In light of the Middle East conflict, we instructed our Construction Risk team to undertake a full review of all construction loans across Australia and New Zealand, in what will be the beginning of a heightened reporting and monitoring period for all active projects, including attending all Project Control Group (PCG) meetings and site walks with builders, developers and Quantity Surveyor’s (QS).
Whilst acknowledging the shifting nature of the conflict in the Middle east, the overarching feedback from our QS’, builders and developers is:
- The extent of the conflict is uncertain, at present the cost increases remain contained.
- If the conflict remains short, it is likely that the impact will be minimal with temporary price increases to select trades and supply costs, a longer conflict heightens the risk of broader and more significant cost escalation.
- As noted by Rider Levett Bucknall (RLB), higher fuel, freight and energy costs are feeding into broader construction cost pressures. This is most visible in construction materials and inputs that are linked to crude oil. Some of the publicised price increases for products and materials include:
- 30% increase for polymer-based products such as plastic pipes and fittings, PVC profiles
- 30-50% increase for bitumen and asphalt
- 10% increase for aluminium cladding and screening
- 5-10% increase for reinforcing steel
There has been media commentary on the potential impact of the conflict on construction projects. It is important to review this impact on our actual portfolio of loans, as the effect varies between different types of construction and stage of development (e.g., our projects have limited exposure to bitumen and asphalt cost inflation, whereas many infrastructure projects and certain subdivision projects have a considerable exposure).
Analysis of Pallas Capital’s Construction Portfolio and the impact of cost escalation
- Pallas’ portfolio has 42 construction projects across Australia and New Zealand. The total loan limit of these construction projects is $1.295bn.
- 11 projects have achieved, or are close to achieving, practical completion; therefore, the number of ‘live’ construction projects is 31 (24 in Australia and 7 in NZ). The loan limits of the live projects is $895.2mn and the total construction cost value of those projects is $460.6mn.
- On average, the live construction projects are 35% complete (by value of works) as certified by our respective QS’. This is an important figure in the context of project delivery risk as there is heightened risk in the early stages of construction, typically when sub-ground works are being undertaken.
- The current total cost to complete for all live construction projects is $300mn which on average is $9.7mn per project.
- 87%of the live construction projects have fixed price contracts. This ensures the cost escalation risk remains with the contractor and not the developer (our borrower).
- Our construction risk team estimates that trade letting sits at approx. 60%on average across all live construction projects. NB: Trade letting is the builder’s procurement process that involves a builder awarding specific trade packages to subcontractors and suppliers, which occurs ahead of the actual trade works being done. When a trade is let, the price is locked in for the builder.
- Applying our current cost to complete, trade letting status and RLB’s published products and materials cost increases, we estimate our total portfolio exposure that may be impacted by cost escalation is $120mn (40% of the cost to complete) or $3.9mn per live construction project. This is the ‘cost base’ rather than the escalation value itself, taking into account the feedback from our QS’ it would be reasonable to expect the escalation value to be a small percentage of this cost base.
- Whilst most of the contracts are fixed price in nature, our construction loans all carry a contingency allowance. NB: This allowance is money available under our loan agreements and not yet allocated to any cost item; therefore, it is available to absorb construction cost increases including as a result of the Middle East conflict. The average undrawn contingency value for the live construction loans is 6.2% of the cost to complete OR 15.4% of the estimated cost escalation value of $120mn.
Our portfolio and exposure to construction loans remains highly diversified and cost escalation remains a contained financial risk for our borrowers. Whilst we remain confident the risk is currently contained from an overall portfolio perspective, we continue to monitor our construction loan book to identify any new issues that arise.
We also highlight that all new potential construction loans (not yet settled) are being screened with the developer and the project QS to ensure no issues exists with these contracts and cost exposure, prior to financial close.
We will continue to monitor the issues closely.
If you are looking to deploy capital into any of our current Open for Investment debt opportunities, please contact your Pallas representative or contact clientservices@pallascapital.com.au