Capacity challenge for Egypt's construction and real estate sector

The government’s push to stimulate the economy after a turbulent post-revolutionary period is good news for Egypt’s construction sector. Dozens of planned mega-projects and public works initiatives mean that the contracting industry is facing a sizeable project pipeline across all segments of the market. Large-scale plans for a new capital city and the expansion of the Suez Canal, coupled with rather more prosaic infrastructure upgrade requirements, promise a welcomingly busy few years for Egypt’s construction firms.

Indictators

The sector has already established itself as an important component of the economy. According to the Central Bank of Egypt, construction’s share of GDP grew by 5.6% in fiscal year 2013/14, reaching 4.8% of the country’s real GDP by the end of the period. Moreover, this portion is likely to grow further over the next decade. According to Construction Week Online, by the end of 2015, construction spending could hit $7.3bn, with the vast majority of this amount –$6.7bn – directed towards non-residential construction projects. This is a dramatic turnaround given that 24 months ago construction spending fell by 5.14%, from LE14.78bn ($2.01bn) in fiscal year 2011/12 to LE14.02bn ($1.91bn) in 2012/13.

According to Beltone Financial, a local investment banking, asset management and research firm, the number of construction projects currently in the pipeline have a combined value of $270bn. A quarter of these are in the real estate and hospitality sector, while a further 20% are in the power sector, although many of the power projects are still in the early planning stages.

Furthermore, there is an additional $140bn worth of potential awards on paper yet to begin construction, as well as a number of mega-projects, such as the $45bn capital city project or the $40bn plan to build 1m new affordable homes in the country. Although these plans could be subject to delays or revision, they present a number of highly valuable opportunities.

The potential spike in construction projects in Egypt can be attributed to, in part, the significant level of demand within the country, which faces a shortfall in housing units and infrastructural bottlenecks. The population in Egypt is currently approaching 90m, with almost 50% under the age of 24. Hesham Shoukri, chairman and CEO of Rooya Group, speaking at a conference in Cairo in September 2015, stated that these dynamics illustrate the potential for real estate investments. “We are living on only 6% of our land, and we are expecting [the population] to be more than 180m by 2050. We can absorb more investments.”

Foreign Investment

Foreign companies, particularly those from the Gulf, are taking a leading role in residential and real estate development in Egypt. Several Gulf governments have made efforts to support the country’s home building programme through companies based in their respective countries.

As a consequence of the Egypt Economic Development Conference (EEDC) in March 2015, an Egyptian-Gulf consortium, consisting of firms from Saudi Arabia, the UAE and Kuwait, committed LE11.2bn ($1.5bn) to three housing projects in the country, according to the press.

A number of firms from the Gulf are also focused on mixed-use developments in Egypt. In January 2015 Qatari Diar received approval from the Egyptian Ministry of Defence for a $2.16bn construction programme in Egypt. Plans for the project include building hotels, shopping malls and residential apartments, all aimed at supporting Egypt’s flagging tourism industry.

Key Segments

Others also see infrastructure as a key focal point for future activity. One of the government’s recent flagship projects has been the widening of the Suez Canal, an $8bn project, necessitating significant involvement from both local contractors and the army. The project was completed in August 2015, in just 12 months, well ahead of schedule (see analysis).

“As it stands now, most of the work is going to the energy sector or the area around the Suez Canal,” Sherif Sweillam, business development manager at Gleeds Construction Consultancy Egypt (Gleeds), told OBG. Due to a lack of natural gas, which has affected generation capacity, Egypt has suffered from chronic power shortages as well as blackouts during the summer months. Consequently, power plant construction has become a priority. In June 2015 the German firm Siemens signed an €8bn deal – the single biggest order of its history – with the Egyptian government. The firm will provide Egypt’s national grid with 16.4 GW of additional supply through the construction of three natural gas-fired power plants and up to 600 wind turbines. This project will increase Egypt’s installed capacity by more than 50%.

Gas Inputs

Meanwhile, due to a natural gas shortage impacting cement producers in Egypt and cutting them off from feedstock supply, local producers are making plans for a transition to coal-fired operations. The government has also been looking to add coal to the generation mix of the national grid. In 2014 Egypt signed two memoranda of understanding (MOUs) for coal-fired generation plants: the first for a 3600-MW plant in South Sinai that was signed with Abu Dhabi-based company Al Nowais; and the second was for a 3000-MW plant to be built close to the Red Sea port of Hamarawein, agreed between Orascom Construction and the Abu Dhabi-based IPIC.

