Mind the cash

Over the last decade, the era of rock bottom interest rates has pumped primed the global appetite for real estate development. Lenders and investors, struggling to find value in other sectors, were tempted by the higher returns on offer in property, and many new players have been enticed into the UK market willing to take on the higher risks and rewards associated with development.

The UK construction sector has boomed off the back of this investment and all its players, developers, funders, consultants, contractors, subcontractors and suppliers have enjoyed sharing the rewards for a period. The UK economy is now 94 months into its recovery since the 2008 crash; our construction sector is in one of its longest periods of sustained growth, but it does appear that we are now seeing a picture of winners and losers as the market cycle has matured.

Our contacts in the world of corporate finance inform us there are more contractors currently in work out arrangements with their banks; this follows fast on the heels of the tragic demise of Carillion a few weeks ago

A tidal wave of cheap money has undeniably pushed property prices and asset valuations to the brink of exhaustion and affordability, but it has also fueled company expansion, acquisition and increased risk taking supported by debt and low borrowing costs. As global economic growth returns, interest rates are now rising in both the US and Europe, with the UK likely to follow rising interest rates could spell trouble for a property and construction sector that has got used to ever rising asset prices and cheap debt. There is a greater risk now of businesses having over reached themselves just as the fiscal current is turning. If we look around us, there are clear examples of increasing liquidity and solvency risks in UK construction, especially in London and South East where some of the puff has come out of the market and the air has become noticeably thinner.

Our contacts in the world of corporate finance inform us there are more contractors currently in work out arrangements with their banks; this follows fast on the heels of the tragic demise of Carillion a few weeks ago, which itself has created a chain reaction of solvency pressures for its clients, JV partners and subcontractors. A well-known London developer commented recently that “any major contractor these days is two bad jobs away from going out of business”. At this stage in the cycle, there are fewer larger projects in the pipeline than before with the high-quality margins that are often needed to repair historic holes in the balance sheet. Not surprisingly, we are receiving more visits from the business development directors of contractors eager to know which sectors are creating new work opportunities.

Meanwhile, there are growing signs of pressure in the consultancy segment with Capita recently announcing it has suspended its dividend following a profits warning and an impending restructure. We see that clients are changing their consultants more frequently when ‘the sums don’t add up anymore’, while professional fee bidding has recently become exceptionally aggressive. Unfortunately, fees have become the easiest line in the development appraisal to cut costs from when IRR is under pressure. Headcounts in consultancy have become reliant on maintaining high volumes of work, but many now sense a tougher climate and have lowered their bids to remain competitive and to continue generating cash.

If 2017 was the year that the UK property and construction sector enjoyed the placebo effect of a Brexit induced market devaluation, then 2018 is the year where businesses need to keep an eye on good old- fashioned management of their cash to protect themselves against this greater volatility

The problems are not limited to the supply side of the industry - developers and other clients are feeling the strain with some selling sites or assets to cover short term cashflow, or to reduce risk and realize more modest profits within a less positive market outlook; some have preferred to re-start their search for value in non-core more affordable locations. We are being approached by an increased number of clients seeking help with distressed projects, banks are more nervous and are challenging to either increase pre-sale percentages on high end residential schemes to 35% or they are pressuring consortia to put in more equity as a condition of a re-financing and cashflow continuation arrangements. In addition, university clients are cutting back on large new build schemes in favor of smaller refurbishments as the cash going into the sector from tuition fees is softening.

We also see housebuilders and developers forced into re-negotiating their Section 106 commitments to maintain even tenuous viability. Many well-known projects have become locked into a cycle of value engineering and re-procurement that delivers diminishing returns. Development products that teams have crafted over agonizingly for period of many years are suddenly too over specified and too expensive for a market that has rapidly changed in terms of tax, regulation and volume of transactions.

In some instances, clients are requesting extended payment terms from their consultants and some have elected to take on more risk and construction manage projects themselves to reduce costs, only later to find themselves embroiled in disputes and higher costs resulting from a collective failure in performance. These are all real situations, based on real conversations with clients, investors, consultants and contractors.

So, the signs are pointing towards the money not flowing at quite the same rate as a few years ago as values come under pressure and Central banks reign in and taper QE, while governments squeeze margins by increasing taxes, levies and regulation. As a result, businesses have more unsold and un-let products on the market and leverage and solvency risks throughout the supply chain are increasing as the industry struggles to create value in this stage of the cycle.

If 2017 was the year that the UK property and construction sector enjoyed the placebo effect of a Brexit induced market devaluation, then 2018 is the year where businesses need to keep an eye on good old-fashioned management of their cash to protect themselves against this greater volatility. International capital from Asia may offer a source of life support during our Brexit interregnum.

In the aftermath of Carillion, the operating environment is changed and there is a need to restore trust and transparency in the commercial and contracting arrangements throughout the property and construction deal map and the measures below could might benefit all parties moving forward:

1. Introduction of greater payment transparency – now could be the moment for Project Bank accounts to be enshrined in UK construction contracts. Anyone involved in managing the fall out from a contractor insolvency will identify with the pain of subcontractors and suppliers who suffer to recover potential ruinous debts, or our clients who must pay twice for the same building work to keep a job running.

2. Avoid over specifying your product given current market uncertainty – maintain flexibility as far possible. Spend more to get more may not work in the current market. 

3. Review financial governance protocols – increased due financial diligence and care in awarding contracts that may be too large for a company’s capability or balance sheet. Check background fundamentals, operating margins, cashflows, levels of debt, level of competition and management churn. Are these stable, rising or falling?

4. Increased rigor over valuation and certification – ensure greater scrutiny is in place in administering on-site / off site valuations, advanced payments and the payment notices.

5. Avoid over reliance on single sectors / cash cows – analyze which sectors will see price growth or price contraction and diversify and find work in markets that are not already perfectly valued.

6. Manage your cash – if it is not in the Bank, then don’t pay out profits.

While we are not in a recession, there is volatility and vulnerability in some areas of the industry caused by over trading and exacerbated by some markets reaching the later stages of their value curve. The recent run on US stocks illustrates how quickly the world can change. Businesses would be well advised to manage their cash reserves in 2018 to protect against the downside. As Warren Buffet famously commented, markets have a habit of revealing those less well protected when the tide turns.