CONSTRUCTION COMES OUT OF A FEVER BUT ARE BREXIT WORRIES TRIGGERING A SLOWDOWN?

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1 CONSTRUCTION COMES OUT OF A FEVER BUT ARE BREXIT WORRIES TRIGGERING A SLOWDOWN? Spring 2016 The Arcadis view is that 2016 will see the UK construction market coming out of a fever and returning to stable growth, knocked temporarily by uncertainty associated with the EU referendum and economic volatility in global markets. Broadly and beyond current uncertainty in the UK, demand will continue to see construction markets grow annually by between 3-5% to Uncertainty in the market, significant capacity constraints and high construction prices are leading to delayed starts on site and an unpredictable market place where viability continues to be a barrier to growth in construction activity. Construction price inflation will continue, increasingly driven by rising input costs, but at lower rates compared to last year. In the face of uncertainty in the first half of this year, particularly in London, we have revised down our London TPI forecast for 2016 slightly to 3.8%. The UK economic outlook remains one of the most positive in the developed world with estimated annual growth at over 2%, which will foster a supportive environment for construction. Depreciation of sterling and some rebounding commodity prices are increasing import and input costs. Scarcity of labour continues to be a primary risk across all sectors and a threat to further growth in the industry. Our market view is based on the assumption that the UK will remain in the EU. A vote to exit would result in a number of potential short and long term impacts on the economy and construction sector. WHAT IS HAPPENING TO TENDER PRICES IN 2016? As forecast in our last Market View at the end of 2015, our updated tender price forecast reflects that we expect prices to continue to grow in We have reduced our assessments of inflation for the year to Q to 3.8% for central London and held them firm for regional construction and infrastructure inflation. Our updated forecast is summarised in table 1 below. Table 1: Construction Tender Price Inflation Forecast Year Regional Markets (%pa) London (%pa) Year on year, Q4 on Q4 Infrastructure (%pa) There is a blend of upward and downward pressure on construction prices due to a variety of key economic and market factors, shown in figure 2. High levels of uncertainty in the market are reported, stemming from the EU referendum, uncertainty in the UK economy and global economic jitters. Most construction material prices continue to fall, data published by BIS shows that materials prices have fallen by around 3.4% in the past 12 months. Despite some rallying of commodity prices in the first quarter of 2016, the long term trend of low prices remains. According to IMF data, metal prices including steel, nickel, aluminium and copper are down by an overall average of 30% since the start of 2015.

2 Labour Currency Overheads & Profit Risk Allowances Plant National TPI London TPI Infrastructure Figure 1: Construction Price Inflation Trends (1986 to 2020) Scale of impact severity (red most severe) Uncertainty Commodities Materials Actual Forecast 2016 has so far generally been a positive year for infrastructure. Continuing delays in privately funded projects such as Hinkley Point have emphasised the importance of the public sector, in both policy and funding, with kick start capital given in the budget for key major programmes including Crossrail 2 and High Speed 3. Mac Alghita, Head of Transport Figure 2: Construction Price Inflation Factors and Severity Labour cost inflation continues due to skills shortages with average construction earnings rising by more than 6% in The depreciating pound has put inflationary pressure on the prices of imported goods. Overhead, profit and risk margins continue to account for a significant portion of construction price inflation. With reasonably robust UK GDP forecasts still in place and notwithstanding any significant black swan events, inflation in the wider economy will also continue to underpin construction price inflation, with the CPI forecast at 1.1% this year and almost 2% in MARKET CONTEXT - WHAT IS THE UK ECONOMIC OUTLOOK? Despite some potential headwinds, data shows that the UK s recovery is still one of the strongest in the world, with relatively robust domestic performance. ONS latest GDP figures for the first quarter of 2016 report 0.4% growth and, though down from 0.6% in the last quarter of 2015, it is still significantly positive with the fall largely attributable to weaker global trade and volatility in the financial markets at the start of the year. However, GDP attributed to construction fell by 0.9% in the first quarter of 2016 according to the ONS a poor start to the year. However, based on the latest OECD forecasts, future GDP growth is set to be 2.3% per annum and HM Treasury Consensus forecasts released in April 2016 project GDP growth at 2.0% and 2.1% for 2016 and 2017 respectively, which represents a strong prospect for sustained performance compared to other developed nations. The UK s job creation trends are broadly positive. National unemployment sits at 5.1%, down on this time last year when it was 5.6% and the lowest seen since Construction unemployment stands at 3.0%, significantly below the national rate. According

