Construction costs likely to rise, tender prices likely to remain stagnant in Warsaw
by Jonathan Cohen, Associate Director, Gleeds Polska
A quick look at the "starts" either now happening or expected in 1Q 2003, identify that despite the doom and gloom in Warsaw's Real Estate market, developers and investors are not being deterred from taking the plunge and constructing to meet the markets' predicted demands of late 2003 and 2004, presented by many of the leading property consultancies.
Złote Tarasy, GVA Immoconsult's Bonifraterska development and Arkadia, to name but three of the large, highly publicized speculative commercial developments represent a much larger number of such developments (many are not publicized until after works commence, but are known through the market grapevine). In addition, more cautious players are commencing pre-leased or pre-sold developments, for example TK Development's Company House II. This phenomenon of "Build while it's bad" is not limited to offices and retail. Logistics developments still continue an example of which is Pro-logis's speculative building permit application for the second 90,000m2 phase of Platan Park and the rumored build to suit for Electrolux in Pruszków. Other headline schemes, whilst not the subject of a strictly commercial decision, such as terminal 2 of Okęcieand on-going road improvements on Jerozolimskie and Wisłastrada show that publicly accessible finance is available to kick-start Warsaw's much needed march into the 21st century.
Whilst few (but an increasing number) of commentators talk about Poland's albeit slow economic recovery, Warsaw has certainly it's fair share of on-going and "starting soon" construction activity. What is the effect of this sustained activity on both Construction Costs and Tender Prices
Construction costs and Tender prices up by 2.1% in 2001, a lower value predicted for 2002.
Based upon the statistic offices' published figures, 2001 saw Construction Cost Inflation (CCI) of around 2.1% (approximately 1% in the first quarter) and Tender Price Inflation (TPI) generally mirrored this value, meaning that the margins achieved by General Contractors were maintained at the relatively competitive levels of 2000. Tender prices throughout 2002 have remained stagnant, again reflecting the CCI level (expected to be around 1.5%). This is reflected by tenders recently received by Gleeds and other cost data for both Warsaw and other markets. What appears to be emerging, however, is a pattern of demand pull CCI in certain sectors (specialist contractors are paying premiums to retain and attract staff to meet the demand of General Contractors and clients requiring their specialist services). These sectors include district heating works, gas, telecommunications, building management systems, fire detection and suppression systems etc and not structures, masonry and carpentry trades. Shop-fitting/finishing trades are likely to follow this trend, as a result of an increased volume of tenant relocation fit-out works predicted over the next year.
Contractors ain't what they used to be.
The post-communist mammoths, which dominated the construction market are now effectively owned (and managed) by large international contracting organizations such as Skanksa (Exbud), Hochtief (Budokor), Ferrovial (Budimex) etc. Others have been taken over by the more forward thinking Polish firms Echo (Mitex) et al. These changes over the past few years have seen great changes in the structure of these businesses, with sell-offs and closures of under-performing departments and massive job-cuts, creating stream-lined organizations, focusing on their areas of excellence, rather than being "Jacks of all trades". These companies, now with reduced overheads, are able to compete in the more competitive marketplace, but due to an increased reliance on sub-contract labour have less flexibility (in times of high volume) and as we are beginning to see are "catching colds" with certain skills and labour shortages. Big names are having trouble keeping their heads above water.
During late '99, 2000, 2001 and 2002, the small contracting organizations, given the abundance of recently redundant tradesmen, the mobility of the market and the relatively bleak outlook, were forced to squeeze their prices to maintain workload. Whilst materially little else has changed, attitudes are beginning to, as workers push for bigger pay-rises (no longer fearing a no-job scenario as many see redundant colleagues finding work) and managers share the belief that "There is work out there". Workers are working overtime to make buildings watertight before winter and to finish buildings to allow timely occupation. This is leading to demand pull inflation, with contractors offering workers incentives to work longer hours. In turn, these small contractors, sensing that their marginal costs are increasing and that it is becoming ever increasingly more difficult to source labour (including illegal foreign labour) are tendering at marginally higher levels (building into their offers, what they perceive to be the future increased cost of employing labour). This perceived cost-push, is effecting the large General Contracting organizations, who have often gambled on being able to squeeze additional profit from their sub-contractors (following their successful bidding for projects), the very sub-contractors who are now withdrawing or increasing their offers.