Among other segments, Egypt’s protracted housing shortage has also risen to the top of the agenda, leading to the Ministry of Housing agreeing a number of projects to build affordable homes across the country.

In March 2014 it was announced that Arabtec would build 1m homes in Egypt at a cost of $40bn. The project could be downsized, however, with the local press reporting in September 2015 that only 100,000 homes were to be built under the initiative in the next five years.

Nonetheless, there are a number of other schemes in the works to support home building. According to the local media, the EEDC resulted in a total of four MOUs signed by the Ministry of Housing and Arab real estate developers. In addition to the Egyptian-Gulf consortium agreement to carry out three housing projects worth LE11.2bn ($1.5bn), three other MOUs were signed at the conference with Saudi-Arabia’s Sisban Holdings and Egypt-based firms Mountain View and Palm Hills. All together the three MOUs have a combined value of $11.2bn, although it is still undecided to what extent the projects will be residential or commercial.

New Capital

While infrastructure and housing comprise the majority of new projects, a number of high-profile master-planned developments are also on the table that, if executed, would provide a significant fillip to the sector.

A new administrative capital city, located 45 km east of Cairo, constitutes what could be the most ambitious Egypt-Gulf partnership to date. The first seven-year phase of the project, which could potentially take up to 40 years to complete in total, is estimated to cost $45bn, and was announced as a joint venture between the government and Capital City Partners, a privately owned UAE investment vehicle, with the Egyptian government owning 24% of the project. At the time of writing, the details of the partnership were still unclear.

According to The Financial Times, Skidmore, Owings and Merrill, the architectural, urban planning and engineering firm, is designing a host of skyscrapers, parliament buildings and government buildings, as well as 25 low-rise residential districts, an international airport larger than Heathrow in London and a theme park four times the size of Disneyland. The city is to house 5m people and create 1.7m new jobs.

The plans also include a building taller than the Eiffel Tower in Paris, along with a network of streets and roads that will encompass more than 10,000 km. All together, the new capital, if fully realised, would be the size of Singapore.

There have been some delays to the contract negotiations between the government and the developers, but progress is continuing apace. In September 2015 the government announced a MOU with the China State Construction Engineering Corporation. According to local press, the firm has agreed to study the financing and building of the administrative sector of the new city, including the ministry buildings, the presidential offices and other government agencies.

Contractor Landscape

While the enormous promise of this project alone should be enough to keep contractors happy, other more concrete developments in the pipeline, such as projects in the electricity and infrastructure sectors, are set to improve the outlook in the near term. However, the workload resulting from the extra investment poses its own challenges for the wider industry, as Rawi Camel-Toueg, CEO of facility management firm ContrackFM, told OBG. “As construction picks up we are seeing some challenges in terms of finding qualified human resources.”

Indeed, the sector appears to be facing somewhat of a skills deficit. “There are not many contractors in the country relative to the population, especially when you measure capability,” Ahmed Belal, CEO at Middle East Contracting Group, told OBG. “The top players are loaded down with projects. The new capital city will probably require 500 contractors, whereas there are only 280 qualified for this in all of Egypt. If Arabtec’s 1m homes are built, we will need at least 200 more companies. There is a significant demand being placed on the sector in coming years.”

Skills

Before the revolution there were 49,000 contractors registered with the Egyptian Federation for Construction and Building Contractors. This number is now down to 11,000, the majority of which, Belal says, do not have the requisite classification to take on sizeable projects. Indeed, according to Belal, only 280 contractors are classified as level 1 to level 3, giving them the capability to execute projects with a value above LE20m ($2.7m). “Only around 20 contractors are considered very strong in that level 1 classification,” Belal told OBG, “which is relatively small for a population of nearly 90m. Out of this number, only a handful are truly of international calibre.”

This skills deficit also extends to engineers. Abdel Aal Hassan Mantawy, general manager of engineering consultancy firm Jawda, told OBG, “Egyptian engineers work hard but their training is not as good as that found in other countries in the region. Work needs to be done on creating a more institutionalised and structured system for training skilled labour if Egypt is serious about successfully completing all of the construction projects currently being planned.” This suggests that the industry could face backlogs and delays. For leading contractors, it also presents a challenge in terms of how to maintain a healthy workbook without stretching resources too thinly. Currently, however, as Sweillam told OBG, contractors are not overextended on their order books.

