Plenty to do: Demographic and economic growth drive demand for development

While the construction industry in many countries may still be in the doldrums, in Saudi Arabia, it is proving to be the driving force behind economic growth. Indeed, the Kingdom is the envy of the region, eyed covetously by contractors elsewhere. All the parts are in place for construction to remain a growing industry over the coming decade. Saudi Arabia’s geography and demography will continue to demand the development of infrastructure, social facilities and housing, suggesting that local and international contractors will have plenty of work.

Demand For Construction

It is not hard to discern the factors driving demand for construction firms in the Kingdom. Saudi Arabia is the biggest market in the region, with a population of 29.2m people in 2012 according to estimates from the Central Department of Statistics and Information (CDSI). With the CDSI pegging population growth at an annual rate of 2.9%, the need for further transport and power infrastructure, as well as residential buildings and social amenities, is unlikely to abate anytime soon. This will be supported by a robust and growing economy. The GDP growth rate reached 6.77% in 2011, according to the CDSI.

This is leading to a plethora of opportunities for contractors. Fawaz Abdel-Hadi, operations director of Drake and Scull Saudi Arabia, told OBG, “We are bidding for different types of project. We are looking at infrastructure, high-rises, medical facilities, universities and transportation. All of these are being upgraded and these projects are everywhere. In other parts of the Arab world, the concentration of business is in the capital, but here it is not like that.”

Indeed, Saudi Arabia is the standout market in a rapidly developing region. According to a study by Merrill Lynch, $4.3trn will be invested in construction projects across the Middle East and North Africa region by 2020, an increase in spending of nearly 80% on levels in 2012. Saudi Arabia will be the driving force for this rapid expansion. The year 2012 saw the Kingdom buck the regional trend, experiencing construction and infrastructure growth of 177% for the year up to July 2012, compared to the same period of 2011, according to Merrill Lynch. This compares to a 41% decline in the region as a whole. Indeed, Merrill Lynch estimates that Saudi Arabia accounts for 46% of the total $448bn project pipeline in the Middle East and North Africa for 2012-13.

While there is some variation as to the particulars, most analysts concur that the Kingdom overall is currently experiencing a rapid expansion of its construction sector. The local National Commercial Bank (NCB), for example, calculated that the value of construction contracts awarded in the first half of 2012 increased by 50% on the 2011 figure, reaching $33.8bn. It seems fairly clear what is driving this growth. Abdel-Hadi told OBG, “The bulk of the money and the investment is in the government’s hands. They have quite an opportunity to invest in infrastructure, utilities and services.”

Government Spending

The 2012 budget makes clear that the government is committed to an expansive building programme. A report by Standard Bank, “Global Focus – 2012 – The Year Ahead”, calculated that the Kingdom committed $159bn to projects in 2012. According to the report, $67bn was allocated for the construction of 500,000 housing units, a key component of the country’s 2011 stimulus package, while $44.6bn was set aside for infrastructure projects and a further $39bn for other construction projects. While this represents the headline investment, the budget has further provisions for spending that will offer opportunities to the construction industry. For example, there is a $45bn allocation for the education sector, which includes provisions for the construction of 742 new schools and 40 new colleges. Similarly in the health care sector, the $23.1bn set aside for the industry includes funds for the construction of 17 new hospitals as well as support for 130 hospitals currently under construction.

Transport Focus

Perhaps the most crucial segment in the shorter term will be transport infrastructure. The 2012 budget allocates $9.4bn for transport, including the expansion of the roads network by as much as 4000 km and the addition of new airports. The government has also committed to an ambitious programme for an extensive rail network in the country. A March 2012 report by the Arab News quoted the Saudi Railways Organisation President, Abdul Aziz Al Hoqail, as saying that the country has sanctioned new rail projects that will cover 7000 km. These projects are already bearing contracts for construction firms in the country. In January, Ibrahim bin Abdulaziz Al Assaf, Minister of Finance and chairman of the Public Investment Fund, signed three contracts with a total value of SR2.3bn ($613.6m) for the North-South railway project. These included five passenger stations, a maintenance work complex and 36 support buildings. More contracts will undoubtedly follow, including the $4.5bn Saudi-Bahrain rail project, part of the wider 2200-km GCC rail network. Transport projects are certainly important for the industry in and of themselves. Indeed, Abdel-Hadi told OBG that infrastructure projects offer the most attractive margins to contractors at the moment. However, they are also likely to spawn further projects, perpetuating the expansion of the construction sector. Sheikh Khalid Al Amoudi, the CEO of Saudi Red Bricks, told OBG, “The arrival of rail will revolutionise Saudi heavy industry, particularly mining. It will enable a constant, cheap and reliable source of transportation and will stimulate the growth of satellite towns along the railways. It will become the lifeblood of urban growth and generation in the Kingdom.”

