What is the State of the U.S. Construction Industry in 2023 and Beyond?
Projecting the performance of the construction industry has gone from difficult to impossible over the last year. Brent Chambers of CapitalPlus, provides an analysis of the market, noting that a looming recession, higher costs of funds, labor shortages and resource availability are all creating pressure on the margins for contractors and, by extension, their factors.
BY BRENT CHAMBERS, EXECUTIVE VICE PRESIDENT, CAPITALPLUS
In my article last year on the state of the construction business I concluded my article from last June on the state of the construction business by saying the crystal ball was becoming extremely fuzzy regarding the outlook for 2023. If I was right about nothing else, I was right about that. In fact, the crystal ball is more than fuzzy, it is right out muddy at best.
Before diving into the muddy mess, let’s take a look at how the industry faired in 2022 and what the experts are projecting for growth in 2023 and beyond. According to IBISWorld, in 2022, the construction industry in the U.S. declined by 4.3% after having a robust 12% increase in Q1/22 and an overall growth rate of 1% in 2021. The decline in 2022 was attributed to many things, including a broken supply chain, high interest rates, pricing pressures and labor shortages. Recent and updated forecasts for 2023 are all over the place, with some suggesting modest growth and some suggesting a large decline. However, most sources suggest the market will experience a flat to modest decline. How much muddier can the outlook be? There are of course exceptions given the microeconomic conditions in select sectors.
The three primary factors that continue to cloud future projections include:
The economy. Is it weak or strong and will there be a recession?
Availability and cost of money
Availability of resources
The Economy
As I sit here writing this article, my TV is playing in the background. On the screen, two political pundits are railing against each other about the “real” state of the economy. One is claiming that the economy is stronger than ever given the many strong job reports and ensuing low unemployment as well as seemingly tamed inflation as a result of “Bidenomics.” The other is talking about recent 40-year high inflation numbers and continued high prices for commodities like gas, clothing, eggs and other staples. This pundit loudly asked,: “How could the economy be strong if only 34% of all adults approve of the president’s handling of the economy?”
So, it is fair to say that the state of the economy is in the eye of the beholder. For the average consumer whose wage increases have been eaten up by inflation, they are unlikely to be comforted about the jobs report, GDP, or any other possible measure. They know that they have less disposable income now than they had several years ago and have gone deeper into debt. For them, times are not good. For the average construction business owner who practices almost exclusively in the residential space, the reduction of disposable income means fewer buyers and reduced backlogs, so for them, the economy stinks. On the other hand, if you have a construction business that practices largely in the multifamily space, the number of renters has exploded and times are great!
For most economists, a strong economy produces a GDP growth rate between 2.5 and 3.5%. According to an article by the Organization for Economic Cooperation and Development in March, real GDP is projected to be about 1.5% in 2023 and is expected to be closer to 1% for 24. The fear of recession, although predicted by many to be a modest one, is a concern for contractors. Historically speaking, construction has been one of the hardest-hit industries during a recession. Only time will tell how bad the recession will be if it occurs at all, further muddying the outlook.
Availability and Cost of Money
To fight inflation, the Federal Reserve raises the federal funds rate (FFR) to slow the rate and amount of money circulating within the economy. This effectively lowers demand and prices for goods and services, which ultimately lowers inflation. In 2022, the Fed raised rates seven times, closing out the year with the FFR at 4.5%. In Q1/23 and Q2/23, the Fed increased the rate three more times, pushing the FFR to 5.25%, and it raised rates once more in July, leaving the FFR at 5.5%.
The net effect of the rising FFR means it is more expensive for banks to borrow from other banks and those costs are ultimately passed on to the public in the form of higher mortgage and interest rates on lines of credit, credit cards, etc. The higher cost of money impacts the overall construction space in many ways, including, at a minimum, lowering demand (backlog), increasing the cost of goods and services, and increasing the number of challenges to getting loans. For the contractors working in the single-family residential arena, not only is demand down as mentioned earlier, but mortgage rates are hovering around 6% to 7%, putting the idea of home ownership out of reach for many. According the National Association of Realtors, in 2022, U.S. residential home sales dropped 17.8% from 2021, the biggest decline since 2008. If these builders can pivot to the multifamily space, great. If not, this will be a potential knockout blow for many businesses.
