House prices and those of commercial property projects will have to rise, by about two per cent, if the country is to avoid the unpalatable sight of some construction companies going bust.
That's the opinion of James MacQueen, Advisory Partner in the construction and real estate sector for business advisory and accountancy firm BDO. He says margins in both residential and commercial sectors are squeezed so tight, they are not sustainable for many companies.
BDO have just completed their 2018 Construction Industry Survey and, while MacQueen says the industry overall has "a strong head of steam", it is composed of two distinct tiers – good operators with strong balance sheets and robust cash resources and "fragile businesses" susceptible to the marketplace's challenges and forces.
"The good operators are still the majority," he says, "and they have the financial strength and other resources to build many of the commercial buildings and housing we need. But there are also too many not in good shape and, for some, these issues will be terminal."
If it sounds odd that the construction industry needs greater profit margins at a time when there is an urgent need for more housing, particularly in Auckland, and when the industry's staff shortages have been well publicised, MacQueen has a simple explanation.
During better times, a lot of employees of solidly performing construction companies set up their own businesses and pitched for business with lower prices. Tender bidding (where rival companies cannot see the level of competing bids) has also encouraged low margins.
Over time, that has all boiled down to profit margins in the commercial sector of no more than 5-6 per cent, says BDO's report, with many having to quote below a 5 per cent margin to secure new projects. It's a little better in residential housing – about 8 per cent, though a third were working off margins of 6 per cent. MacQueen says neither margin is sufficient.
"I know it will not be what everyone wants to hear but margins in both sectors have to rise for everyone's financial survival," he says. "That will lead to higher prices but the alternative is there will almost certainly be a few companies fall over. That will lead to a sort of natural reorganisation; it will take out many of the companies not in good shape at present; a kind of survival of the fittest.
"It could also lead to a domino effect, impacting on good businesses too."
"Higher margins are needed to help firms deal with factors like increased risk, the new retentions regime, increased overheads, lack of resources, cash flow and lack of profitability – all major issues impacting on long-term sustainability."
The survey showed slim margins were causing problems in risk and cash flow. Some companies did not have spare funds – and had no ability to accumulate them – to put aside for when things went wrong on a project.
The survey showed 27 per cent of New Zealand construction companies were either on overdraft or found juggling cash flow a problem while 41 per cent were paid late by clients in spite of contractual obligations requiring them to pay on time.
"My view is that a well-run head construction company should never have an overdraft. If it does, it points to other underlying problems," says MacQueen.
"What sometimes occurs is that a construction company will experience one big, bad job…it happens. That one bad job can eliminate all their cash reserves and they are operating on low margins which cannot get them out of difficulty. Another bad job and they are history."
The BDO survey also investigated retentions being held in trust. After the 2013 collapse of Mainzeal, leaving unsecured creditor debts of at least $117 million, new legalisation required construction companies, developers and property owners having construction work done to make new provisions regarding retention payments.
Retentions are sub-contractors' pay, held back for a period to ensure any remedial work required is completed, even if the project is finished. Retentions payable typically comprise 6-7 per cent of construction companies' total turnover.
They are supposed to be held in trust but the survey showed that 74 per cent of those with retentions had not checked to see if they were being held in trust. Of those who did check, 36 per cent found non-compliance – meaning they may not be paid their retentions at the end of the job.
Even more alarmingly, the survey found a third of construction companies were unwilling to confirm they were complying with the retentions law by putting that money in trust.
"There's only one reason I can think of for that," says MacQueen. "They can't confirm because they haven't paid the money in and they haven't paid it in because they haven't got it. That is how close to the wind some are sailing."
Having said all that, MacQueen is at pains to emphasise that most construction companies are in good health: "I think there is a good number of good, solid companies out there with good management and systems – and they are the ones sustaining the industry at present."
But unless the industry was able to operate on higher margins, some of the weaker companies may go to the wall. New Zealand could also face similar measures to Australia where the light regulatory touch did not work and the government brought in "heavy-handed" legislation requiring strict financial methods – a "nightmare' to administer and having an even worse effect on cash flow.
* To download BDO's 2018 Construction Survey, go to www.bdo.nz/constructionsurvey