In the longer term, this may enable greater private sector participation in the development of the Kingdom’s urban fabric. However, in the shorter term, the funding of most projects, particularly pertaining to infrastructure and lower income housing, is likely to remain in the hands of the government. The ninth five-year development plan of the Ministry of Economy and Planning estimates public spending of $384bn between 2010 and 2014. Beyond this, the government is also likely to play a crucial role in financing development. While there have been significant efforts to encourage private sector participation in the development of the new economic cities – four planned urban centres and loci of economic growth, to be located in different parts of the country and built at a cost of $60bn – the government continues to provide the impetus and the loans for developers to fulfil this vision.

Nature Of Contracts

The central role of the government in the construction industry creates opportunities and challenges for the sector. A pressing consideration is the tendering and contract process. According to an article written by Ben Cowling of the legal firm Clyde & Co in May 2012, contracts for government work are often weighted more favourably towards the employer (i.e. the government), in terms of risk. This potentially includes greater rights for the termination of a contract and limitations on the cost escalation mechanism. According to Cowling, “Variations are limited to a maximum increase of 10% and a maximum decrease of 20% in the total contract value.” Indeed, most contracts in the market are either lump sum, if it is a design and build project, or remeasurable if the design has been completed.

There are few cost-plus contracts in the market, a situation that limits contractors’ ability to mitigate risks associated with increasing input costs. Still, contractors who spoke to OBG seemed comfortable with the situation. Indeed, Abdel-Hadi suggests that in recent years there has been a significant improvement in the tendering process. “During the last two or three years, I have noticed positive signs that the government is taking huge steps to implement proper procedures [for tendering]. They are transparent as much as possible,” he told OBG.

Abdel-Hadi points to the trend towards classification of contractors for publicly tendered work as a significant step forward. Operated by the Ministry of Municipal and Rural Affairs, the classification system divides the market based on a contractor’s financial position, previous experience and resources and equipment. According to Al Tamimi & Company, contractors that achieve a Grade 1 classification are able to enter into contracts in excess of $74.66m, while those that only achieve a Grade 5 can enter into contracts up to $1.86m in size. This segmentation should create more opportunities for a variety of players, allowing large regional construction firms to operate in the same market as small local players. Furthermore, according to Abdel-Hadi, it demonstrates a more nuanced understanding of the contracting market by public sector clients. “It’s not solely tendered on price anymore. There has been a better understanding of contracts recently,” he said.

Building Codes

This should also improve the standard of the industry in the Kingdom. This can also be seen in the evolution of regulations regarding building standards. According to Abdel-Hadi, “On the whole, I see that this is becoming a main concern and the government is putting it into the overall regulation”. The first move towards the standardisation of building practices came in 2000 with a royal decree ordering the establishment of a national committee to develop a national building code. Work began on the code in 2003 and it was completed in 2007. The Saudi National Building Code covers all aspects of the industry from use and occupancy of buildings to zoning, and safety classifications for building materials. The regulations are undoubtedly improving the quality, efficiency and safety of building in the Kingdom. This is supported by the emergence of a more mature and sophisticated construction industry. According to Al Amoudi, “The market is going towards higher specification and higher quality building products. Given the rising population and the pressure on urban centres, it is only logical that there will be more high-rise buildings. This requires higher quality materials.”

Financing

The government, therefore, plays a dual role in the sector as leading client and regulator of the industry. Its position as client is not only indispensable because of the limited nature of private sector developers to fund infrastructure and real estate projects, but also because it provides a form of support and guarantee to contractors in the Kingdom. The contractor may have to take on more risk in Saudi Arabia, but the fact that the client is a government with strong revenue streams offers some form of security. According to Abdel-Hadi, this helps contractors access financing. “If it is a government-backed project, you will get more lenient terms and more financial facilities from the banks,” he said.

Reputation, credit history and project worthiness are also important, according to Mazen Fayed, director of corporate communications for Saudi Oger. “Financing is accessible once companies prove a sound credit history and reputation. Nevertheless, when working with government projects, it is important to understand the dynamics of the payment cycles, and efficient management of cash flow is essential,” Mazen told OBG. The cost of borrowing for state-backed projects is usually 7-10% interest with all the normal facilities in a project financing structure available. Indeed, bank credit to the sector has been increasing steadily. According to the Saudi Arabian Monetary Agency (SAMA), credit from commercial banks to the building and construction industry increased by 25.4% to SR69.8bn ($18.6bn) in 2011. The first three quarters of this year saw credit increase by a further 2.8% to SR72.5bn ($19.3bn).