3 to the Bank of England, labour participation is close to its mid-term equilibrium level meaning that future employment growth will come from inward migration raising questions about any impacts on migration associated with a Brexit scenario. The Bank of England and Office for Budget Responsibility (OBR) both expect wage growth to pick up over the rest of the year forecasting 3.25% by mid-2016 and 3.6% over the course of this year respectfully. Many construction trades have seen higher wage inflation than this with average increases of 6%, with some trades reportedly pushing closer to 10% wage growth in GLOBAL ECONOMY - HOW WILL THE TURBULENCE IMPACT THE UK CONSTRUCTION? The UK s economic recovery, particularly in property and construction markets, has been closely related to wider, global market forces and the prevalence of inward foreign investment. Savills reported in April 2016 that UK commercial activity had risen at a slower pace, +8.9% in March 2016 down from +11.0% in February due to a weaker increase in private investment. Anecdotal evidence from the market suggests that it is likely this slowdown is temporary, associated with the upcoming EU referendum. The IMF s most recent forecast for global growth is more optimistic than 2015 with estimates of 3.4% and 3.6% in 2016 and Whilst the OECD is forecasting 3.0% and 3.3% in 2016 and 2017 respectively. However, both organisations have still flagged concerns of slow recoveries in developed nations and a spluttering of growth in emerging economies; projected to be impacted by weak trade, investment and commodity prices, low inflation and poor wage conditions. Steep declines in global equity markets and high debt exposures coupled with volatile capital flows in emerging economies are creating substantial risks of financial instability. Whilst economic turbulence and uncertainty will have a negative impact on demand globally and regionally, this is likely to be countered in the medium term by proactive demand side policy measures undertaken by governments and central banks in the form of both monetary and fiscal interventions. Negative or very low interest rates, quantitative easing, tax cuts and adjustments to public spending are deployed across a variety of nations to help boost activity and asset prices. Clients are taking the opportunity presented by a slowdown in the market to optimise the unit mix of schemes in order to better suit changing patterns of demand. James Knight, Head of Residential UK CONSTRUCTION MARKETS The industry narrative from the past two years and into the first quarter of 2016 has been one of high market demand, rapid price inflation, a bullish supply chain and severe capacity issues. Construction Products Association (CPA) data shows that following 2014 s heady construction output growth of 8.8%, 2015 saw flatter growth of 6.5%, powered predominantly by growing private investment in housing, infrastructure and industrial sectors. Weak output reported by the ONS at the beginning of this year underlines the fact that patterns of demand are less consistent than in previous years. The CPA forecast further, albeit flatter, output growth of

4 corrections will be temporary in most markets. One unexpected side-effect of fall in London prime values is that they have led to development spreading more widely around the major UK cities, potentially driving additional tender price growth in those locations. In spite of short term uncertainty levels of demand are still strong. Supply chain capacity constraints are still resulting in protracted procurement periods for many projects in London and beyond, delaying starts on site. Very high volumes of two stage procurement have led to a further deterioration in market conditions associated with sub-contract package procurement and major contractors are still struggling to manage second stage bids, further delaying projects. A number of high profile job cancellations by clients and contractors in London have highlighted that these problems have not gone away. around 4.0% and 4.8% in 2016 and 2017 respectively, with 2016 s forecast recently downgraded in the face of weakening global growth, Brexit fears and skills shortages. Based on recent downgraded forecasts from CPA and Experian, the signs are still that construction output will stabilise at around 4-5% in the coming years. Based on historic trends this is a strong, positive forecast. Despite some signs of a slowdown in the face of uncertainty, London remains a buoyant market operating close to capacity. Clients should expect continued price rises, albeit at a slower pace. Clients still have to present their projects as attractive, low risk opportunities to secure high quality contractor resource in what remains a seller s market Mark Prior, Arcadis City Executive, London Markit s latest PMI data for construction saw the index fall to 52.0 in April down from 54.2 in March, and a 2015 average of The fall in the value of the index can be attributed to the reduction in the pace of output growth. The indicator still remains above the 50 no change value and whilst disappointing, still reflects positive levels of confidence. Land Registry figures released in April 2016 also indicate a softening of house prices. Prices fell by an average of 0.5% between February and March in all regions except London and the East