by Paul K. Reimer, AFSB, Liberty Mutual Surety
At the end of fiscal year 2016, the vast majority of construction companies had an optimistic but cautious outlook on the economy. Backlogs were healthier than they had been in years, profit margins had returned for GCs and subcontractors alike, and construction spending overall was on the rise. Per the U.S. Census Bureau, Construction Put in Place in 2016 was more than $1.18 billion versus $1 billion just two years prior. This resulted in what many felt was the true start of an economic turnaround after several struggling years. The outlook was bright. Daily discussions revolved around how a new government majority would result in increased infrastructure spending, increased bank lending, and tax reform.
The outlook has somewhat adjusted as we move through 2017 and toward 2018. We are no longer seeing prominent growth in the marketplace but more of a sustained outlook. The market has remained consistent with the overall economy, a general 2 percent to 3 percent gain, while certain pockets of the construction market are exceeding others.
From this surety underwriter’s perspective, the market has flattened out and remains steady in the majority of marketplaces. Construction contractors pushing programs have somewhat leveled off and profit margins appear sound. Work is more steadily available than in recent years and we are now hearing stories of subcontractors turning away work because they are at capacity after downsizing their organizations in prior years. As we continue to progress through the year and beyond, three topics that will remain on the forefront of an underwriter’s mind while evaluating contractors are the current skilled labor shortage, material costs, and interest rates.
Skilled Labor Shortage
Whether you are a union or non-union firm, you have been affected by the inability to find qualified skilled labor. Per Tradesman International, over a five-year period through 2011, the construction industry lost 2.3 million jobs. As backlogs shrunk from the rougher times of the construction downturn, underwriters constantly questioned how overhead would be covered and what, if any, cuts could be made. Numerous contractors reduced their work forces’ overtime to cut overhead that simply could not be covered. A surplus of available employees was created that had limited options.
In the past few years, the market has returned but the laborers have not. Many individuals either left the industry altogether for other careers or simply retired. Compounded with a generation of students whose high schools were graded on college placement or did not encourage the trades, we have a current shortage and troubling labor outlook.
The average subcontractor now faces an abundance of profitable work with a depleted staff and resources. While cutting staffs down to their “A&B” teams may have saved their organization in the downturn, it now hamstrings their ability to expand. Many find themselves forced into bringing in new employees who may not understand their corporate mindset and methodologies. This is a major concern from the underwriting side as owners are forced to decide between simply standing firm with the resources on hand or hiring and growing. If you can find an employee with the skills you are looking for—great. However, keep in mind that hiring the wrong employee could have drastic ramifications on the project you assign him or her. What is the potential trickle-down or up effect on the overall organization? One poor decision could potentially jeopardize the company’s balance sheet and ability to obtain future work.
In order to have the construction marketplace grow as an industry, we need to focus on acquiring the right talent and retaining it. Without a newfound emphasis on this somewhat simple principle, we could see a combination of poor construction products and increased costs driven by wages. This mixture could have long-term negative results on construction returns.
Material pricing for contractors on long-term projects has, and always will be, a concern and a key component to overall project pricing. Once a project has started, a contractor has little leverage to bill material cost increases to a job (unless they include an agreement in their contract) so the ultimate effect is a reduction of the original profit margin. We have recently seen increases in fuel, metals, drywall, and lumber, which are key to multiple facets of construction.
Per the Producer Price Index, increases in metals—copper, iron and steel scrap and brass—have shown the highest increases over 2017. Products such as drywall, glass, and cement have all shown lesser increases—2 percent to 7 percent respectively—over the year. The only material decreases we are seeing in 2017 have been insulation and asphalt paving.
“Buy American” provisions have also become more prevalent in many construction contracts. These clauses typically require GCs and subs to purchase at minimum a certain percentage, or a particular product, for a project from a U.S. supplier. This has, in certain instances, increased trade costs and put stress on suppliers. While the intent of these provisions is to stimulate the U.S. economy, it has artificially increased construction cost and added another stress point to contractors prosecuting work.
Ideally, contractors can lock in prices with suppliers at the time of award and also bill for stored materials either on-site or in warehouses. This limits price fluctuation risks. Having strong supplier relationships remain key to protecting contractors, especially specialty contractors with limited sources to find materials. As contract terms become more onerous, owners look to push costs such as stored materials back on the contractors. If these terms are accepted, we could see additional stress put on subcontractors and material suppliers.
One of the biggest factors driving construction has been, and will always be, cost. With interest rates low, we have seen private sector building increase. One of the major beneficiaries of this low-interest rate cycle has been single-family construction. New starts hit a historic low in 2009 and increased by double-digit margins through 2015. Low availability of existing inventory combined with first-time buyers looking to take advantage of low 30-year mortgages has provided a boost. Residential building has historically been a leading indication of economic cycles. With interest rates at historic lows, one would think that this trend will hold steady until we see significant adjustments.
Nonresidential construction has not seen the same robust uptick that residential has from low-interest rates; however, things remain steady for most. We do, nevertheless, continue to see an overall lag in infrastructure spending resulting in site work and heavy/highway contractors continuing to look for work. Many now await to see what President Trump’s infrastructure plans turn out to be and what Congress will ultimately approve. The belief of seeing any impact in 2017 or early 2018 is no longer a reality.
As we have already seen the Federal Reserve do in 2017, we will continue to see increases in interest rates throughout the coming quarters that will affect construction lending and overall borrowing. Many authorities believe that we will only see moderate increases in an attempt to deter any downturns.
From a corporate standpoint, contractors have been able to take advantage of low-interest rates over the last several years as well. Refinancing or purchasing of equipment at lower rates has driven down CAPEX and allowed fleets of construction equipment to be revamped at a lower cost. We have also seen the decreased cost of bank line usage, which has helped reduce interest expense burdens. The flip side of this is as interest rates rise, underwriters will be concerned about those same interest expenses now increasing. Contractors should be proactive, lock in low rates when possible, and limit working capital line usage where possible. Cash will remain king in the underwriting world and the ability to self-finance or float costs without bank help will continue to be beneficial.
While some economic experts see insecurity for 2018 and beyond, I believe the industry will continue to see moderate growth in large metropolitan markets around the United States, with additional opportunities via larger, mega projects. The AIA Consensus Forecast projects annual growth in the 3.5 percent to 4.0 percent range for the remainder of 2017 as well as for 2018. Potential factors such as corporate tax cuts, increased private investment through public-private partnerships, and state and local governments playing a more pivotal role in infrastructure improvements will be critical moving forward.
As several sectors of construction have shown positive trends, we must continue to monitor infrastructure, healthcare, and retail closely. Uncertainty around a potential infrastructure spending package promised by the federal government, the failed attempt at repealing/replacing the Affordable Care Act, and the continued closing of major chain stores that move shopping to the internet will all play key factors.
I truly feel that the economic outlook through 2018 is a positive one. Contractors must continue to stay the course, maintain the profit margins they have worked back to, and invest in the future so construction can continue to evolve and advance itself in a fiscally allowable way.
Paul Reimer is a contract underwriting officer at Liberty Mutual Surety. He began his career in Liberty’s training program in 2007 before working in the field and eventually assuming a home office role in 2014. Reimer graduated from Penn State University with a Bachelor’s of Science in marketing.