This suggests that the environment for the contractor is strong. The opportunities to grow the workbook supported by a strong credit environment should provide plenty of chances for construction firms to expand in Saudi Arabia. According to some developers with whom OBG spoke, most contractors would not bid for work unless they could secure margins of profit in the region of 20%. Such figures suggest a market still very much in favour of the contractor. However, with the growing publicity of the Saudi market, and the realisation of its potential, such bloated profits might not last long. According to Kjell Gundersen, the CEO of Jotun, “Contractors the world over are looking to Saudi at the moment. We are seeing new players arriving each day, particularly from the East Asia. Competition is becoming fierce, and margins are being slashed.”

Fakher Al Shawaf, the general manager of construction firm Al Bawani, echoed this sentiment, saying that although there are a wealth of opportunities in the market, competition is growing fierce. One result of this, Al Shawaf said, is that alliances and joint ventures have become more common as a tool to maximise competitive advantage.

Business Environment

The Kingdom is reasonably well placed in terms of the business environment. According to the “Doing Business Report 2013” from the World Bank, the country ranks 22 out of 185 economies, up one place on 2012. It is also relatively well placed for construction firms, ranking 32nd for dealing with construction permits. Nonetheless, there are concerns for new entrants. According to Ben Cowling, partner in projects, construction and infrastructure at Clyde & Co, writing in contractors need to think about before they enter the Saudi construction market. These include local establishment, teaming and JV arrangements, licensing, visa issues, labour issues (including Saudiisation requirements), import and export procedures, insurance, accounting and finance issues, tax and zakat issues and dispute-resolution processes.” The local market certainly has unique characteristics. According to Abdel-Hadi, “The laws here are different from the rest of the GCC, but firms are reluctant to come here because they don’t have the experience and know how. They are not difficult regulations, they are just different. The business practices, registering a company, having sponsorship, alliances and partnerships, relations with banks, shareholding and managing resources are all different.”

Material & Input Costs

Nonetheless, the amount of opportunities in the Kingdom are likely to outweigh concerns over local business practices. As competition increases and contract values and margins shrink, one of the most important considerations is input costs. According to Mohammed Al Samhan, director of real estate services at the General Organisation of Social Insurance (GOSI), “Contractor costs are rising because of increases on all kinds of materials.” However, not everybody agrees with this assessment. Abdel-Hadi suggests that material prices and input costs have remained stable for contractors over the last 12 months. On key basic materials, such as cement, there is some stability. In March 2012, for example, the government announced controls for cement prices, setting a factory price of SR12 ($3.20) per bag, a retail price of SR14 ($3.74), and a bulk price of SR240 ($64) per tonne. For steel as well, the government has price regulations in place. According to a presentation by the regional director of the Arab Iron and Steel Union, Adel Hussein, in Casablanca in October 2012, Qatar Steel rebar exports to Saudi were stable at around $720 per tonne, while Turkish suppliers have been selling to Jeddah at approximately $590 per tonne.

However, for both materials price pressure could be a significant factor in the coming years given the current supply and demand dynamics. According to Hussein, Saudi crude steel output has increased by more than 2m tonnes to 6.9m tonnes in the last four years. Nonetheless, the Kingdom still suffers a steel billet shortage. Hussein estimates that local producers – Saudi Arabian Basic Industries Corporation (SABIC), Al Tuwairqi and Rajhi Steel – will produce 7.4m tonnes of billets in 2012, leaving a need for 2.5m tonnes of imports. Furthermore, a recent report by RNCOS Industry Research Solutions estimated that Saudi steel consumption will grow at an annual rate of 19.5% up to 2015. This could have a knock-on effect on pricing and input costs for contractors.

Cement Expense

A similar trend could also impact the cement sector. A January 2012 report by NCB Capital warned of supply constraints in the cement sector over the coming 12 to 24 months. The report estimated utilisation rates within the industry of 90% to 95% in 2011 on sales of 48.5m tonnes, suggesting that there is little spare capacity in the country. This has been good news for cement producers, but not so much for contractors.

Eisa Baeisa, CEO of Tabuk Cement, told OBG, “If capacity is not increased, there will be overdemand soon. Particularly as a result of the huge demand coming from Medina, all the cement factories are serving projects there.” Baeisa said that currently there was no shortage, but that “60% of cement production is focused on Riyadh and the Eastern Province. The ministry has to look at this. The west needs more cement factories. The potential shortage is predominantly related to the geographic localisation of the factories. Some areas do not have access to cement, and as a consequence the cost increases a lot due to transportation fees.”

