Building costs take a breather, but for how long?

The FNB Commercial Property Finance Residential Building Cost Index for the first quarter of 2007, constructed by Industryinsight, suggests some slowing down in residential building cost inflation, after a significant surge in building cost pressures last year.

The index reflects the average building cost per square metre, as charged by building contractors when winning tenders in the formal residential property sector. It excludes affordable and so-called “RDP” housing. The average building cost per square metre was measured at R4 883,91 for the first quarter.

While slightly down from the previous quarter’s average of R5 104,12/square metre, current levels are a far cry from averages of around R2000/square metre in 1998 just prior to the property boom.

Year-on-year, building cost inflation measured 26% for the first quarter. This is significantly down from the 39,2% peak in the final quarter of 2006, and ends a strong cost surge that began at the beginning of last year. It is possible that contractor pricing power is beginning to suffer a little at the hands of rising interest rates and some consequent weakening in demand growth, resulting in some cost control measures.

Furthermore the relative strength at the lower end of the market, the result of an affordability deterioration over the boom years, may be an increasing incentive for a portion of development activity to shift away from the more luxurious end of the market towards the lower, less frills, end.

The downturn in building cost inflation is expected to be short-lived. Prior to the end-2006 peak in building cost inflation, the previous 2004 peak was at 24,4% in the first quarter of 2004. That previous peak was arguably reflective of a high degree of pricing power of contractors due to extremely strong growth in demand for residential property at the height of the property boom. At that stage, materials cost inflation was relatively low, and skills shortages appeared less of a constraint.

Furthermore, new property buyers were arguably less cost-conscious in those days because affordability was less of an issue than it is today. At 39,2% in the final quarter of last year, the most recent peak outstrips the previous cost inflation peak despite demand growth conditions being softer than in 2004. Admittedly there was something of a mini-surge in demand growth for residential property through 2006, which may have played some role.
However, I believe that the 2006 cost surge was more “cost push” inflation than the 2004 “demand pull” inflation.

Contractors are arguably faced with greater input shortages today compared with a few years ago. These shortages can range from materials and skills shortages to bulk services supply. The shortages are partly reflected in the producer price index for building materials, which has steadily risen over the past year to near 16% year-on-year early in 2007.

Traditional supply and demand theory would suggest that, given that residential building activity tapered slightly in 2005 and 2006, one should have seen a moderation in building input cost inflation. However, residential property development competes with other sectors for many inputs, and the input supply crunch is being assisted by the rapid pace of building activity in the non-residential property sector as well as by the proliferation of infrastructure projects across the economy.

For many infrastructure projects, 2010 is a “deadline” fast approaching. In addition, the banking sector’s affordable housing drive is beginning to step up a gear or two. Therefore, while some relative weakness in demand in the formal residential market may have resulted in some tapering in building cost inflation recently, the sector is experiencing significant competition for inputs from other sectors, which could be a driver of strong building cost inflation over the rest of the decade.

As a result, it is expected that the first quarter slowdown in year-on-year building cost inflation may be short-lived.
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