19/04/2010

How to get the construction industry out of recession

A year has passed since the collapse of Lehman Brothers and the UK Government’s decision to take a majority stake in some of the major banks. In that time the Government and the Bank of England have orchestrated a programme of bailouts and quantitative easing, pumping hundreds of billions of pounds into the banking system in an effort to stimulate economic stability and a return to growth.  The Bank of England has reduced interest rates to an historically low 0.5% and the indications are that such low rates will be maintained for possibly another 12 months. The banks have begun to repair their broken balance sheets. Investment bankers are recouping their losses on the stock markets. However the UK remains in recession, whilst other major economies are returning to growth. The property and construction sectors have been ravaged and the prospects for a recovery in 2010 remain doubtful. However there are economic, political and commercial strategies which might work.

A highly controversial feature of the Government’s economic stimulus was the supposed £12 billion pound VAT give away by the temporary reduction in the rate by 2.5%. Many people doubt whether this was money well spent. Given the level of high street discounting one cannot help but question whether this measure has had the desired effect. Frankly in the construction sector any notional savings to be achieved were minimal and were dependent upon employers being able to raise the necessary funding at all. Given the lack of funding for commercial property development on realistic terms, the VAT saving hardly came into the equation. Whilst some banks have said they are willing to lend, most commercial developers have found that the loan to value ratios are unachievable. Businesses simply do not have sufficient cash reserves to be able to fund say 40% of the cost of a development. Without sufficient equity, no amount of “willingness to lend” by the banks will help the poor developers. This is a massive problem for the UK economy as a whole, because property development and construction procurement are about the creation of new growth.

There is an alternative way forward, which would cost a fraction of the amount so far spent by the Government. It is an idea which is designed to pour money into the place in the economy which needs it the most, but which will ensure the most effective cascade of money and jobs throughout the whole economy.

The large scale commercial property developer creates brand new retail centres, office schemes, industrial parks etc. They put something entirely new on the landscape and into the economy. And In doing so they create much more.

During the course of a scheme the developer creates employment for builders and design professionals. Plant and machinery and building materials are needed, and once the scheme is completed then the new development needs to be fitted out and furnished. All of these requirements keep other manufacturers and suppliers in production. New occupiers then take the completed development, and they require all the usual electrical, gas, and water services, so this keeps the power generation and utility industries in business. And of course those companies who occupy and use the new premises will have workforces. Almost everything is linked in some way to the successful completion of a new development scheme, and this keeps the economy growing, and maintains employment levels.

At present there is precious little property development going on and consequently the construction industry is on its knees. Up and down the country major development schemes have been moth-balled. This has had a major impact on the order books for manufacturers of plant and machinery and building materials, and employment in the building sector is plummeting. With so many job losses people are not spending money and the economy as a whole has fallen deeper into recession. Even though the banks may want to lend, the terms on which such lending is available are unsustainable. Commerce is caught in a trap, where the banks’ balance sheets dictate that they cannot lend more than about 60% of the cost of a scheme, but the borrower does not have the cash to fund the remaining 40%.

The solution is for the Government to fund directly all of the biggest planned development schemes around the country which have been moth-balled to date. In Leeds the Harewood Quarter scheme has been delayed. In Bradford the city centre redevelopment has yet to really get going. The same pattern emerges across the whole country.

The Government could agree to provide the necessary funding directly to commercial developers on more realistic terms than the banks can offer at present. Most developers would be keen to proceed with their developments whilst interest rates are so low. They just need to be able to borrow a higher proportion of the overall development cost. Many developers may be prepared to share a small proportion of their profit on a scheme with the Government in return for being able to keep their businesses going. By taking a small share of the developer’s profit the Government can in due course put this towards the national debt repayment.

In the meantime, the developer will employ all the contractors and design consultants, and will continue to purchase or hire all the plant, machinery, materials and labour needed to complete the works. This will secure masses of jobs in the local economy surrounding each scheme, keeping people employed.  Given the scale of many large schemes it will almost be “business as usual”.

From a legal perspective this solution should be very simple and straightforward, when compared with the complexities of rescuing the banks. There is no need for nationalisation, nor does their need to be any transfer of ownership of a developer or its scheme. In much the same way as a bank might take various forms of security over the developer’s property, so too could the Government. If a developer’s land is already mortgaged to a bank then the Government could provide a replacement loan, enabling the developer to clear the debt due to that bank. The bank may be happy in the current climate to reduce its commercial property loan book. The Government’s funding could be for both new land acquisition as well as for development funding.

If this approach was to be replicated across twenty UK cities in respect of the very largest schemes this could quickly get the wheels of commerce turning again. Order books might fill up, and employment increase. This is because property development really does breathe new life into the economy. Many people have a jaded view of property developers, but it is important nevertheless to remember that they are a catalyst for employment and wealth creation throughout the economy.

If the Government wants to chance just a fraction of what it has so far spent then it could do a lot worse than start pouring money into commercial property schemes across the country, and watch it cascade down. In the months following the general election the Government will inevitably start making huge cuts in areas of public service spending. Much of the construction industry traditionally depends on this to carry it through recessionary times. If this crutch is taken away an already precarious position may worsen. There is now a short opportunity for the Government to give the private sector an urgent stimulus.

A final thought: when public sector procurement collapses in the face of Government cutbacks, contractors will become even more desperate for business. Private sector developers who have the cash to be able to start schemes may be salivating at the prospect of contractors having to slash their tenders even further. With the right support from the Government it could conceivably become an extremely good time for commercial developers to start building again.

If you wish to discuss the issues outlined in this article, or any issues around construction procurement, please contact Richard Piper, Head of Construction Procurement at Gordons LLP on 0113 227 0100 or e-mail: richard.piper@gordonsllp.com