CAN FOREIGN INVESTMENT HELP UK CONSTRUCTION REGAIN MOMENTUM?

Demand for constructionFirst quarter UK economic growth came in at 0.2%, which was below expectations. Q2 rose only very slightly at 0.3%, although HM Treasury’s consensus forecast estimates growth to be 1.6% and 1.4% for 2017 and 2018 respectively. It remains to be seen whether the UK is on course for this, though current indicators are weaker than expected, with construction GDP falling -0.9% and representing one of the main causes for a drag on UK growth.

Consumer price inflation is expected to peak at 3% by the end of 2017 and consumer spending contracted at the steepest rate for four years in Q2, with tightening credit conditions and slow wage growth. The health of the construction market is directly linked to the economy, so any uncertainty or threat can endanger the progress of projects.

Latest ONS data recorded all work output of £11.43bn in May, down 1.2% from £11.56bn in April and the lowest volume since August 2016. However, this data is both volatile and variable by sector, meaning no solid conclusions can yet be drawn.

The construction PMI dropped from 54.8 in June to 51.9 in July, signalling the weakest construction performance since August 2016. Deteriorating order books, lower volumes of commercial building and a softer expansion of housing activity were highlighted factors.

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EU Referendum

RESIDENTIAL: • Mainstream ‘for sale’

housebuilding remains stable, with completions at an eight-year high in 2016. With signs of softening house prices, there may be some risk to current output.

• Prime residential construction demand has stabilised after falls last year, but the risk profiles of these projects are creating difficulties in attracting supply-chain interest.

• The institutional rented sector is expanding. With over £16bn chasing investable schemes, the trend looks set to continue. Manchester and Birmingham are particular hotspots for private rented sector construction demand.

• Registered providers have developed ambitious pipeline targets and continue to broaden the tenures on offer. This significant source of demand will continue to grow.

INFRASTRUCTURE: • Major projects and programmes

continue to dominate the outlook for future demand. Hinkley Point C, High Speed 2, and the Silvertown Tunnel are some of those contributing to robust levels of demand growth.

• There are some downside risks to future demand. Delays to government decision making still represent a threat, as does reliance on private sector investment – particularly in the power sector. Furthermore, capacity constraints are likely to temper the volume of work that can be delivered.

COMMERCIAL: • The office sector recorded

capital value growth of 0.4% over the month of June, boosted by performance outside of Central London.*

• While rental values at the all-UK level were flat in June, this disguised a divergence in performance between Central London, where rental values fell -0.3%, and markets outside the capital, where rental values rose. *

• Demand for new construction of Central London offices is down by up to 20%, but continues to be stable or up in other regions, for example Birmingham.

• The retail sector is expected to suffer from reduced consumer spending as inflation climbs – this will depress construction demand in some segments. However, the proposed £1.4bn expansion of Brent Cross shopping centre and £390m expansion of Buchanan Galleries shopping centre in Glasgow are examples of pockets of ongoing demand.

Resi image Infra imageCommercial image

*Source: CBRE

The government housing white paper's proposals on municipal housing could be a game changer for the pace and scale of project inception.

Transaction numbers and asset value will be crucial in supporting viability. Success in bringing forward investable 'build to rent' projects will be vital for future expansion.

Existing capacity constraints in the delivery of infrastructure projects could keep a lid on output growth.

Government's commitment to provide a consistent pipeline will be crucial in supporting supply chain investment in productivity boosting initiatives such as o�site manufacture.

Whether the politcal and economic environment supports demand for o�ce space will be a signifi-cant factor in key markets such as London. In retail, the extent to which inflation, tightening credit conditions and falls in real wage growth impact on consumer spending will play a role in demand.

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Rising construction costs will hamper the viability of projects.

Existing capacity constraints in the delivery of highways projects could limit output growth.

As HS2 moves to delivery, constrained capacity in the rail supply chain could limit output growth.

The willingness and ability of private investors to shoulder construction risks will be pivotal in progressing major nuclear new build.

