Residential Building is Not About to Crash

 Despite the fall in approvals the pipeline of work remains high

Because of the housing crisis there was a lot of attention given to the 5.8% fall in Australian residential building approvals for housing over the year to February 2024, the most recent data. Approvals for other residential (medium and high rise buildings) are now down to around half the level of 2022, while approvals for houses have declined by much less, around 15%. 

 

On the surface, these declining approvals look like a problem for residential building in the future, but this is not the case because of the backlog of work that has accumulated over the last few years. The combined value of work yet to be done on projects already commenced and the value of work on projects approved but not yet started is known as the ‘pipeline’ of future work.

 

In June 2023 there was $56 billion of residential building work yet to be done, a record amount, and in December it was $53bn. As Figure 1 shows, the value of work yet to be done on detached houses fell from $24bn to $21bn in 2023 and fell on other residential (medium and high rise buildings) from $33bn to $31bn. This slight slowdown in the value of work yet to be done reflects the 6.4% decline in commencements between December 2022 and December 2023, but does not change the fact that there were 226,035 dwellings under construction in December 2023 compared to 237,684 in December 2022. The value of residential work done only fell by 1.5% in the year to December 2023, and is still at a very high level. 

 

 

Figure 1. The value of work remaining to be done on jobs under construction 

 Source: ABS Building Activity, seasonally adjusted chain volume measures. 

 

 

The fall in the value of work yet to be done has been offset by increases in the value of work on projects approved but not yet started. Between December 2022 and December 2023 this increased from $5bn to $6bn for houses and, after falling to $10bn, was back at $11bn for other residential. In December 2023 the value of work on projects approved but not yet started was at a record level of $17.8bn. While some of these projects will not get built, for the great majority the question is when not whether they will be started. 

 

 

Figure 2. Value of work on projects approved but not yet started.

Source: ABS Building Activity, seasonally adjusted chain volume measures. 

 

 

When the value of work yet to be done on projects already commenced and the value of work on projects approved but not yet started is combined into the ‘pipeline’ of future work, the total in December 2023 was $70.6bn, slightly down from the record $72bn in December 2022. This is well above the previous record high of $58bn reached in 2018, and the result of sustained increases since the low of $44bn in 2020. 

 

 

Figure 3. Total value of work in the pipeline

Source: ABS Building Activity, seasonally adjusted chain volume measures. 

 

 

Why has the pipeline of work grown so fast and become so large? 

 

Despite the increase in interest rates since 2022 house prices have increased and the value of residential work done has barely changed. Monetary policy in Australia targets residential building because decreased consumer spending due to increased interest on residential mortgages is the RBA’s primary means of reducing inflation. Higher interest rates reduce the number of potential buyers of new homes so developers reduce project commencements, which have declined but not by much. However, developers continue making applications for development approval on sites they own because the outcome and time these will take is uncertain, and an approval is an option that can be exercised in the future. This increases the amount of work to be done on projects not yet started, and the cost of those projects is rising due to inflation. 

 

A second reason is the recent large increases in non-residential building and engineering construction, and the resulting competition for resources. The value of non-residential work done increased by 12% and engineering by 17% in the year to December 2023. Although the exchange of workers between industry sectors is limited, key trades like electricians and materials like concrete are both shared and finite, and non-residential construction will often be prepared to pay more for labour and materials than residential work. In particular, the increase in non-residential building from $12.8bn in December 2021 to $14.6bn in December 2023 (Figure 4) countered the decline in residential building so the total volume of building work has not fallen. 

 

Figure 4. Total construction

 

 Source: ABS Construction Work Done, chain volume measures.

 

A third, related, reason is the shortage of workers to complete the projects already started. The ABS had 1,229.8 million people employed in construction in December 2023, an increase of 0.0% since December 2022. Reallocation of workers between industries is typically small, not much more than a couple of percent of total employment a year, and tens of thousands of workers can't move from retailing to construction quickly or easily. More and better training opportunities would be one way to help solve the industry’s problems, as would higher retention rates for apprentices. 

