Hyperinflation of material, labor, and equipment costs is having widespread ramifications for the construction industry, including project funding issues, cancellation of contracts, and contractor defaults. Despite the flurry of current construction happening around the country due to infrastructure investments and the demand for new housing, it’s a challenging time, especially for smaller trade contractors. In 2021, the annual construction input inflation rate reached a shocking 19.6%. For the sake of perspective, the non-residential construction inflation rate was 4.4% in 2020 and 1.8% in 2019. The vast majority of contractors in today’s industry haven't had to navigate an inflationary environment that exceeded 5% for more than 30 years, which means many have never experienced hyperinflation and are struggling with how to handle it as well as the negative impact it can have on the bottom line (source 4).
MORE EXPENSIVE MATERIALS
The pandemic-induced economic shutdown dramatically reduced the production of construction materials including pipe, lumber, and steel - seriously disrupting supply chains and causing widespread material shortages. Subsequently, contractors are now paying much higher prices for construction materials and experiencing significant project delays. No sector of construction has escaped price hikes. Any project requiring significant materials or equipment such as piping, HVAC units, or electrical wiring is being hit hard because of the large percentage of material needed. In addition, any trade or project with traditionally high material or labor costs is feeling the pinch. In July 2022 material costs were up 17.4% over those of July 2021, making it increasingly tough to find and afford materials, especially for smaller trade contractors already struggling to turn a profit.1 From December 2020 to December 2021, the increases in construction input cost indexes ranged from 14.6% for new multifamily construction to 20.7% for commercial structures.4 While some commodity prices are starting to settle a bit, construction equipment and material prices are likely to remain high even if year-over-year price increases moderate.3 With COVID-19 lockdowns continuing in China, the world's leading manufacturer, and Europe facing severe energy crises, supply chain snarls and high prices are expected to be an issue for the foreseeable future.3
Losing money on materials can be a triggering event that starts a contractor on the path toward bankruptcy. Because borrowing costs are rising and the current risk of recession is elevated, project owners are increasingly resistant to paying higher construction costs. This means contractors should remain focused on maintaining appropriate cash flow and eliminating costs as opportunities arise.3 Many construction projects, such as municipal and governmental projects, include hard bid pricing and if there’s no escalation clause in a contract to help provide relief from hyperinflated prices, contractors are then stuck paying for higher costs out of their own pockets. Those losses may not be shining through on Profit & Loss sheets yet, but it’s likely to become more apparent in construction financials at the end of 2022 and into 2023.
RISING WAGES, ECONOMIC INFLATION, & INTEREST RATES
The current economic environment has also resulted in the exodus of skilled labor from the construction sector. While the industry added 32,000 jobs in July 2022, it’s estimated that up to 1.2 million construction workers will leave the construction industry before the year is out, further exacerbating a strained workforce. The competition for qualified workers is tight, forcing contractors to increase wages in an attempt to compete on projects and attract or retain workers, which further eats into profits. Between December 2019 and December 2021, construction wages grew 7.9%. At the same time, wages in transportation and warehousing jumped 12.6%, tempting many experienced workers away from construction and creating better paying alternatives for workers who can’t or choose not to pursue college degrees.5
Currently, there are around 25% more unfilled construction positions than new hires, and it’s anticipated that wages will continue to grow because of elevated demand. Nearly every statistic about the construction workforce shows a significant shortage becoming more endemic. In addition, all of this is converging as the federal infrastructure bill adds to the industry’s demands, with $550B in approved spending requiring an estimated 3.2 million new workers. However, since the end of the Great Recession, the percentage of construction workers aged 25-54 has dropped 8%, while the share of workers age 55 or older has risen to 20%. With an average retirement age of 61—a fifth of the industry is at risk of leaving within the next 6 years.5
As the price of materials and cost of wages have gone up, so has economic inflation. In June 2022, U.S. economic inflation hit 8.6%. However, the rate of inflation appears to be slowing, and the demand for new construction is still prevalent given the current U.S. housing shortage. However, the Federal Reserve has also steadily increased interest rates over the last year in an attempt to combat inflation, which is beginning to hurt home sales. The combination of inflation and a nearly 3% jump in mortgage interest rates in the first half of 2022 has deterred many homebuyers and started to deflate the real estate market.1 Small and medium size municipalities are also struggling to adequately fund projects like new schools, parking lots, etc., so they’re putting them on hold or canceling projects entirely.
CONSEQUENCES FOR CONTRACTORS
A perfect storm of supply chain snarls, rising costs, workforce shortages, delayed delivery times, and smaller bid price increases threaten to push some contractors out of business.4 It’s not uncommon for subcontractors to close their doors due to an inability to keep up with unit pricing or other rising costs, but even companies with a long track record of success aren’t guaranteed to successfully navigate the current economy. Solid contractors with decades of experience can still be overwhelmed with too much work, take on jobs too large for their capacity, or find they have insufficient working capital to cope with growing pains. For example, if a 5-year construction contract was originally budgeted at $1.3M, but 2 years later the job cost is $1.7M due to inflation, the general contractor may be unable to complete the job at the inflated price point. This gap is causing companies to default, projects to be canceled, or clients to be forced to rebid jobs that have already been contracted.