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18 Month Demand Outlook

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New work construction output growth Q1 2017 vs. Q4 2016

New work construction output growth forecast (central scenario)

Approx proportion of annual UK new work construction output based on 2016 data

New work construction output growth 2016 vs. 2015

Source: ONS Source: CPA Spring Forecast

DEMAND OUTLOOK

SPECIAL FOCUS: Foreign direct investment (FDI) in constructionForeign investors play a key role in supporting construction demand, often bringing scale and longevity that can stimulate growth over the longer term.

FDI projects relate to the establishment of business operations or acquiring business assets, for example buying into a development project or contracting business. This is distinct from investment in assets, for example the purchase of prime real estate.

One watch out is the Chinese government’s forthcoming capital controls announced last November, aimed at keeping some control over outflows of money. It is reported by some that increasingly onerous capital control measures on private companies in China could potentially limit future foreign investment activities. Any slowdown in Chinese investment could be significantly felt in the UK.

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Source: Department for International Trade

Since the Brexit vote, there have been some subtle shifts in the origin of FDI project investment.

• Chinese and Hong Kong investment has risen almost 3%.

• France saw investment rise 13%.

• The Middle East and Africa saw investment rise 14%.

• Investment from the United States and India dropped 2% and 9% respectively.

In 2016 more money was invested in the UK by foreign investors than any other European nation. The amount invested in building, infrastructure and energy projects increased by 8% to approximately £5.2bn, accounting for about 6% of new construction output.

When it comes to foreign investment in property assets, significant growth has been observed in the last few years, particularly from China, Hong Kong and Singapore.

• In 2016, 13% of new build sales in London were to foreign buyers, with the majority then placed on the private rented market.

• Middle and Far Eastern buyers have been particularly active, almost doubling the amount of money they have spent in the UK’s regional markets to nearly £2bn in 2016.

• In total, foreign investors accounted for nearly one third of all investment in the UK regional commercial property market last year.

• In Edinburgh, they made up 80% of all of 2016’s spending on commercial property.

Even without the devaluation of sterling, the UK is a highly attractive place to invest and holds some key competitive advantages:

• OPPORTUNITY. 2016 saw a record number of start-ups – 650,000 – with 30% of these in London. Manchester, Birmingham, Glasgow and Leeds also boasted impressive growth.

• REGULATION. The UK is 7th in the World Bank ‘Ease of Doing Business’ rankings 2017.

• CONFIDENCE. The UK comes fourth in A.T. Kearney’s FDI Confidence Index in 2016; up one place on 2015.

• TAX. The UK’s tax system is ranked in the top 10 most business friendly in the world according to the October 2016 World Bank: Ease of Doing Business report.

• WORLD-CLASS TALENT AND SKILLS. In 2015/16, the UK was the top-rated major European economy for growing, retaining and attracting global talent, according to Insead’s Human Capital Leadership Institute.

*Source: Department for International Trade

Levels of foreign investment originating from China have grown in recent years, but this is under threat. The Chinese government implemented capital controls last November, aimed at controlling outflows of money. Increasingly onerous capital control measures on private companies could potentially limit future foreign investment activities. The risk could increase if Chinese investors also sell existing positions or assets.

Chinese construction firm CNBM will plough £2.5 billion into the development of 25,000 modular homes in the UK, creating over 1,000 jobs in six new factories in Scotland, Wales and England.

China's R&F Properties purchased the Vauxhall Square development in central London and is delivering a scheme which includes two 50 storey residential towers, aimed at demand for high-end properties from foreign buyers.

Denmark-based firm DONG Energy is to build a £60million plant at Northwich, Cheshire, and plans to invest £12billion in renewable energy projects in the UK by 2020.

THIS PRESENTS A HUGE OPPORTUNITY FOR UK CONSTRUCTION THROUGH GROWING OR NEW SOURCES OF DEMAND. FOR EXAMPLE:

What next for prices and costs?In some sectors, we do not currently see anything other than a two-year potential slowdown in demand growth. We have not changed our Spring forecast.

• UK economic growth forecasts have held relatively steady.

• UK government has made some early concessions in the Brexit negotiations, playing to the likelihood of a softer Brexit.

