With current events like the Ukraine crisis bumping energy and commodity prices, inflation has become a severe threat to the global economy in 2022. The inflation rise has impacted most sectors worldwide, and the construction sector in the Middle East is no exception.
There are many factors for the rise of prices, including; the rising global demand which is still recovering from the COVID-19 pandemic, an impacted labor market, supply chain disruptions, and increased energy prices is resulting in shortages and, therefore, the rise of inflation. Oxford Economics has provided a forecast for global inflation of 5.2% for 2022, compared to the previous projection of 4.3%.
The soaring construction market in the Middle East
Urbanisation has been rapidly growing across the Middle East region, resulting in the growth of the demand for affordable housing, transportation, social and utility infrastructure.
The Royal Institution of Chartered Surveyors (RICS) observed that the construction industry experienced a boom worldwide in late 2021, with the demand for new housing being a key factor. This results in a new increased demand for labor which led to a shortage of personnel in the Middle East, especially after construction workers returned to their home countries during the COVID-19 pandemic.
The increase of urban development lies at the core of economic vision programmes that many countries in the region to reduce the dependence of their economies on hydrocarbons and boost sustainable development, for example, Saudi's Vision 2030.
These plans are leading record levels of activity in the construction industry across the Middle East. MEED Projects estimated that $156 billion of new construction projects were awarded across the Middle East region in 2021, and it is expected to rise over in 2022. Saudi Arabia accounts for approximately 37% of the region's spending in 2021, and is by far the largest driver of construction activity in with ‘giga-projects’ like Qiddiya, Amaala, NEOM, Diriyah Gate, ROSHN, Al Ula, and SPARK.
The impact of price inflation on Saudi Arabia's construction sector
The global construction boom has created a larger demand for construction materials such as steel, and this demand is boosted even more in Saudi Arabia thanks to the current construction of the giga-projects. In 2021 the price of materials such as aluminium, iron, and copper, increased around 45% and 51% while the price of steel reinforced bars grew 46% in some parts of Saudi Arabia.
It seems like steel prices may have peaked for now, but the strength of the demand will most likely continue to drive the price of steel bars in key markets across the Middle East and in Saudi Arabia.
Another factor increasing the construction costs in the country is the kingdom's dependence on imported construction materials, mainly from Europe and China. While the government is currently working to reduce this dependence, this will take some time, thus the construction sector will remain reliant on imported materials.
We estimated that tender prices rose by an average of 4.5% across the kingdom in 2021, and we expect that they will see a greater increase during 2022. With the current strength of demand and the shortage of qualified local contractors, price inflation (TPI) is expected to be more than 7% in the country this year. TPI is unlikely to be as high in other markets within the region.
Challenges and opportunities
Accelerating price inflation in the construction sector poses challenges for contactors, investors and occupiers, however, contractors and developers are anticipated to face pressure to a greater extent. The Saudi market has historically benefitted from higher levels of liquidity and the recent spike in oil prices will undoubtedly have helped in this regard. This in turn should alleviate some pressure off public sector agencies tasked with key roles in ‘nation building’ and may allow them more room to maneuver when striking a balance between achieving financial returns and delivering sustainable, thriving cities and communities for the longer term. Furthermore, higher construction costs are more likely to be absorbed rather than projects coming to a halt.
Saudi Arabia’s government and related entities account for a large proportion of overall demand for real estate. This combined with increased private sector demand resulting from initiatives such Program HQ (which will require international businesses to establish their regional headquarters in Saudi Arabia if they wish to continue to operate in the market) and a shortage of Grade A space means that rents have been under upward pressure.
With investors and tenants to some extent shielded from the impact of higher construction costs in Saudi Arabia, the brunt of this increase is more likely to be felt by developers as higher construction costs squeeze margins. The construction sector in Saudi Arabia is currently constrained by a number of distinctly local factors, which are less prevalent elsewhere in the region. These include a relatively low level of modular construction, limited local manufacture of building products and the small number of tier 1 contractors and developers. Undoubtedly progress on these fronts will be made in the medium to long-run, but it will take some time before it can offset the expected short-term squeeze on development margins.
Modular construction techniques are currently up to 30% more expensive than traditional labour-intensive methods of construction. But as modular construction techniques become more cost-competitive over time, the potential economies of scale achievable – especially in context of the various giga projects underway in Saudi Arabia – could transform the current landscape. An increase in locally produced materials to serve the construction industry is also likely to improve development margins, but it is likely to take time to ‘ramp up’ local manufacturing.
As previously noted, the Saudi construction sector is currently characterised by a limited number of tier 1 local developers and contractors. The government has recognised this and is seeking to open up the market to foreign players. Recently, there have been a number of joint ventures with overseas developers and contractors (with firms originating from the UAE playing an increasingly important role) and this trend looks set to gain momentum. Given the greater depth and experience of regional players, this should allow scope to maintain development margins. There will also need to be a further focus on the existing supply chain, as the focus on “local” needs to be a priority for the market to continue to develop. There is also a prominent role for the development community to play in right-sizing the local tier 2 contracting market opportunities.
In summary, higher construction costs will likely result in reduced development margins across Saudi Arabia’s market this year. Nonetheless, savvy developers will seek to maintain their margins by implementing various measures. Focus on downstream operational cost reduction, implemented in the design stage will help lessen the impact of higher construction costs on the development model. For example, in the short-term, we are likely to see an increased focus on improving the operational efficiency of projects through a greater use of technology (including the wider application of ‘digital twin’ technologies) to monitor and improve OPEX. Over the longer term, developers will explore new technologies to reduce construction costs and pay greater attention to incorporating green technologies in order to build more sustainable buildings. Their success in these areas will determine the timing and extent to which the downward pressure on margins will be alleviated.