The good news is that demand for construction services is going to remain strong for the next few years, and prices are going to rise rapidly. The bad news is that labour shortages and China's astonishing boom will push up suppliers' costs, too. Davis Langdon and Everest reports

With Britain "enjoying its longest period of sustained economic growth for more than 200 years" according to Gordon Brown's Budget speech, it is little wonder that building tender prices have experienced seven continuous years of real growth over and above underlying inflation.

Tender prices in Greater London, measured by DLE's Tender Price Index, edged up in the first quarter of 2004 by 0.5%, in line with expectations. Over the latest 12-month period, the index shows an increase in tender prices of 2.5%. This is the lowest year on year increase since the end of 1996, when the economic and construction recovery of the 1990s was temporarily halted.
But across the nation as a whole, tender prices have continued to move forward at a faster rate, averaging a rise of 4% over the year just completed.

Construction output

The latest revised construction output figures issued by the DTI show that the volume of output in 2003 rose at constant prices for the ninth consecutive year, and that the volume of all work was 24% higher than it was in 1994. The seasonally adjusted figures show that output rose throughout the year.

Since the DTI rebased its data to 2000 at the end of last, there has been a great deal of confusion over the output figures. This has resulted in revised data being issued for the second time. The latest data set shows a rather more even pattern of output growth: 2% in 2001, 4.2% in 2002 and 4.5% in 2003.

The table below left shows the trends in 2003 for industry sectors. It shows that, last year, additional construction work worth a little more than £9bn was undertaken by the industry throughout Britain. This provided contractors with continued high levels of capacity usage, kept site wages on a rising trend, maintained shortages of skilled craftspeople in many areas and further exacerbated difficulties in compiling tender lists for many projects.

The figures also illustrate how the private new housing market has grown strongly – rising nearly 18% over the past two years in real terms, resulting in further demands for bricklayers and dryliners, and rebounding into other sectors. The lack of suitable skilled craftspeople lies behind the government's push for prefabrication, although this is still to be used in significant volume.
The data also shows how the public sector, in conjunction with the private housing market, more than balanced the significant decline in infrastructure works last year and the drop in private commercial activity.

London

In London, price increases have been more restrained as the construction industry has experienced a degree of retrenchment following the slowing down of office building activity. DTI figures show construction output in London in 2003 grew by 1.4% in current price terms (compared with 10.6% for England as a whole) but that new work output fell 8% (compared with 8% growth in England). Private commercial work fell 21% last year from the peak that it reached in 2002, after nine years of growth.

Although this has resulted in lower inflation than elsewhere, most contractors, subcontractors and consultants have been able to shift resources into other areas, notably public non-housing work. In London, work in this sector has increased by 64% over the past two years. Output has risen in the private housing market by 66%. However, demolition contractors remain keen for work and rates in the office fit-out market are very competitive. The fall-off in office developments has seen some curtain walling contractors move into new territory by submitting keen tenders for private residential schemes and the "architectural" end of the education market.

Inflationary factors

The cost of preliminaries has grown steadily over the last year. The salaries of management and supervisory staff have risen in response to demand, insurance premiums have undergone well-publicised hikes, scaffolding costs have risen more than most other trades and, in some areas, security costs have also risen substantially.

Brick and blockwork rates, fuelled by the increase in housing activity, have leapt in many areas, as bricklayers have been able to play sites off against each other and drive up pay. Percentage increases in bricklayers' rates in East Anglia, the North, the Midlands and Wales have reached double figures over the past year.

Other traditional trades also continue to be in short supply. Designers and contractors are having to consider alternative solutions to enable projects to proceed on time and within budget. There is greater interest in off-site manufacture of external envelope components and internal finishes. In drainage, there is greater use of plastic materials that can be installed by a less skilled workforce.

The other big story is that of steel prices. Metal prices have been rising steeply for more than a year, partly as a result of supply problems (such as production difficulties at the world's largest copper mines in Indonesia and Chile), but also because the booming Chinese economy is swallowing every raw material in sight. At least 30% of the world's steel production is now reckoned to be heading to China. This is also largely to blame for a huge surge in the shipping costs of iron ore and coal – the main raw materials for steel – which have risen fourfold over the past 18 months.

As a result, the price of steel has risen in the USA, Europe and the UK. Corus lifted its basic section prices by £23 a tonne in January and is expected to have raised prices by another £30 from 1 April. As the year progresses, further increases of at least the same magnitude are likely to have amounted to a rise of £120 a tonne for steel sections by the end of the year, a rise of about 30%. Price increases for hollow sections are even greater: prices are expected to have risen 35% by May, with more to follow.

European suppliers' price rises are higher still. European producers are more dependent on scrap as a raw material and scrap prices have more than doubled over the past year. Fabricators and subcontractors are beginning to price these rises and anticipated increases into tenders, sometimes with a rider as protection against further unexpected price escalation.
Lead times have also begun to lengthen, with a particularly sharp reduction in the availability of hollow sections.