of England. Whilst the mainstream London housing market was in the black, the prime residential sector in London saw falls of up to 10.0%, attributed to George Osborne s stamp duty reforms and current economic and political uncertainty. However, with Savills forecasting regional mainstream and London prime residential price growth of circa 4.25% and 5% per annum respectively to 2020, it is likely that recent price INPUT PRICES HOW MUCH ARE THEY AFFECTING CONSTRUCTION PRICES? Analysis of BCIS cost indices covering labour, plant and materials shows that input costs have risen by less than 1% over the past two years. Input cost rises have been driven by strong labour cost inflation as materials costs have fallen - the latest BIS construction materials data shows that material prices have fallen by around 3.4% just in the past 12 months. The past overall long term trend of depressed commodity prices has supported this static trend - steel prices fell by 30% in the 18 months to the final quarter of 2015 due to oversupply in the global market. Oil prices are around 64% lower than levels seen in the first half of Input cost savings, which have not generally been passed to clients combined with margin-based tender price inflation have helped the supply chain, including manufacturers and distributors, to rebuild their margins quicker than expected. The devaluation in sterling is increasing the cost of imports and key commodity prices are experiencing a resurgence. Reuters reported in March the iron ore price rebounding to $53/tonne, a 43% increase since December 2015 and some UK steel suppliers increased prices by 100/tonne in the first quarter of this year, with warning to expect further price rises. We are aware of packages in major London projects increasing in cost by as much as 1m to 3m, due to the devaluation of sterling since December With rising input costs on one side and slower growth in the construction market on the other, this may present a challenge for contractors who will have to balance an increasing cost base with potential for greater competitive pressure. Will a falling pipeline be enough to keep the lid on price increases? Depending on the longer term outcome following the EU referendum, contractors and clients will likely need to look different approaches to mitigate cost inflation to ensure that projects remain viable.

5 RESIDENTIAL IS THERE A SLOWDOWN? For the first quarter of 2016, housebuilding in the UK reported a sluggish performance leading to growing concerns that the Government will not meet its pledge to build one million homes by The NHBC recorded that during December 2015 to February 2016, the number of new home registrations showed an 8% decrease on the same period last year. According to the RICS, the significant decline in private housebuilding during the first quarter of 2016 is a result of the symptomatic uncertainty around the EU referendum, planning delays and London s mayoral election. Sadiq Khan s recent election will likely create a very different development environment. Whilst existing consents are unlikely to be affected, aspirations for half of all new homes built to be affordable, pegged to local average earnings and new homes offered to Londoners first, with limits on off-plan sales to overseas buyers may make future viability of schemes more challenging. Further analysis of the RICS survey showed a still very strong but slowing rate of pipeline renewal with 36% of housebuilders experiencing increased workloads in the first quarter of 2016, compared to 50% this time last year - the weakest data since the second quarter of The slowdown in the residential market continues to be led by London where research by Lonres shows that prime central London transactions in the first quarter of 2016 fell by 31% on their peak two years earlier and down 13% year on year. Recent changes to the stamp duty land tax will impact development returns. We estimate that the percentage stamp duty tax liability of Gross Development Value has increased by between 9% and 64%, depending on the composition of buy-to-let and first or second home purchasers. In addition, lower oil prices, currency fluctuations and growing economic pressures in the emerging markets have heightened the risks for some overseas investors resulting in the cooling down of the market. Whilst there are still high levels of interest in development, the market is changing. Domestic demand is increasingly being targeted as international demand slows and off pitch locations being sought. As developers work through the viability of planned schemes, including in some cases reconfiguration and redesign, this is causing some delays to starts on site in the sector and a slowing in the pipeline. A more sluggish residential market, will have a knock on effect, causing a slowdown in construction orders. It is too early to say whether increases to stamp duty on buy-to-let purchases will undermine supply in the private rented sector. Rent increases of 5% year on year UK wide and 8% year on year in London in April suggest a shortage of supply and mean the sector is likely to retain attractiveness. Our own research however shows that 35,000 prime London homes are due for construction over the next 10 years which will represent a 10% increase from 2015 and the slowest rate recorded since the start of the survey.

