U.K. builders are seeing construction costs soar to levels last seen over eight years ago, a surge that threatens future activity in the sector, observers say.
The construction material price index increased 5.8% year over year in January, according to U.K. government figures. The latest Markit/CIPS U.K. Construction Purchasing Managers' Index found construction costs jumped to their highest levels in January since 2008.
Intense cost inflation continued in February as companies reported the second-fastest rise in input costs since August 2008. Analysts said the sharp rise in building costs was largely driven by the weak sterling exchange rate, which has been down by between 10% and 15% against the euro since the country voted to leave the European Union in June 2016.
"Cost pressures continued to rise, particularly for imported raw materials, and compound the risks that activity will be unable to grow at current rates over the next 12 months," Construction Products Association senior economist Rebecca Larkin said in February.
IHS Markit senior economist Tim Moore noted in a release that for some construction companies, swelling costs have had a "disruptive impact" on contract negotiations.
Allan Wilén, economics director at construction data provider Glenigan, said in an interview with S&P Global Market Intelligence that the currency depreciation has had a direct impact on imported products, which makes up about a quarter of materials used in the U.K. He added that domestically made products also face upward pressure on costs due to higher energy prices and the cost of imported raw materials.
The economist said increased construction costs could have a "restraining influence" on future construction. He said some projects may well be under review, but added it was difficult to know if this is due to the weaker sterling as projects are often reappraised for cost reasons.
Small- and medium-sized construction enterprises, which make up a significant proportion of activity, could be forced to close if marginal costs continue to grow and make them less competitive than larger companies, Matt Carrington-Moore, chief marketing officer at construction company Scape Group, said in an interview.
Carrington-Moore said sudden price swings could have a major impact on the sector. "In our view, the increased cost of materials, tied with the premium attached to scarce talent, places greater pressure on construction firms' profit margins," he said.
More than 70% of smaller building firms have seen costs rise due to currency depreciation and expect further cost growth of 10% to 15% as the year unfolds, the Federation of Master Builders said in earlier 2017. As of January, SMEs in the construction industry reported cost increases of 22% for Spanish slate and 20% for timber, according to the FMB.
However, rising costs are not expected to have a direct impact on many of the U.K.'s listed landlords, according to Robert Duncan, director of research at Numis Securities.
SNL-covered companies had a total of 249 U.K. projects in the pre-construction stage as of March 28, according to S&P Global Market Intelligence data. U and I Group PLC had the most projects not yet under construction in the U.K., at 27 properties.
In an interview, Numis' Duncan said cost inflation is less likely to directly affect the U.K.'s listed real estate sector, which is generally less active in development compared to unlisted players. Nevertheless, he said listed companies that did develop may indirectly benefit.
The analyst argued that many private companies would be squeezed harder than listed businesses, such as Derwent London Plc and Great Portland Estates Plc, which he said were better positioned and had generally purchased sites at lower values. "In other words, they will have the capacity to swallow the rising construction costs and still make a pretty attractive margin," he said.
Duncan said the listed sector's resilient position could give them an edge when negotiating costs with building firms. Rising cost inflation isn't the only challenge facing U.K. construction — the sector also faces a chronic skilled labor deficit, which analysts agree is critical to the future of construction.