The rise in scrap prices has also had an impact on the cost of reinforcement bars: suppliers lifted prices by £39 a tonne on 1 February with warnings of likely supply shortages and further price increases. Contractors are including noticeably higher rates in tenders to cover this eventuality. Some contractors are including rates of more than £800 a tonne compared with a typical price of £550-600 a tonne in the second half of last year.

Procurement

The amount of work available has enabled most contractors in most areas to select work with low risk and to influence procurement routes. Single-stage competitive tenders are a no-no for many large and medium-size contractors and, in many other cases, the number of tenderers has to be limited to attract interest, though the capacity of the industry frequently dictates short tender lists in any case. In the absence of partnering or direct negotiation, there is a clear preference on the part of contractors for two-stage tendering.

Requests for extensions of tendering time have been commonplace ever since many contractors' estimating departments slimmed down in an attempt to reduce overheads in the early 1990s. The growth of design-and-build has exacerbated this problem and a tender enquiry with bills of quantities may sometimes attract more interest than one without. However, the problem is often the result of clients setting unrealistically short tender periods in the first place, often with minimal design information available.

The vogue for partnering and framework agreements has certainly been to the greater benefit of the larger contractors and it is in their field of operations that competitive tender lists are most difficult to compile. It is expected that Building's next Top 100 Contractors Survey will reveal further significant increases in profit margins.

Smaller contractors are often also losing out on much of the public sector's bundled packages of work as well as the large private sector schemes. South Wales, for instance, currently has a number of major schemes under way – such as the Millennium Building, Swansea Maritime Museum and the Welsh assembly government building – but these are largely handled by major contractors and suppliers from outside the region, leaving local contractors and trades largely unaffected.

Consequently, in most regions, smaller projects tend to be easier to procure than the larger schemes. However, blue chip clients can still attract keen prices with the lure of possible future additional work.

Forecast

Construction activity has generally been forecast to increase in 2004 (by between 1.5% and 3.2% according to forecasts by the Construction Products Association and Construction Forecasting and Research at the start of the year). Private commercial work was forecast to decline between 4.7% and 6% but this will be more than offset by increases in the public non-housing arena (predicted to rise 12% to 13%).

In the Budget, Gordon Brown pledged to continue spending on defence, healthcare and transport, and increase spending on education by an annual average of 4.4% in real terms. This will help to fund the "Schools for the Future" programme, which aims to rebuild or refurbish every secondary school in England.

The chancellor was also upbeat about the economy, predicting GDP growth of 3-3.5% in 2004 and 2005. His last prediction, widely dismissed by economists and commentators, turned out to be spot on, leading to much more muted comment this time. The fall in the London office market may well have bottomed out. Take-up of space rose at the end of last year and British Land's recent pre-let of 420,000 ft2 to Willis Group Holdings was the biggest such deal since 2002. Many now believe there will be a shortage of quality space by 2006 and a number of substantial new build schemes look likely to start on site this year. If there turns out to be a sudden burst of activity towards the end of this year or early next year, considerable price pressures could arise. This is because many of the industry's larger players have moved resources into areas that seem unlikely to suffer any short-term retrenchment.

Steel prices look certain to continue to rise, affecting all steel-framed structures (which constitute the bulk of city office developments) but also affecting the price of reinforcement in concrete-framed buildings. Steel cladding prices will rise, affecting the cost of industrial buildings.

Other resources may also see higher inflation than in recent years. All metal prices have risen substantially and oil prices remain close to a 13-year high. Landfill prices are set to rise sharply – the standard rate of tax increased by £1 a tonne to £15 a tonne from 1 April, in line with yearly increases proposed in 1999. The tax will rise £3 a tonne in 2005/6 and at least £3 a tonne in until the rate of reaches £35 a tonne. But more importantly, from 16 July 2004 the implementation of the European landfill directive will severely curtail the number of commercial landfills that will be able to accept hazardous or special waste.

Currently, more than 200 landfills may accept this waste but there have been only 11 applications from throughout England and Wales, including just one in the south of England, for the new licence, and there are no indications of any further applications in the near future. The result of this is that the tipping cost of hazardous material will rise sharply, perhaps between 100% and 200%, which may affect make some schemes too expensive to build.

Tender price rises in London in the year ahead may begin to accelerate as the year progresses if private commercial work begins to return to the market. An average increase of 3-4% is forecast. Greater demand in 2005 is likely to see tender prices rise 3.5-5% in the year to the first quarter of 2006. Nationally, continued demands on resources are likely to see slightly higher inflation in most regions over the coming year, in the range of 3.5-5%.

Ups and downs at a glance

Current trends
↓ Construction output rose for ninth consecutive year, and volume of work was up 24%
↑ Construction output in London grew 1.4% in 2003 compared with 10.6% for the whole of UK
↑ Steel prices are rocketing and the costs of some products are rising up to 35%
↑ Contractors’ profit margins are gradually increasing as more firms adopt partnering practices

Forecast
↑ The Construction Products Association and Construction Forecasting and Research predict that poor figures in commercial work will be more than offset by growth in public non-housing by up to 13%
↑ Tender prices in London are likely to rise between 3% and 4% over the next year