This could impact contractors in the future. Indeed, the government price cap has helped stabilise prices, but transportation and trading margins could still impact the price paid by the industry. According to Baeisa, “Prices are not rising ex-factory, but transportation substantially increases the final cost for consumers. Prices of cement are controlled by the government, but intermediaries can then add their share and the final price increases in expense.”

New Supply Boost

Such a trend could affect operating margins in the shorter term, but the pipeline for cement supply suggests that additional capacity will meet any shortfall in the medium term. According to a May 2012 report by Al Rajhi Capital, cement production is expected to reach more than 66m tonnes per year by 2015, a significant step up from the 47m tonne projection for 2012. Indeed, according to Al Rajhi Capital, Saudi Arabia remains the cheapest cement producer in the GCC, supported by fuel subsidies and as such it is an attractive market for expansion. It should come as little surprise, therefore, that China Daily reported in September 2012 that the country’s ministry of commerce was trying to increase awareness amongst Chinese firms about the investment opportunities in the Saudi Arabian building materials market.

“Cement production is an energy intensive industry and the low fuel tariffs here in Saudi mean that there is very little incentive for producers to adopt efficient practices,” Guy Chaperon, the CEO of Al Safwa Cement Company, told OBG. “These subsidies mean that Saudi Arabia is one of the cheapest places in the world to produce cement, but also make it one of the least energy efficient cement industries,”

Spike Avoidance

Such efforts may well prevent a price spike in the local building material industry, a move that would be welcomed by local contractors and developers. Currently, there is not too much to worry about. It would appear that current total construction costs have remained stable as a result of the controls on material costs. Developers with whom OBG spoke predicted that shell and core construction costs in the residential sector would likely remain largely static again in the next 12 months.

Current shell and core construction costs in Saudi Arabia are estimated to average SR6000 ($1600) to SR6500 ($1735) per sq metre for low-rise buildings and SR8000 ($2135) to SR9000 ($2400) per sq metre for high-rise buildings. This suggests that the Kingdom is at the higher end of the spectrum in terms of building costs in the region. According to Davis Langdon, luxury high-rise building costs in Abu Dhabi averaged $1800 per sq metre in 2012, while in Doha they were $2000 per sq metre. Saudi Arabia is still significantly below the costliest markets such as New York, which has an average luxury high-rise construction cost of $4500 per sq metre.

“Construction in Saudi Arabia has not seen this sort of growth since the 1970s,” Mohammed Al Hammouri, chairman of the Mechanical and Chemical Supplies Company, told OBG. “This boom is noteworthy for the rising demand for technologies and materials. Projects such as the Haramain High-Speed Rail network and King Abdullah Financial District in Riyadh are raising the bar for standards in the sector, and we are seeing more demand for high-end products than ever before.” Nonetheless, such pricing could impact the viability of private developers, particularly considering that land prices are also pushing up development costs. According to Al Samhan, “The cost of land is increasing at an insane rate. Prices have reached unacceptable levels and we assume there must be a correction.”

According to a report by Colliers International, land prices in Jeddah, for example, jumped up by 30% in 2011. This could present problems, although the situation does not yet seem critical. According to Al Samhan, returns on their developments vary from 5% to 7% for residential projects. Given that the company is relatively conservative and looking for a steady income stream, some developers in the luxury segment could expect higher margins. Furthermore, the government is directly funding essential projects such as low-cost housing and infrastructure.

For infrastructure in particular, the government may also look to the public-private partnership (PPP) model. One of the first steps was taken in this direction in August 2012 when a consortium headed by TAV Airports was awarded a build-operate-transfer contract for the expansion of Medina airport. The 25-year operating agreement will require an investment of up to $1.5bn for the development of new terminals and associated facilities. The new airport is expected to have the capacity for 8m passengers per year in the first phase, which should be completed by 2015. In the second phase, expected to be complete by 2020, this will rise by 12m passengers.

The introduction of the PPP model for such a showpiece project illustrates the government’s intent to meet pressing infrastructure requirements. If more private funding can be accessed over the coming years and the PPP model adopted more frequently, the opportunities are only likely to increase.

Outlook

Indeed, the prospects for the industry in both the short and long term look very strong. An expanding population and growing economy, coupled with existing shortfalls in housing and infrastructure, suggest that there will be a large and robust pipeline of projects in the coming years. Abdel-Hadi told OBG, “The future is in Saudi for sure. They have the money, the opportunity and it’s a big country, but the infrastructure is lacking.” Furthermore, while challenges for new entrants remain, the market is gaining in maturity with an improved tendering environment. Increased competition has the potential to reduce the profit margins for contractors, but it is also likely to improve quality. The rapid expansion of the economy should ensure that there is still plenty of work to go around. As such, the promise of Saudi Arabia and its reputation as the market to watch is likely to be fulfilled over the next decade.