Higher interest rates tend to impact contractors in the private sector much more than those focusing on government work. In the private sector, higher rates have a chilling effect on investors and developers. Uncertainty in the economy only compounds this variable, causing projects to be delayed or canceled altogether. A reduction in project load forces contractors to choose between retaining non-productive labor, investing in their businesses (technology, diversification, etc.), or remaining profitable. These are stark tradeoffs and with an average net margin for construction at 3% to 5%, contractors do not have much room with which to play.
The firms working on government-related projects tend to have less impact on backlogs given the U.S. government’s spending practices. In 2021, the U.S. passed the $1.2 trillion Infrastructure Investment and Jobs Act, with the legislation signed into law later that year. This was quickly followed by the passage of the Inflation Reduction Act. Contractors focused on services that promote modernization of infrastructure, renewable energy and green construction will certainly feel (and continue to feel) the positive impact of these bills on their pipelines. But make no mistake, the macroeconomics of higher interest rates is clear. Regardless of how strong your pipeline is, higher interest rates ultimately trickle down and impact every aspect of every contractor’s cost of goods, including equipment, materials and supplies, subcontractors, and labor.
But hey, who’s worried about the cost of money if lenders aren’t lending? Construction is considered extremely risky for many reasons and as a result, the number of lenders operating in this space is inherently limited. To pour salt on the wound, banks are pulling back on lending due to the recent banking crisis. Fears that the headwinds of banking collapses are still blowing and the crisis may not be over are forcing those operating in the space to rethink their position with their construction portfolios, or worse, withdrawing from the market completely.
Availability of Resources
Besides clients, construction firms need three essential things: raw materials (building supplies), specialized equipment and labor. During and shortly after the brunt of the COVID-19 pandemic, the supply chain was completely broken. Contractors struggled to get any supplies, much less get them on a timely basis, and costs went sky high. Thankfully, the ill effects of the pandemic have mostly dissipated and the supply chain is recovering well in most areas. Supplies are generally more available, and costs have moderated a bit, although not by a lot due to inflationary factors. However, many suppliers did not survive the pandemic, causing lengthy lead times to remain. Large contractors are taking advantage of their purchasing power and pre-purchasing select supplies, especially long lead items, which allows them to manage productivity. The downside is small businesses are still struggling to get select items.
In addition to pre-purchasing supplies and locking in prices, smart contractors have learned to put escalation clauses in their contracts or include line items to pass on overages or shortfalls on to clients. The smaller or non-niche firms that have no leverage when it comes to negotiating contracts remain at risk, although the improvement in the supply chain has mitigated this risk a bit.
Labor shortages — and more specifically skilled labor shortages — impact each and every construction contractor, whether you are large or small and regardless of the sectors in which you work. To put it bluntly: The labor outlook is dismal.
In 2022, there were almost 390,000 job openings each month. According to the Associated Builders and Contractors, as of the last day in May, there were still 366,000 unfilled positions. This slight reduction is a result of a cooling housing market. In the long term, even as the construction industry rebounds, there is no light at the end of the tunnel. One in four workers are older than 55 and approaching retirement. Fewer and fewer of the younger generations are entering the industry and demand will continue to increase. The impacts of a labor shortage on the construction industry include higher labor costs to attract and keep employees, along with the extension of projects, which drives costs up at a time when firms are already facing other pressures on margins. The shortages in skilled labor may even be more impactful. The lack of appropriate skilled labor will slow projects, but even worse, it can lead to issues in quality, and poor quality is the death knell for a contractor.
In summary, the crystal ball went from a bit fuzzy to muddy as hell. There may be more uncertainty and headwinds in the construction market than ever before. That said, the construction industry is made up of a tough and resilient bunch to say the least. The firms that are proactive in managing overhead costs, focusing on accurate estimating and putting in place project accounting that will ensure jobs are completed within scope, schedule and budget will not only survive but thrive when the headwinds die down. Those that are winging it like they did during good times may not.
Established in 1998, CapitalPlus is a provider of accounts receivable financing and materials financing for construction companies, general contractors, subcontractors and disaster recovery providers of all sizes and types.