 

According to the ABS, unemployment is historically low at 3.8% of the workforce, as is the underemployment rate of 6.5%. In March 2024 the participation rate was 66.6%, monthly hours worked increased, full-time employment increased to 9.9 million and part-time employment was 4.4 million people. The pool of available labour is small, there were 573,000 unemployed people in March, and the question of where more workers will come from has few possible answers: maybe early retirees would return to work with better working conditions; reducing hospital waiting lists might get people back to work; higher immigration favouring trades cuts both ways by increasing demand for housing. 

 

Finally, hundreds of building companies and professional services firms have failed over the last few years (Figure 5). How much impact insolvencies have on residential commencements and completions is hard to know, but there has to some effect as affected projects can be delayed by contract renegotiations, suppliers not being paid, and clients having to refinance the work. How many projects have been affected is also unknown, but the cumulative number of dwellings would be in the thousands, and incomplete projects are sitting in the pipeline. 

 

Figure 5. Insolvencies

 

Source: RBA Financial Stability Review – March 2024

 

 

Conclusion

 

The decline in approvals for residential other building has been significant, but has been much smaller for detached houses. However, although total residential building approvals have fallen to around half their level in 2022, the value of work in the pipeline for projects under construction and yet to be started has not, and is currently close to $71bn, just below the record high of $72bn at the end of 2022. 

 

Residential commencements in 2023 were only down by 6.4% on 2002, therefore expected completions in 2024 will not be much below the 2023 level of 172,725 dwellings. During 2021-23 between 40 and 45,000 dwellings have been completed each quarter, which may be less than the 50,000 plus quarterly completions between 2016-19 but is still close to the industry’s capacity to deliver new housing. 

 

Residential building capacity has been affected by the increase in non-residential building work, as the total volume of building work done is now at a historically high level. The limited supply of materials and availability of workers will reduce the number of residential building commencements and increase the time taken for completions. This will have the effect of keeping the value of work in the pipeline high through 2025, and probably further into the future as approvals increase from their current low level. 

 

Therefore, the good news is that residential building is unlikely to significantly decline in the near future, despite the recent fall in approvals. That level of expected completions, however, is well below the number required to meet the housing targets of the Commonwealth and State governments. The bad news is that it is hard to see how the supply of new housing can be increased in the short term, given the increase in non-residential building and public sector engineering construction. At these levels, the amount of work in progress is increasing the time taken to complete projects due to limits on the availability of workers and supply constraints. 

 

 

The Long Cycle in Australian Construction Productivity

 

Over the last 15 years, Construction productivity in Australia has gone through a long cycle and ended up more or less where it began. The Australian Bureau of Statistics Construction labour productivity index rose from 92.88 in 2006-07 to 95.36 in 2010-111, before rapidly increasing to 115.94 in 2013-14, then falling to 99.1 in 2021-22. What explains the 10 year cycle between 2011 and 2021?

Productivity estimates require both a measure of labour inputs, such as hours worked or people employed, and a measure of output, called Industry value added (IVA, the difference between total revenue and total costs). IVA is then adjusted for changes in prices of materials and labour to estimate Gross value added (GVA) using price indexes. The ABS has a Construction industry labour productivity index, but does not have separate indexes for the different construction industry sectors.

However, using GVA data, estimates of productivity for the industry sectors of Engineering construction, Building construction and Construction services can be found. The GVA data comes from the ABS National Accounts (chain volume measures of economic activity). The number of people employed includes all workers in June each year, and comes from ABS Australian Industry. The construction work done data is from the ABS chain volume Value of Construction Work Done, which is expenditure on construction adjusted for inflation.

GVA per person employed is a useful proxy for industry productivity. As a combination of real output and employment, GVA per person employed looks like a measure of productivity and, while not precise, it is indicative of industry trends. As a measure of productivity, annual GVA per person employed follows a similar path to the ABS productivity index, which uses the number of hours worked for labour input. If output is increasing faster than employment, labour productivity will also increase.

In Figure 1 Construction GVA per person employed in thousands of dollars per person is compared to the ABS labour productivity index for Construction from their Estimates of Industry Multifactor Productivity. There is a good match between the two because they both use industry GVA for output and are both based on the 2020-21 year, although the long cycle between 2011 and 2021 is more pronounced in the GVA per person data. The ABS labour productivity index is 2020-21 = 100, and went from 92.88 in 2006-07 to 115.94 in 2013-14 before falling to 99.1 in 2021-22.

