kitchen appliances, stylish bathrooms or marble kitchen surfaces.

Consumers have been willing to pay top dollar for new developments, but they fully expect and demand quality products to be shipped in in return. 

It's not only consumers that are more demanding today. Approvals tend to come with challenging hurdles attached. 

In the case of Barangaroo, for example, Lend Lease is accountable for the designing of an Integrated Travel Demand Management Plan and the Design of a Transport Square. 

An entire new ferry wharf has been planned for the suburb by Lend Lease, and a City Walk bridge is to be constructed, also by the developer.

More than this, if you've ever seen the basement area of a major new development under construction, you'll be familiar with the tremendously sophisticated and technological nature of today's developments.  

Lest there was any doubt about the complexity of today's major developments, the Barangaroo project team was compelled to construct a prototype tower in western Sydney as a practice or dry run before commencing work on the structures proper. 

Leveraged developers operating on tight margins cannot afford unforeseen delays or to make costly mistakes and therefore plans are carried out in meticulous detail. 

7 - Marketing costs

Architects prepare magnificent three dimensional designs for new projects today, which can subsequently be used in sophisticated and compelling marketing campaigns by developers in order to secure offshore sales. 

8 - Key worker and affordable housing requirements

New development approvals today tend to require considerable key worker and/or affordable housing components which are likely to be provided at a net loss for the developer. 

In Barangaroo South's case, 2.3% of the housing must be sold at a significant discount for key worker housing, adversely impacting project returns.

9 - Community requirements during the construction process

More stringent than they used to be, requiring that construction activity may only take place between agreed upon times, with disruption from heavy plant to be minimised for the benefit of local residents. 

I could go on, but I think that will suffice for now...

Not all doom and gloom?

Does this mean we are doomed to ever-more expensive construction techniques which outpace inflation as wages and associated costs increase in perpetuity? No, not necessarily so.

Remember, developers and their management teams are incentivised to maximise shareholder returns, and thus are duly motivated to seek out cost savings (this is already underway through the subtle, gradual reduction of average plot and dwelling sizes) and efficiencies from the development and construction process. 

An example of changes me might see? 

Although many of us associate the hyphenated words "pre-fabricated" with cheap post-War housing, the future of Australian construction appears likely to lie in a process that is not dissimilar.

Due to our extreme climate and relatively small population (and equivalently small average development sizes), and thus also due to a lack of economies of scale, Australia has been slow to embrace the concept of pre-fabricated construction on its major developments. 

However, Australia's largest developers, including Lend Lease, are now actively looking towards pre-fab as a key growth sector within the construction industry and one which may assist developers in bringing average construction cost per multi-unit dwelling under control. 

Acceptance of pre-fab techniques on standalone dwellings is understandably likely to be a slow burn, but on some multistorey apartment developments - with appropriately detailed ple-planning - the use of pre-cast concrete may afford the opportunity to shave 5-10% from the real cost of conventional construction techniques, presenting potential advantages in terms of time, cost and quality. 

However, it is unrealistic to expect that developers will simply pass on any savings or cheaper costs of construction to the end user, being motivated by maximising return on investment as they are so compelled to be.

More realistically, efficiencies in construction would initially manifest themselves in improved developer margins and thereafter in more competitive tender processes. 

In other words, as price takers not price makers, competing developers may slow the increase in the prices of new multistorey apartment dwellings over time, rather than reducing sticker prices.

Implications for affordability

In terms of providing more affordable housing supply, the RBA's research implies that this may be achieved to some extent in outer suburbs by forcing the release of more land in order to bring average and median lot prices down. 

In inner suburbs, however, the combined costs of land remediation, development and construction present major obstacles to providing cheaper supply, although in theory of course building more supply in aggregate may ultimately help to ease the pressure on inner ring prices. 

If I sound sceptical, it's because in my experience most Sydneysiders appear to have a diminished interest in living in outer capital city suburbs, variously due to to poor transport links, diabolical city traffic, inferior infrastructure, a desire to be located close to work and the coast, and near to friends, among a whole host of other reasons.