6 COMMERCIAL HAS THE CYCLE TURNED? Performance in the offices sector has been strong since mid Despite a bullish past 18 months, the first quarter of 2016 has seen a slowdown in tender price inflation growth and signs that wider economic concerns and domestic political uncertainty borne out of the EU referendum are forcing clients to consider their development plans and in some cases put projects on hold. According to the RICS and Building Magazine, demand among international investors for UK commercial property is now at its lowest level since RICS records began in 2014, with just 5% of surveyors reporting increased interest from overseas companies over the last three months. In the second quarter of 2015 this figure stood at 36%. The first quarter has also seen some reverses in the fortunes of the major London REITs, with developers suffering disappointing and below average share performance shareholders could be selling in anticipation of a wider decline in asset values as the effect of yield compression reduces. The commercial sector still has capacity challenges. Considering the sector is not operating at anywhere near its historic peak level output currently 40% lower than in 2002 capacity issues are a result of the aggregation of demand in other sectors, most notably residential, which shares much of the same supply chain. Demand from a buoyant infrastructure sector has also contributed to an extent. The two stage process, prolific in the commercial sector, has been under the strain of severe capacity constraints of the past year as suppliers struggle with the time, resource and commercial imperatives needed to make it work. Despite the challenges cited above, developer sentiment is generally positive, with Savills recording an increase in their Total Commercial Development Activity Index in March 2016 and market opinion broadly in alignment that the assessment may change following upcoming election and referendum results due by the end of the first half. INFRASTRUCTURE NATIONAL INFRASTRUCTURE PLANS; RHETORIC OR HARD CASH? The first quarter of 2016 has been especially positive and has seen the bedding-in of the National Infrastructure Commission (NIC) following its establishment at the end of last year, the formation of the new Infrastructure and Projects Authority (IPA), the release of the National Infrastructure Delivery Plan (NIDP) and key infrastructure announcements in George Osborne s March Budget including initial development funding for Crossrail 2 and High Speed 3. With infrastructure investment being such a powerful driver of economic growth and a vital part of the government s efforts to rebalance the economy, it is no surprise that the sector has been in the spotlight certainly saw strong output growth and the outlook for infrastructure remains impressive as it goes from strength to strength with the CPA estimating growth of over 50% to 2019 in the sector. The NIDP outlines details of 483 billion of investment in over 600 infrastructure projects and programmes in all sectors and spread across the UK, to and beyond. However, with the government committing to only invest over 100 billion in that period, will the rest of the programme translate into site starts? Crossrail 2 is certainly well-placed, with the government committing 80m to Transport for London to fund outline designs and feasibility studies. Broad political support, including the new London mayor Sadiq Khan, as well as high levels of confidence in the ability of such a new line to give return on investment sets out a very strong position. High Speed 3 is also now in a position to develop significantly with 60m given in the Budget, following encouragement from the NIC - this should provide a kick start to transport investment in the North. By contrast, progress of Hinkley Point C and airport expansion face far greater headwinds and are proving much more elusive. There is yet to be a decision on the expansion of Heathrow or Gatwick and a final decision on the 18bn Hinkley Point C has been pushed back (again) to September of this year. Delays on these critical projects illustrate the continuing commercial and political challenge that the IPA will need to unlock to secure the high volumes of private sector experience and investment anticipated in the NIDP. Despite a slight slowdown in the market in 2016, due to political and economic uncertainty and Brexit worries, the outlook for UK construction markets is very strong. Confronted by the problem of rising construction prices and intense competition for resources, clients are taking the opportunity to look at how their procurement and commercial strategies engage the supply chain Simon Light, UK Client Development Director Although the infrastructure sector has seen less direct price inflation pressure than in other sectors of the industry, there is no doubt that resource constraints will have a greater impact on major engineering projects as workload increases at a forecast 10% per annum between now and The difficulty in securing adequate resources has no quick solution and the ability of labour supply to meet market demand remains the most significant risk to growth in the sector. The continued use of collaborative models to share risks and benefits is likely to provide the best environment for clients and the supply chain to jointly tackle these issues.