It is clear that aside from the big contractors in the market, many of the smaller players are struggling to remain relevant and survive. In January 2015 the Egyptian Federation for Construction and Building Contractors (EFCBC) announced that 12,000 of the 15,000 small and medium-sized construction companies that are registered with the federation are experiencing problems.

Financing

The main challenge for smaller market players lies in funding and financing their projects. Daker Abdellah, a member of the EFCBC, told local media that the commercial banking sector lacks confidence in the feasibility studies and financial and administrative management of small and medium-sized construction firms in Egypt.

While specific training programmes could potentially help these smaller firms to become viable in the long term, the general financing environment in Egypt will not offer encouragement to them. “Financing large construction projects is an issue. It is not a preferred area for banks given the risks and delays over the past few years. Collection can be an issue, as can quality and cash flows,” Belal told OBG. “Banks will only finance fast-track projects, not long-term ones, as they have to look out for the safety of their depositor’s money.” When financing and debt is available, it is expensive. Overdraft fee facilities can reach as high as 16% for contracting firms, according to Belal.

For international contractors and construction firms this is not an issue, as most of them access funding abroad and deploy little capital in the local market. For domestic firms, the lack and cost of financing provides a stern challenge to operability.

However, not everybody is pessimistic about the situation, with many pointing out that cash flows and the financing environment should improve as the government commits to its spending programme. “The lack of funds is a source of difficulty, but this would have been a bigger issue in 2014. Now it has become a government priority. They are doing better on implementing projects and making payments go through,” Sweillam told OBG.

Partnerships

The government is looking at a number of ways to ensure that funds are in place to execute projects in a timely manner and fulfill obligations to contractors. One plan is to bring in private capital to help fund the government’s infrastructure drive. Sweillam told OBG that the government is looking into the prospect of public-private partnership (PPP) agreements.

Thus far, this financing model has been used sparingly, although there is significant scope to develop it in the future. Nada Shousha, director for Egypt at the International Finance Corporation, told local media in September 2015, ‘“There is a large space for future PPPs in infrastructure, port expansions, and industrial and logistics zones. The Suez Canal Area Master Plan has been recently developed, [but] the promotion of investments in the area [is] yet to [identify] clear investment projects.” Whether PPP models can play a central role in the construction surge remains to be seen.

There are still reservations about the practical implementation of such a financing model in the market. “The PPP framework is not well developed and is struggling so far,” Waleed Abdel-Fattah, senior vice president and North Africa regional manager at construction consultancy firm, Hill International, told OBG. “There are not many successful examples of projects that have been implemented under the plans [but] there is a pipeline of projects currently being planned, so we’ll see how they go. The laws and role of local players still need to be refined, as do the pricing formulas.” Meanwhile, in its “Egypt Construction Market Report” for the third quarter of 2014, Gleeds has stated that PPP initiatives are “a distant possibility” while some within the industry are more hopeful that partnerships with the private sector will play a role in years to come. “In general, the perception in Egypt is that PPPs are expensive and complicated transactions and that the government is not particularly set up to deal with them, which is why there have only been a few that could be deemed truly successful over the past years,” Osama Bishai, CEO of Orascom Construction, told OBG. “That said, if they can be developed properly in the future, that would be beneficial, especially in terms of taking some of the financing pressures off of the government’s shoulders.”

Building Materials

At the moment, the pressure on input costs is increasing in a building materials market that continues to be price sensitive. However, during the earlier part of the year, the raw material prices have been more benign.

“Even though demand is increasing, the local residential construction market remains very price sensitive,” Manish Mehra, regional head, Middle East and Egypt, at Asian Paints told OBG. “The consumption of economy and value-for-money paints has been growing well this year.” Indeed, as Tor Hatlo-Johansen, managing director at Jotun, told OBG, “Cost is an increasing concern when it comes to inputs for new build projects: in recent years, for example, consumers have been utilising cheaper paint at the expense of quality.”

Challenges

The government’s 2014 decision to reduce the unsustainable energy subsidy programme has also had a knock-on effect on construction projects. Bruce Haswell, regional director at Gleeds, told OBG, “Inflation in building materials is escalating much faster than normal. This is not because of demand but because of fiscal reasons, such as the fuel subsidy reduction. It has doubled the cost of many construction materials because of increased energy prices.”

