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How will the rise in interest rates affect the construction industry?

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Posted by Michael Hiscock on 13 November 2017

Michael Hiscock Partner - Head of Construction

The Bank of England has done something it hasn’t done in nearly ten years: raise interest rates. With the UK job market and the economy growing steadily, increased rates are not surprising and are a sign of an improving economy and recovery from the recession of 2008.

How will the rise in interest rates affect the construction industry?

Realistically, this interest rate increase will have little to no immediate impact on the construction industry, subject to my comments below in respect of fluctuations/pricing mechanisms.

However, it is important to understand that the Bank of England intends to increase interest rates gradually over time, with two further increases expected over the next year. As this will have consequences for business, this is a good time to understand how a continuing increase in interest rates will affect the construction industry generally and, in particular, your business.

Expense

An increase in interest rates will mean that construction projects will become more expensive.

With the cost of materials rising, and a falling pound rate, there are some clear risks to the construction industry, further exacerbated by the uncertainty of Brexit. Construction companies may need to consider realigning their pricing for projects to build in the increased costs from higher interest rates.

Cash flow

Put simply; this is the process of ensuring the organisation has enough money – or working capital – to function, without putting itself at risk.

Most construction companies tend to operate with limited cash flow leaving them with little flexibility when interest rates rise: the additional cash needed to repay loans can be non-existent. This could cause a host of issues. Companies may find themselves having to self-fund or delay paying their receivables. Some contractors will also put off investment and expansion plans, further slowing the growth of the company (and impacting on the industry as a whole).

In light of this rate rise, the most obvious step to take is to ensure invoices are raised correctly, sent out promptly and paid on time. From a practical perspective, this may include calling customers to remind them when payment is due and be rigorous about following up after that.

The National Federation of Builders believes the rise will now help construction SMEs chase late payments across their supply chains as, under The Late Payment of Commercial Debts Regulations of 2013, they can claim 8% of the debt plus the increased base rate.

The interest rate rise may also prompt some contractors to review any lengthy payment terms being proposed or other terms with which they have to comply.

If there is a lengthy delay between when money is expected from customers, and when payments are due to suppliers, it may be worthwhile considering invoice discounting or factoring to help bridge the gap.

When dealing with suppliers, consider fixing prices for raw materials while the prices are still low. Committing to a certain amount, or period, of spending with a supplier, may help to achieve the best possible price in the medium term.

Borrowing/lending

When interest levels are low, companies can borrow to invest more easily and increase profitability on the back of the investment. The money earnt on projects should be sufficient to pay off the loan and produce a profit.

An increase in interest rates will make loans more expensive, thus impacting a company’s ability to obtain funding for growth. 

While small business owners with fixed-rate loans may not be immediately affected when interest rates rise, company owners with loans that have fluctuating interest rates may find it more difficult to repay their loans. Higher loan payments may lead to reduced profitability which, in turn, can make securing future funding more difficult. Without these loans, businesses may have to redirect their resources away from innovation and reinvestment.

To the extent your business is dependent on credit, your costs are likely to go up

Fluctuations/pricing mechanism

Fluctuations are provisions built into standard construction contracts that provide a mechanism for dealing with the effects of inflation. The contractor will be expected to take inflation into account when calculating their price for a project. The fluctuations’ provision allows for the contractor to be reimbursed for price changes to specified items (a fluctuating price).

Among many things, fluctuation clauses in contracts will allow for changes in taxation. Depending on the wording of the contract, a business may benefit from the recent base rate rise by allowing them to increase their prices, albeit by a nominal amount.

Although this initial increase may not give immediate cause for concern, with already low-profit margins and the likelihood of interest rates continuing to rise, it is important to consider adjusting and adapting to future interest rate rises. This forward planning will help you to protect your business from the negative effects and take advantage of the positive ones.

About the author

Michael Hiscock

Partner - Head of Construction

Michael is a specialist in construction and engineering procurement, advising on a wide variety of works contracts.

Michael Hiscock

Michael is a specialist in construction and engineering procurement, advising on a wide variety of works contracts.

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