7 THE REFERENDUM ON UK MEMBERSHIP OF THE EUROPEAN UNION A WATERSHED MOMENT FOR UK CONSTRUCTION? Our current market view is based on a Remain scenario. Given that a Brexit scenario, could potentially have a significant impact on UK GDP in the short and long term, what could be the potential impacts and benefits for construction? Whilst there will be some short term effects, the real impacts will be felt through long term implications of GDP growth, sterling weakness and constraints affecting the labour market. Short-term decision making. Delays to investment and development decisions are already having an impact on the pipeline and on the timing of site starts. A Brexit outcome will result in further delays and disruption to existing schemes. Short-term sector specific impacts. In our view, relatively little construction demand will be directly impacted by a Brexit decision with sectors linked to commercial and industrial markets equivalent to roughly 8% of output in 2015 most likely to be hit. Economic slowdown. Many forecasts of the Brexit scenario anticipate negative GDP impacts. The Treasury forecasts a best and worst case permanent GDP loss of 3% and 9% whilst the Confederation of British Industry estimates a best and worst case permanent GDP loss of 2% and 8%. Weaker underlying growth will prove detrimental to the construction sector which has historically reacted to economic downturns by going into recession. Further devaluation of sterling. Should the pound continue to fall this will continue to drive inflation of import costs - but also boost exports. Construction is generally a significant importer of resources, particularly in commercial and other high end sectors, and so input costs are likely to rise with any depreciation of sterling. The depreciation in sterling of the past year has likely driven a 2-3% inflationary effect in construction. However, materials availability is unlikely to be an issue, with most European suppliers having well established distribution networks in the UK. Meeting labour needs. The industry has traditionally relied on migrant labour to overcome the endemic skills shortages that it faces. Access to a wider labour pool in the past decade has been a huge benefit to the industry but has also reduced the incentives to train UK recruits or increase labour productivity. In our view, it is unlikely that a Brexit vote will result in limits on overseas workers though a visa and permit based system will make the UK a less attractive work location. Whatever the outcome, the labour market will remain a constraint, making it vital that the industry considers how to produce more with less and how labour can be used more efficiently. In summary, the impact of the EU referendum result on construction, centres on the UK economy s ability to continue to grow, afford finance, propagate spending by the public sector and attract foreign investment. With most assessments forecasting a negative impact on UK GDP in both the short and long term, it is likely that a Brexit scenario will be a negative result for the construction industry, leading to falls in demand and adverse impacts on the financial health and growth of the sector. CONTACT Will Waller Market Intelligence Lead T +44 (0) E will.waller@arcadis.com Simon Rawlinson Head of Strategic Research & Insight T +44 (0) E Simon Light UK Client Development Director T +44 (0) E Mark Prior City Executive, London E mark.prior@arcadis.com James Knight Head of Residential T +44 (0) E james.knight@arcadis.com Mac Alghita Head of Transport E mac.alghita@arcadis.com

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