The power situation has been making life difficult for building material producers over the last two years. Fayez Habib Gress, chairman and managing director of Ascom, an extractor and supplier of limestone, gypsum, clays and other minerals, told OBG, “The cement industry has really suffered over the past few years as a result of high energy prices and lack of demand following the revolution. That said, there has been a turn around, and I expect the industry to resume operating at nominal capacity in 2015. But I don’t expect any new production capacity to be added over the coming year because of the lack of energy and demand being not that high.”

Cement

The cement industry has seen significant price escalation in the last two years on the back of energy-driven supply constraints. Prices for the material increased by 20% in fiscal year 2013/14. Ghada Alaa, a researcher at Beltone Financial, told OBG that by the end of the 2014 calendar year, the import parity price for domestic cement was approximately LE600 ($82) per tonne. This is, according to Alaa, largely the result of under-utilisation of capacity due to natural gas shortages. Although the country had a production capacity of 70m tonnes in 2014, actual production was at 52m tonnes for the full year.

The government has been directing natural gas for power generation in order to prevent the blackouts that affect the country during the summer months. As such, cement producers have seen a curtailment of their natural gas allotment, the primary energy source for domestic production. This is a particular blow for an industry that is a leading consumer of gas. According to a report published by the Ministry of Environment in April 2015, cement producers are responsible for 35% of all primary energy consumption in the country. They also account for 46% of natural gas consumed by energy-intensive industries in Egypt.

In order to cope with this challenge in the medium term, the industry will transfer to coal-fired plants, which is likely to reduce costs, but for long-term sustainability some industry players believe the industry needs to look to diversification, “There is still a lot of work to be done in improving the diversification of the energy mix, as there haven’t been many advancements recently,” Bruno Carre, managing director of Suez Cement, told OBG. “The utilisation of coal for cement is useful but more needs to be done, through biomass and waste-to-energy, for example,” he added.

In the short term, however, producers have had to scale down production levels and the government has turned to the international market for gas imports, a move that will incur additional costs. According to Pro Global Media, a news site for the building materials industry, as a result of these trends, Suez Cement experienced energy cost increases of 25% to 35% in 2014.

Furthermore, some cost increases are down to the regulation of imported building materials, and these constraints also affect contractors and projects. “Due to tougher regulations, imported powder raw materials are facing strict controls at the border, making it increasingly difficult to comply with production timelines, as well as increasing the likelihood of fines for non-compliance,” Mohamed Ibrahim, the managing director of Dry-mix, explained to OBG.

Moreover, some, including Ayman Nafie, managing director of BASF, a major chemical company that sells construction chemicals in Egypt, believe the cement industry is not reaching the limits of cement production capacity. “The big challenge for Egypt is to secure power for the existing cement producers. The industry does not need more investment to support future construction growth” Nafie told OBG.

Costs

Cost increases in the cement industry are inevitably passed onto the construction industry, as the product consumer. Furthermore, it is not only the cement industry that has felt the knock-on effect caused by energy supply issues. A range of energy and fuel-cost increases have affected the construction industry as a whole. In the third quarter of 2014 petroleum oil, the main fuel for transporting construction materials, increased by 64%, while natural gas increased by 75% for steel – and 33% for cement – and gasoline 92 by 40%, thus affecting a range of input materials as well as operating expenses for general contractors and developers. For example, earthworks, asphalt pavement and landscaping items increased by more than 15% in that quarter, according to Gleeds. One of the few positives for construction firms is that the cost of labour has remained steady. In the third quarter of 2014, Gleeds reports that daily wage estimates within the industry ranged from LE60 ($8) for an unskilled labourer to LE200 ($27) for a foreman and LE300 ($41) for an underwater welder. The company also forecast construction material inflation of 12% for the full year in 2014, with the expectation of a more normal inflation figure of 6% for 2015 and 5-8% for 2016.

Despite bright spots in the short- to medium-term outlook for the industry, many contractors are, in 2015, facing the strain of rising costs. According to Belal, profit margins are hovering around 7%, while Alaa estimates that for the bigger industry players the figure could be a little higher. “For residential real estate projects, a leading contractor could have profit margins of up to 10%, but for more complex infrastructure projects this could be 12-15%,” Alaa told OBG.