Figure 1. Construction Gross Value Added per Person Employed and Labour Productivity

In Figure 2 the Value of construction work done is shown with GVA per person employed, and there is a clear relationship between the two. Over the 15 year period Construction work done peaked twice, first in 2014 during the mining boom and then in 2018 with new infrastructure projects. Construction GVA per person followed a similar trend to the rises and falls in work done. 

Figure 2. Gross Value Added per Person Employed and Construction Work Done

Significantly, Figure 2 shows GVA per person employed also peaked in 2014 as it followed changes in work done. Productivity increased when construction was rising after 2011 during the mining boom, and then decreased as the mining boom ended. The first stage of this long-run cycle of increasing construction work done and GVA per person employed in construction was entirely due to the large number of large, capital intensive resource projects completed during the mining boom between 2011 and 2017, followed by transport and energy sectors commencing in the second stage from 2018.

Engineering Construction

The mining boom started in the 2000s but took off after 2010 with many large energy and resource projects. As Figure 3 shows, the value of Engineering work done doubled between 2007 and 2013, and as it did Engineering GVA per person employed increased by around 20%. Engineering GVA per person followed the rise and fall and subsequent fall in the value of work done, and is now well below the peak years. The value of Engineering work done includes associated expenditure on machinery and equipment, so a lot of the increase was due to the capital investment required for the LNG plants, offshore platforms, railways and new mines constructed.

Figure 3. Gross Value Added per Person Employed and Engineering Work Done

Building Construction and Construction Services

Using Australian Industry employment data, GVA per person employed can also be found for both Building construction and Construction services as well as Engineering. Here a slight decline in Building has been offset by a small rise in Construction services GVA per person over the 15 years, as GVA per person since 2006-07 in Building has declined slightly, from $179,000 to $148,000 in 2021-22, while it increased for Construction services, from $84,000 to $102,000. As shown in Figure 4, the level of GVA per person in Construction services is around two-thirds of the level for Building construction, because Construction services are generally labour intensive and will therefore have a lower value of output per person. 

The range in output per person employed between Engineering, Building and Construction services reflects the differences in capital requirements of these three sectors, and expenditure on purchases of software, equipment and machinery by firms in the three sectors. The higher the capital requirements, or capital intensity, of an industry, the higher the level of output per person employed is expected to be, because workers with more capital are more productive. Both excavators and shovels require one operator, but the former shifts more soil.

Figure 4. GVA per Person Employed in Engineering, Building and Construction Services

The strong relationship between the value of Engineering work done and GVA per person seen in Engineering is not found for Building and the value of Building work done. Despite the increase in the value of Building work done after 2014 there was no increase in GVA per person, rather there was a slight decline as residential building increased during the transition after the mining boom, as shown in Figure 5. This may also be an indicator of increased use of prefabrication and offsite manufacturing reducing the value added of onsite work, but we have no reliable data on that. 

Figure 5. Gross Value Added per Person Employed and Building Work Done

For Construction Services there is real GVA but not real work done data, so total construction work done is used in Figure 6, as the trades work across Building and Engineering. Here, GVA per person does increase as work increases, but peaks in 2016 and then falls away. The number of people employed increased from 723,000 in 2015-16 to 854,000 in 2020-21, and may have contributed to the fall in GVA per person if that increase included many new workers with little experience and limited skills. There was a particularly big increase in employment in 2020-21, when over 60,000 more people were employed in Construction services, and employment grew much faster than work done. As a result, GVA per person dropped by $8,000 before recovering in 2021-22.

Figure 6. Gross Value Added per Person Employed and Total Construction Work Done

Conclusion

Over the last 15 years, construction productivity in Australia has gone through a long cycle and ended up more or less where it began. Rising from $115,000 per person employed in 2007 to $149,000 in 2014, an increase of 29%, GVA per person employed then started falling and was back to $125,000 per person in 2022.