When it comes to projects that require bonding, such as most government infrastructure or construction projects, it’s also causing gaps between the levels contractors have historically been able to bond vs. the higher project costs. Due to the inflated cost and the fact that most government projects are bid several years out, a contractor's financials will no longer support the necessary bond amount needed to complete the work. Contract bonding is typically required at the state, federal, or municipal level by lenders, general contractors, or private owners, among others. The amount required can vary by project as it is more of a credit obligation than an insurance issue.
While surety bonds often work in conjunction with insurance for construction projects, it is not a form of insurance. Surety bonds typically cover contracts. When working on federal projects, governmental agencies generally require a surety bond to ensure that the contractor performs in accordance with the contract. It also includes a labor and material bond to make sure the general contractors pay subcontractors and material vendors. Surety bonds known as license and permit bonds are also often required of contractors by public entities.
HELPING CONTRACTORS NAVIGATE CURRENT CHALLENGES
The many factors impacting construction are deeply intertwined, which creates significant challenges for the construction industry. Contractors would be wise to proactively communicate with clients about how these issues could impact a project. It’s also important to consider the timing of starting a project. If, for example, materials such as windows won’t be available for several weeks or months, a building project could be damaged by wind or rain. Other exposures like construction site accidents may also become more prevalent if construction teams are operating with smaller crews or hiring less-skilled workers due to the labor shortage.1
According to data from the Bureau of Labor Statistics, the 12.5% annual increase through December 2021 in the bid price fell far short of the Producer Price Index’s 19.6% input price increase, indicating contractors were absorbing more of the cost increases. Construction profit margins currently hover between 3.5% and 5%. This means the gap between bid price increases and input cost increases is 7.1%. In this hyperinflated environment, those who refuse to face such facts will find denial doesn’t prevent them from losing money. Planning for cost inflation and carefully re-evaluating contract terms will play a key role in prevent losses in 2022 and beyond.4
Contractors may find that insurance and surety bond premiums are higher based on inflation impacts, increased revenue, and higher building values, which makes coverage more expensive. To thrive in this challenging market, contractors should pay attention to large bid spreads and carefully review project contracts, insurance policies, and bond forms for burdensome language. It’s up to retail agents to help their construction clients navigate the marketplace and mitigate other exposures that could push costs higher.
Agents should also look for dependable insurance and bonding partners with extensive experience in the construction space. With the help of trusted retail agent as well as insurance specialists and bonding advisors, contractors can face current challenges with greater confidence and be better positioned to take advantage of new opportunities in the years ahead. Contact your local CRC Group producer today to learn how we can help your construction clients make smart decisions in today’s marketplace.
- Jeff Booth is Senior Vice President and Chief Underwriting Officer with Allstar Surety. For the past 25+ years he has specialized in non-standard/small standard surety business.
- Jason Centrella is an AllStar Surety Branch Manager and Senior Underwriter with 40+ years of experience in the surety and construction industry.
- Stefan Tauger is a Regional Vice President with AllStar Surety. He has more than 20 years of experience in surety underwriting and serves as Branch Manager for the Denver regional office.
ABOUT ALLSTAR SURETY
Founded in 1965, Allstar’s family of operating companies have remained steadfast in their commitment to providing the highest quality service and products to surety, fidelity, and insurance professionals. AllStar Surety maintains offices nationwide, offering both commercial and contract surety products to an expanding network of retail agencies. As a managing general underwriter (MGU) for several "A" rated/T-listed companies, AllStar Surety is a one-stop shop for almost any bond need. Learn more about AllStar Surety here.
- 4 Issues Facing Contractors That Agents Must Know, Insurance Journal, September 19, 2022 https://www.insurancejournal.com/ magazines/mag-features/2022/09/19/684591.htm
- What are Surety Bonds, NASBP. https://www.nasbp.org/getabond/about-surety
- Monthly Construction Input Prices Dip in August, but Are Up 17% from a Year Ago, Associated Builders & Contractors, September 14, 2022. https://www.abc.org/News-Media/News-Releases/entryid/19596/monthly-construction-input-prices-dip-in-august-but-are-up-17- from-a-year-ago-says-abc
- 2022 Construction Inflation Alert, Construction Financial Management Association. https://cfma.org/articles/2-22-construction-inflation-alert
- The Construction Labor Shortage Is Set To Intensify Over Next 6 Months, Bisnow, June 28, 2022. https://www.bisnow.com/national/news/top-talent/short-materials-now-short-workers-constructions-cost-set-to-rise-amid-new-labor-woes-113573