Cash Flows

Many contracting firms have faced issues in terms of cash flow due, in part, to delayed payments. The Ministry of Electricity, for example, has debts of as much as LE4bn ($545.2m). As a consequence, contractors are asking for guarantees when undertaking work with this ministry and other government bodies. “Over 2011-14, all contractors have been significantly hit. Even the largest contractors have been loss-making on the bottom line,” Alaa told OBG.

Although caused by delayed payments and other cash flow issues, the lack of liquidity facing a significant number of firms is also a result of the controlled devaluation of the Egyptian pound. Ongoing throughout 2015, the move is aimed at improving investment and export numbers, and subsequently improving the foreign exchange situation in the country.

However, this is also likely to have an impact on imports and inflation. Contractors and the wider construction industry are vulnerable to a weakening pound due to their reliance on imports. “Most of the previous contracts were priced in Egyptian pounds, but contractors are trying to get them re-priced in dollars now,” Alaa told OBG. El Sewedy Electric, for example, managed to get about 70% of one of its latest projects priced in US dollars, according to Alaa.

Mitigating Risk

The problem for many contractors regarding the uncertainty surrounding costs associated with currency and other inputs is that they bear most of the risk. While there are some flexible cost-plus contracts in the market, this is not the norm. With most bids in Egyptian pounds, this could put pressure on the profit margins of contractors. To help mitigate the risks of cost escalation for the contracting industry, Sweillam told OBG, “Most of the contracts are lump sum, but most of the developers have agreed to higher exchange rates with the dollar when they sign. They also add a formula for inflation.”

However, many sector players feel that, in general terms, regulation and customary practice do not support the contractor. “The current construction law established in 2006 and 2007 favours investors over contractors. For instance, there are very significant penalties for delays or stoppages, which obviously have been frequent over the past few years given the political situation. This has created considerable financial difficulties for contractors,” Belal told OBG.

Regulatory Reform

Belal also feels that the current construction law and tendering rules do not factor in the importance of quality in the selection process and the contract terms, but rather focus almost exclusively on price. “Investors and developers are able to extract many concessions from the contractors. There is also an inefficient dispute resolution system. It goes to an Egyptian court, and then it is assigned to a technical expert. It can take between one to three years to be resolved,” Belal told OBG.

Outlook

With cement prices dropping by 6% in the first half of 2015, on the back of a 2% contraction in demand, the present situation is far from perfect for the contracting sector and the construction industry as a whole. Nonetheless, most analysts remain bullish about the prospects for the sector moving forward, and certain trends point towards an imminent upturn. Hani Younan, market development consultant at BASF, the leading chemical company, which sells admixtures in the country, told OBG, “There are a lot of mega-projects – the tunnels under the canal, the roads, the bridges and many projects for housing. So the increase in bulk sales will continue.” Regional neighbours like Saudi Arabia, Kuwait and the UAE are helping to finance a number of these projects, and a number of companies from the UK, Europe and China have also expressed interest.

All of this is good news for the construction industry, which has already seen production rebound in, for example, the building material segments — 2015 has been marked by surplus cement production, which stood at roughly 850,000 tonnes in May, of which 818,000 tonnes were distributed to the local market, while annual production rose from 50m tonnes in 2014 to an estimated 60m tonnes in 2015. In September 2015, total cement production increased to 969,403 tonnes, up 143,147 tonnes, or 17.3%, from August, according to Daily News Egypt, while the government has also announced plans to offer 12 new cement production licenses for companies located in several Upper Egypt governorates, indicating rising confidence in the future availability of feedstock. As the problems facing material producers subside, it is expected that prices will also flatten out. Gleeds predicts construction material inflation to level off to a more manageable figure for the full year 2015 and into 2016. The company predicts a figure of 6% for 2015 and 5-8% for 2016.

Indeed, the government-driven emphasis on construction spending has sent a wave of optimism through the market. The new administrative capital project alone is planned to build a city the size of Singapore and aims to include an airport larger than London’s Heathrow as well as more than 10,000 km of streets. Although some mega-projects may not see the light of day in their current conception, there is a diverse range of other projects in the pipeline that should keep contractors busy for the foreseeable future. Furthermore, although they are currently feeling the brunt of long overdue subsidy reforms and currency issues, the hope is that in the medium term these measures will strengthen the economy and, consequently, the industry. While question marks remain over funding and payment terms, there is a strong sense that conditions for the sector arechanging for the better. The government is staking significant political capital on its construction-driven stimulus. If it fully materialises, the industry might serve as a growth driver for years to come.