• Despite a hung parliament as a result of the snap general election, the government has not changed, although there has been an increase in uncertainty.

• Scottish referendum has been ruled out, at least until after Brexit.

• The EU maintains a hard-line negotiating stance.

We have maintained our view that the infrastructure market will remain inflationary. We have adjusted our view for the buildings markets - there is a lower chance of a slowdown affecting building construction markets during 2017, but a greater likelihood in 2018.

THE ARCADIS TENDER PRICE FORECAST - MOVEMENT IN THE YEAR TO Q4

Year Lower Regional Upper Regional Lower London Upper London Infrastructure2017 -1% 3% -1% 2% 3%2018 -2% 1% -3% 1% 3%2019 2% 2% 3% 3% 5%2020 3% 3% 4% 4% 5%2021 3% 3% 4% 4% 5%

• Brexit-related slowdown taking hold from Q4 2017 into 2018, driven by uncertainty surrounding EU negotiations and adverse impacts on demand in commercial sectors.

• Continued growth in infrastructure output.

• From 2019, as negotiations conclude, uncertainty lifts and the UK’s strong economic performance continues.

• Our London and Regional TPI forecasts only include the buildings sectors and cover all regions of the UK. They must therefore inform inflation risk allowances according to specific sectors and regions in question.

• We expect different sectors and sub-sectors to see different pricing conditions.

• Arcadis infrastructure TPI only includes infrastructure.

Note: These are assumptions related to the TPI forecast

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Infrastructure

KEY FACTORS SHAPING THE DIRECTION OF TENDER PRICES:

• Will the economic slowdown accelerate and threaten investment? End user demand is softening in some sectors. Does it make sense to continue to build?

• Who will carry on building? How many clients will keep building and in which sectors?

• Will the public sector sustain current levels of spend? Will the government boost public capital investment in this parliament?

• Will we see a race to the bottom? Suppliers have learnt from the last downturn and will aim to avoid low-margin bidding.

• How fragile is the supply chain? Despite improved business conditions, the supply chain is still affected by weak balance sheets.

• How profitable is the supply chain? Can it practically reduce construction prices?

• Can better management truly reduce costs? The current environment presents an opportunity to re-evaluate efficiency and productivity.

DIVERGING ATTRIBUTES

The influence of size, complexity, risk profile, location and sector on tender pricing is accentuated in this highly uncertain and volatile environment.

Projects that are complex and carry elevated risk profiles are attracting less interest from the supply chain and are likely to see more robust tender price levels.

INPUT COSTS

The Arcadis input cost index for Q1 2017 rose 6.5% in the year and 1.1% over the quarter. However, data for Q2 and emerging data for Q3 shows that growth is stalling.

LABOUR

The BCIS labour cost index rose 2.7% in the year to May 2017. The main inflationary driver is the skills shortage aligned to growth affecting specific trades. The ability to import skills from the EU and beyond after 2019 help mitigate the shortage. However, average wage growth in con-struction has been falling since the end of 2016 and rose just 0.5% in April – it was 4.5% in April last year.

PLANT

The BCIS plant cost index rose 6.1% in the year to May 2017 but was flat over the quarter.

MATERIALS

The BCIS materials cost index rose 5.5% in the year to May 2017. The vast majority of the inflationary impact due to the devaluation of sterling has now fed through, and is showing itself in reduced escalation of materials cost indices. This makes the future strength or weakness of sterling against the Euro a key focus. Projects with higher proportions of ‘currency-linked’ packages will remain most vulnerable to currency volatility.

Bigger more complex projects

Projects with higher risk profiles

Hotter regional markets e.g. Manchester

Smaller less complex projects

Competitive tension

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Projects with lower risk profiles

Cooling regional markets e.g. Central London

Contact

www.arcadis.com

@ArcadisUK

Arcadis United Kingdom

Simon RawlinsonHead of Strategic Research and InsightE simon.rawlinson@arcadis.com

Will WallerMarket Intelligence LeadE will.waller@arcadis.com

Simon LightUK Client Development DirectorE simon.light@arcadis.com