This long cycle in Australian construction productivity followed changes in the value of Engineering work done. Productivity increased as Engineering construction rose after 2011, and then decreased as the mining boom ended. This long-run cycle in construction productivity was entirely due to the capital intensive resource projects completed between 2011 and 2017 by Engineering construction, where the machinery and equipment required for LNG plants, offshore platforms and new mines is included in the value of work done. This greatly increased the value of work done, but much of the increase was therefore not invested directly in construction work.

The strong relationship between changes in the value of work done and GVA per person seen in Engineering is not found for Building construction or Construction services. The higher capital intensity of Engineering work appears to lift GVA per person with increasing work done, as more expenditure on machinery and equipment is included in this sector compared to building.

Despite the increase in the value of building work done after 2014 there was no increase in Building GVA per person, rather there was a slight decline. For Construction services, GVA per person did increase to 2016 as construction work done increased, before falling away as the number of people employed increased faster than the value of work done.

What can be taken from this episode? Firstly, over 15 years there has been little change in overall construction labour productivity and, unlike Engineering, for Building and Construction services increasing work done has seen productivity fall slightly since 2014 as employment increased faster than output. Second, the lack of any real trend in construction productivity, despite changes in output and a continual increase in the number of people employed, suggests the industry is at the limits of efficiency, based on current technology. As output increases the number of people also increases, often a bit more than output but sometimes slightly less, so GVA per person is not improving. Therefore the industry may be somewhere close to the efficiency frontier in delivering projects, but there is no trend at either the industry or sector level of increasing productivity.

Construction is Not a Service Industry

 Intermediate Inputs Show Construction is a Production Industry 

There is no agreement on what the construction industry produces. Some researchers believe the industry provides services (management, coordination, finance), others believe the industry delivers products (buildings and structures). The former group argues that the main task of the industry is one of coordinating site processes while the latter are more concerned with the physical production of buildings and works. 

Is the industry’s output a service, the management of construction, or a product? Construction can be seen as a service industry because the industry uses subcontractors to do the majority of work onsite. The role of builders and contractors is to organise the production process, providing a service, while the delivery of the product (a building or structure) is the responsibility of the subcontractors who carry out the work. 

By restricting analysis to the level of main contractors, it is a logical step to argue that the role of contractors is to provide management services for clients. Therefore the industry is a service industry, like finance and health, not a goods producing industry like mining or manufacturing.

While right about the role of contractors as managers, this mistakes one part of construction for the whole. Contractors are responsible for the purchase of all the intermediate inputs required for their projects, such as supplies of materials and components. Subcontracted onsite work is only one part of the production process, and the contractor is responsible for the final product.

Data from the Australian Bureau of Statistics supports the product view of construction, using the relative contribution to industry Output of Total Intermediate Use (TIU) and Gross Value Added (GVA). The ABS explains:

The graph illustrates the relative contribution to total Output of Australian Production by Total Intermediate Use (TIU) and Gross Value Added (GVA) components for 2020-21. The TIU to Output ratio for industries that primarily produce goods is typically different to that of industries that primarily provide services. Industries producing goods - Agriculture, Mining and Manufacturing – require relatively large amounts of material intermediate inputs, usually resulting in a higher TIU to Output ratio. 

In contrast, service based industries such as Financial and Insurance Services, Education and Training, Health Care and Social Assistance have a much lower TIU to Output ratio as they rely more heavily on labour inputs. For example, Education and Training, Health Care and Social Assistance have TIU to Output ratios of 30.7% and 31.7% respectively. 

The ratio of TIU to total output shows manufacturing with 72% and Construction at 70% are the industries with the highest levels. The majority of industries are around the 50% level.

On the definition of construction there are two views.  On the one hand is the view that it is management of the productionprocess, and therefore a service.  On the other hand some researchers see output as the production of buildings and structures, physical products with certain characteristics that differentiate construction from manufacturing or other industries.

The view that construction is a service industry is based on the role of contractors providing management of projects, which is a business service. However, service industries typically have a high share of labour costs and a low share of intermediate inputs, but the intermediate input share of construction output is 70%. Therefore, construction is not a service industry.