Australia’s construction sector has become increasingly divided as residential builders have become more likely to default on trade payments than their commercial counterparts, a new report has found.

But builders across both sectors continue to face elevated levels of financial strain.

In a report released last week, credit reporting agency CreditorWatch analysed current market conditions as well as indicators of financial stress across the nation’s construction sector.

On the positive side, the report found that activity levels are healthy and are likely to remain this way over the near term.

This is happening as residential building is being underpinned by a strong pipeline of work whilst commercial building activity is being supported by the boom in data centre development.

Financially, however, the report found that the sector faces challenges associated with higher interest rates, rising costs, compressed margins and fixed price contracts.

As a result, the overall industry faces above average (and rising) levels of payment defaults and insolvency (see below).

Furthermore, the report found that the residential sector has been particularly challenged.

As a result, residential builders are now more likely than their commercial counterparts to default on their payments (see below).

Significant challenge

The latest report comes as Australia’s building industry has faced pressures over recent years on account of COVID-related supply challenges, rising energy prices, higher interest rates, ongoing labour shortages and higher fuel costs associated with the Iran War.

Over the five years to March, data from the Australian Bureau of Statistics indicates that output prices for building construction across the nation increased by 37.8 percent.

This was before the effect of the Iran War and the associated rise in fuel costs, which has led to suppliers of many products adding fuel surcharges to their prices.

According to the report, the impact of the Iran War has been significant.

Since the beginning of the war, it says that steel prices have risen by between 15 and 25 percent whilst fuel surcharges have added an additional $400 to the cost of a typical concrete slab for a residential house.

At the same time, three further interest rate rises so far this year have added to the cost and availability of finance.

All this is happening at a time of continued pressures on skilled labour prices and availability.

(In recent years, a gap has emerged as payment defaults in the residential construction sector have risen faster than those in the commercial construction sector. Both residential and commercial construction payment defaults are well above averages for all industries. Image source: CreditorWatch).

Three observations

From the report, three observations stand out.

First, the sector overall is under significant financial strain.

Even before COVID, both residential and commercial builders recorded higher rates of payment defaults and insolvencies relative to other businesses across the economy (see chart).

Since COVID and the outbreak of the Ukraine war, however, payment default and insolvency rates have surged across both sectors.

As a result, payment defaults across the residential and commercial building sectors now stand at 2.5 percent and 1.9 percent respectively.

This is well above the 0.6 percent average across the economy and is many times higher compared with the rates that were seen a decade ago (see chart).

Meanwhile, insolvency rates across both sectors (1.1 percent each across the past twelve months) are well above the 0.7 percent average across all industries.

Second, the report shows that within the sector, the balance of stress and risk has shifted.

For much of the past ten years, the commercial building sector has recorded higher levels of insolvency than the residential sector (see chart).

Thanks to a recent surge, however, insolvency rates in residential building (1.1 percent) now match those in the commercial sector.

Beyond that, a gap has emerged in payment default rates, which have blown out in the residential sector to a larger degree compared with those in the commercial sector.

In its report, CreditorWatch attributed this to several factors.

Compared with their commercial counterparts, the report said that residential builders are less well equipped to absorb rising costs and interest rate increases.

This reflects narrower margins, smaller balance sheets, greater dependence upon progress payments and pre-sales, less bargaining power with suppliers and greater sensitivity to interest rate increases.

Finally, the report found that financial stress is particularly high among specific subsectors.

For example:

• Insolvency levels are particularly high for companies who operate in building structure services. Thise includes concreting, bricklaying, roofing and structural steel framing.
• Levels of ATO tax debt defaults are particularly high for those companies who are involved in building completion services. This includes plastering, carpentry, tiling, carpet laying, painting, decorating and glazing.

(Insolvency rates in residential building have now converged with those in commercial building. Image source: CreditorWatch.)

Proactive measures needed

In an interview with Sourcable, CreditorWatch chief economist Ivan Colhoun said that the construction sector is facing a contrast as financial stress persists despite healthy activity levels.

“I would distinguish between market conditions and financial performance and resilience,” Colhoun said, asked about current trends in activity levels and financial outcomes.

“If I look at market conditions, there seems to be a reasonable pipeline of work both in residential and commercial building.

“Commercial is benefiting from the data centre boom worldwide.

“And in residential, approvals have been picking up for the last twelve or so months.

So there is a lot of work for at least twelve to eighteen months I would think.

“But if you are running the business … both sectors – both parts of construction – have been facing significant challenges in terms of costs.

“You think about interest rates, you think about raw materials, you think about labour prices, wage rates and labour availability, they’ve all been going in the wrong direction.

“They’ve both (residential and commercial building sectors) had to face those pressures.

“In the data we’ve been analyzing, it says that residential builders had been doing better (compared with commercial builders) before COVID,

“Now, there is not that gap.

“Our guess is that interest rates were pretty low before COVID (helping residential builders) and that coming out of COVID, they have been higher than they have been for awhile.

“We think that residential builders as they are not as big companies, they don’t have cash reserves or the access to finance that larger builders have.”

In response to pressures, Colhoun encouraged business to take proactive measures.

To help offset the rise in costs, he encourages builders to look at their operations and identify any potential efficiency improvements.

As much as possible, builders should ensure that contracts into which they enter provide adequate flexibility to enable suitable price adjustments in response to unforeseen circumstances.

In cases where fixed price contracts cannot be avoided, contractors should ensure that suitable allowance for potential unexpected cost increases is reflected in their bids.

Finally, he encourages builders to ensure that the temporary fuel price surcharges are taken off when these are no longer needed.

“The other thing I would say is that when fuel prices come back down – as they have – you need to be going to your suppliers and saying, ‘you need to reverse your fuel surcharge,” Colhoun said.

“You need to look at fuel surcharges and make sure that those fuel surcharges which have been put on come back off if prices come back down and don’t just sit there and become part of your costs.”

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