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The strong zloty, the gamble being taken
The effect of the strong zloty is not as immediately apparent as some commentators would suggest. General construction contracts for large internationally financed projects have been traditionally awarded in US dollars (USD) and are increasingly awarded in Euros. However, a growing number of seasoned investors/developers within the market are setting budgets and awarding contracts in złoties, accepting currency fluctuation risk, in return for lower prices and simpler accounts and reporting. It is still apparent, however, that the Euro is increasingly the currency being favoured, with business plans, bank-loans and construction contracts using the currency that Poland will no-doubt be using in the not too distant future and therefore the currency that will be used for quoting future rental values and property valuation.
In simple terms, with a contract awarded in złoties, the General Contractor is likely to have certain costs fixed in other currencies (for example lifts, chillers, fan-coil units etc) and will have to cover his risk. Most predict a weakening of the złoty and therefore increased costs for a General Contractor under this scenario.
With a contract awarded in Euros or USD, the General Contractor will have most of his costs fixed in złoties, meaning that he will profit, if and when, the złoty falls (or will he?). He will certainly benefit in simple terms (and often, with this in mind takes the gamble of applying a lower margin and falls into a trap). However he is then losing in five other areas 'the hidden costs":-
a) VAT, as the 22% paid on an installment, is worth less (in real terms) when recovered a few months later. Over a one year period, a 10% devaluation (.83% per month) can amount to almost a 2% additional cost on paying VAT (around 0.4% of the General Contract Sum).
b) His overheads rise (office rent, fuel costs etc) given the inflationary effect in złoties, reflecting the weakening of the currency. Over a one year period, a 10% devaluation is likely to have a smaller inflationary effect (but still significant) on those costs, not fixed on signing the General Contract.
c) Amortisation of his advanced payment (often upto 15% if applicable) will be for złoties at a rate lower than the prevailing rate (i.e. he is paid only 85% of his contract value at the better rate)
d) His sub-contractors' costs increase as they have often taken some exchange-rate-risk and also due to b) above. This often results in their inability to complete the works (due to insolvency etc, or their inability to secure finance) in which case the General Contractor has to find a replacement, usually at a higher cost. Often sub-contractors are unable to resource projects adequately, due to their inadequate cost recovery, thus creating problems (and costs) for the General Contractor.
e) Gambles often taken on letting packages late (to maximise negotiation time and to minimise variation risk), result in no exchange-rate fluctuation benefit.
The changing face of procurement
As developers and investors look at ways of reducing the cost of their investments, supply chain management is now being taken very seriously. Assessments of Risk vs Cost Savings result in developers undertaking "one-offs" electing to source certain components and installation services directly, thus saving the compounded profits of General Contractor, Sub-contractor and often Sub-sub-contractor. This technique, often used by the General Contractor to minimise his costs is now being used by developers and investors to the dismay of the General Contractor.
Management Contracting is being increasingly used, the Client taking a leading role in the procurement of works packages, reducing the General Contractor's (Management Contractor's) profit margins.
2003 ?
As discussed, 2003 does not look good for the large general contracting organizations. Low cost expectations of developers and investors (based in-turn upon commercial rental levels) will mean that the General Contractor will continue to be squeezed by the market and his sub-contractors will not make his life any easier. Predictions of big names going under are hardly predictions !
The survivors will be those organizations who maintain workload through local dominance, low cost-base and an ability to adapt. I talked earlier about the Mammoths who have shed staff. This was the right move at the right time, but these same companies now need to forge alliances with specialists, able to provide cheap labour when required.
We expect that TPI for 2003 of around 1.5% (greatest rise during 3Q and 4Q), however CCI levels in Warsaw to increase to around 3.5%, meaning a squeeze of around 2% for the General Contractor. This he will accept, gambling on the weakening of the złoty and failing to realise the hidden costs highlighted above.
Developers and investors should also pay heed and ensure that the General Contractors (and sub-contractors) selected for their projects have the financial resource to survive what will be a difficult year.
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