Construction industry will struggle amid high interest rates

In the UK, incremental rises have left the base interest rate at 5.25% - a level not seen since the global financial crisis of 2008. Globally, interest rates are also rising, as bodies like the US Federal Reserve and European Central Bank (ECB) try to combat world-wide inflation issues.

The reasons for this are, of course, well-understood. The global Covid-19 pandemic required unique financial stimulus in the form of unprecedented low interest rates and, in many jurisdictions, ‘quantitative easing’ of government bond buying by central banks. As a result, base interest rates – which have sat around 1%, or even lower, for more than a decade – have now increased roughly tenfold. Central banks have also warned that these higher rates are here to stay for a while.

As the impact of these higher rates begins to bite we can expect an increase in terminations, suspensions, scaling back of projects and, sadly inevitably, insolvencies.

Economic impact of higher interest rates

The cost of debt – and the opportunity cost of investing funds elsewhere – have a big impact upon the construction industry. This is the case in all sectors, from infrastructure, energy, real estate and elsewhere. This is because so many of the major investments that construction projects entail are debt-financed in one way or another.

As a result, as the cost of that debt rises, it makes construction projects less profitable. In extreme cases, it makes a previously sound investment opportunity financially unviable. With global interest rates set to remain high for the foreseeable future, the construction industry should prepare for the following impacts.

A general industry slowdown

As fewer projects remain financially feasible, there will be fewer new projects undertaken and more projects in the pipeline put on hold, or at least scaled back. In practice, this is being experienced particularly and first in house building, residential and commercial projects.

Easing of pricing pressure          

For many years the construction industry has faced the challenge of rising costs driven by work volumes – especially in the aftermath of the pandemic. But supply chain, resource and labour issues should ease as the effect of higher rates reduces the volume of work. This is, of course, the driving reason behind central banks’ increasing of those rates.

Reduced asset prices

This again will especially apply to housing, residential and commercial. In the UK, for example, house prices have fallen 3.8% over the past 12 months according to one survey, making this the largest fall in the last 14 years. It is no coincidence that, despite such unprecedented economic shocks of the Covid-19 pandemic, the war in Ukraine and resulting energy crisis, the biggest drop in UK house prices coincides with the first material rise in interest rates in that 14 year period.

Some forecasters feel there is worse to come, for example the Resolution Foundation warned that prices could fall by 25% over the next five years.  

Wider challenges posed by higher rates

Perhaps the key factor in this cycle of higher interest rates is the fact that so much debt is now financed over fixed periods, rather than being immediately subject to increases in central bank base rates. An astonishing $1.8 trillion of debt matures over the next 12 months and will need to be refinanced at the current higher interest rates. That trend is only set to continue: $4tn of debt will mature in the next 24 months, and $6.5tn will mature over the next 36 months.

This factor has been seen in microcosm in the UK mortgage market, where now a larger proportion of mortgages are still on fixed rates for a set period and are only now coming to be renewed. As a result, the effect of the rising rates on UK mortgages has so far been delayed.

However, that cushion will not last once the fixed rate periods end in coming months. In this context, it is not difficult to see why financial experts have warned that the market does not yet reflect the full impact of the past year of rate hikes.

Another key factor in this cycle is that, in the wake of the pandemic, many governments find their capital budgets heavily constrained. As a result, their ability – and indeed willingness – to counterbalance the reduction in construction work in the private sector has been severely impacted. In the UK, for example, the nations’ largest infrastructure project, HS2, has been slowed down and pared back to save cost and delay expenditure.

The legal impact of higher interest rates

The current economic squeeze will likely have a number of knock-on legal effects for the construction industry.

Insolvencies

Sadly, the construction industry remains poorly funded and has low resilience to fluctuations in work volumes. This, coupled with the higher cost of debt which many organisations in the construction industry are subject to, will lead to an increase in insolvencies. Given the huge amount of commercial debt still to be refinanced, this will affect employers as well as the construction industry’s contractors and supply chain.

Terminations

Given the impact on the financial viability of construction projects, as in previous higher rates cycles it is likely that many projects will have to be terminated. This may be brought about by employer insolvency or by the action of funders.

Alternatively, termination may occur through the express terms which construction contracts contain enabling an employer to terminate a contractor’s employment on the project in certain limited circumstances. In even more limited circumstances, termination can be carried out at ‘common law’.

Only rarely, however, is there a right to terminate a contract ‘at will’ – without any default on the part of the contractor – although an exception exists in the NEC suite of construction contracts. If no such right exists, then terminating the contract will be a breach, rendering the employer liable for the contractor’s demobilisation costs and, moreover, lost profit on the balance of the works not undertaken.

Suspension

Given the difficulty terminating a contract at will, employers may be forced to suspend construction while other sources of funds are found, or asset prices rise and debt rates fall.  Express rights to suspend work, usually for a limited period and on terms where the contractor is recompensed its loss, are more commonly found in construction contracts. It is likely that these will be exercised more frequently as this interest rate ‘cliff face’ is scaled.

Omissions and ‘value engineering’

If not completely abandoned, projects might need to be scaled back to increase their affordability. In practice, this can be done by utilising contractual powers to vary the works. These powers usually include an ability to omit part of the works, but not if that work is to be carried out by another contractor simply for a cheaper price.

Similarly, design and scope change provisions can be used to switch to less expensive solutions, often known as ‘value engineering’. In practice, however, many contracts do not contain clear mechanisms for valuing those omissions or value engineering changes.

More construction disputes

It is not hard to see that these practical and legal impacts are likely to lead to an increase in the number of disputes between parties to construction contracts. This has been the case in previous high interest rate cycles.

The industry is, however, generally in a better position to handle those disputes in this cycle.  This is because of the development of swifter, less expensive dispute resolution processes, including adjudication in many jurisdictions, dispute review boards, and the increased appreciation of the benefits of alternative dispute resolution processes like mediation.