Building inflation reflects a market under pressure

Besides base effects, though, one cannot ignore relatively weak residential market conditions which are probably playing a key role. However, looking past the short term cycle, it is probably realistic to expect further surges in building cost inflation at times through to 2010.

The FNB CPF* Residential Building Cost Index for the third quarter of 2007, constructed by Industryinsight indicates some further slowing down in residential building cost inflation, the fourth consecutive quarter (given some backward revisions to previous datapoints) of declining year-on-year inflation following 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 R5,621 for the third quarter. This is mildly up from the previous quarter’s revised average of R5,548/square metre.

Year-on-year, building cost inflation measured 11.1% for the third quarter. This is a further decline from the revised 21.8% registered in the first quarter, and well-down from the 38.8% peak reached in the third quarter of 2006. The slowdown is believed to be reflective of a residential market increasingly under pressure from the lengthy period of interest rate hiking along with a slowing economy. One would expect contractor pricing power to suffer as a result.

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. Such a shift can also have an impact on the index’s price inflation rate.

It is also possible that the lower inflation rate is partly reflective of lower materials cost inflation, which has shown some decline, over the past 2 quarters. This is indicated in the producer index for building materials.

WHERE TO FROM HERE? DESPITE THE CURRENT LULL, HIGH BUILDING COST INFLATION IS PROBABLY NOT OVER YET.

The downturn in building cost inflation could continue into 2008, but looking further into the future I would expect that on average building cost inflation will be strong during the rest of the decade. The residential property market is expected to gradually turn for the better in 2008, spurred on by interest rates reaching their peak and an economy starting to turn for the better once again after the current lull. This is expected to lead to solid growth in residential building activity in the longer term, especially on the lower and more affordable end.

In addition, the proliferation of infrastructure projects as 2010 approaches, and expectation of still higher non-residential building activity, could expose the residential construction sector to considerable competition for certain production inputs if it hasn’t already.

This combination of steady residential demand growth and expected supply constraints should be the recipe for strong building cost surges from time to time, and that in turn should be positive from a returns on residential property point of view.
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