The risk of widespread financial stress in the residential construction sector is “elevated”, the Reserve Bank said in a review of the sector.
The sector is facing a sharp rise in materials costs, compounded by shortages of labour and materials. Margins on existing fixed-price contracts have been eroded.
The cost of building materials has increased by 20 per cent since the start of 2021. The rise in interest rates since May has added to the pressure.
Construction company insolvencies have increased sharply, exceeding their pre-pandemic levels and accounting for close to 30 per cent of all company insolvencies.
In an article in its latest Financial Stability Review, the RBA said: “Further insolvencies are expected in the near term as many builders continue to work through fixed-price contracts taken on when costs were substantially lower and debt servicing costs lower.”
The RBA said that the direct implications for the financial system are limited because banks have very small exposures to builders. Combined bank lending to builders and construction services business is less than A$40 billion as of August – about 0.8 per cent of total bank assets.
But there is potential for financial stress to spread to other businesses within the broader construction industry and to some households.
Builders have responded by raising prices on new contracts and renegotiating some existing contracts but the share of medium-sized and larger builders recording negative net operating cash flows in a given quarter has risen sharply since the start of 2021. And the risk of persistently weak cash flows has increased.
Builders have liquidity buffers (cash, receivables and other short-term assets) equivalent to around three months’ turnover, which is lower than other businesses in other industries.
The RBA said its survey data show that a growing number of builders are drawing down on reserves built up through COVID.
Because builders rely heavily on sub-contractors, financial stress can spread quickly. For the median builder around 40 per cent of liabilities are short-term unsecured trade credit – around twice as much as other businesses.
To date, transmission of financial stress from builders to their sub-contractors appears to have been limited. At the start of 2022 the share of construction services businesses running operating losses had declined from the COVID lockdown period but profit margins are lower than pre-pandemic levels.
Banks have indirect links to construction businesses through households that own and operate small construction businesses and depend on business income to service their debts. Around 2 per cent of residential mortgage borrowers rely on income from construction businesses and construction accounts for 10 per cent of employment.
In addition, households currently building a home are exposed to the industry and are likely to have mortgages with banks.
On the positive side, there is strong demand for construction workers and there is a large pipeline of work in the residential construction sector.
Further ahead, risks of broader transmission of financial stress across the industry and to households would increase if residential construction activity slows substantially and input costs remain high.