Saudi Arabia's construction and engineering sector remains competitive despite changes in the global marketplace

As the largest member of the GCC and blessed with considerable hydrocarbons reserves, it is not hard to see why Saudi Arabia is often touted as the next big construction market in the region. Despite operating challenges and associated risks, the government’s decision to push forward with an ambitious development agenda has alerted numerous construction firms to the country’s potential. The energy sector especially is expected to see a number of promising developments.

Gasem S Al Shaikh, CEO of the Petroleum, Chemicals and Mining Company, told OBG, “As projects flourish around the country, the year 2015 will be a turning point for engineering, procurement and construction contractors, especially in terms of construction and maintenance in the oil and gas sector.” However, as global conditions shift, 2015 is likely to provide a significant test to this judgment of the sector’s worth.

Economic Environment & Demand

The local construction industry has reached a critical juncture, with 2013 proving to be a record year for construction contract value – in no small part the consequence of three Riyadh metro contracts with a combined value of $22.5bn. With the government laying out an expansive plan for development in sectors ranging from social infrastructure to transportation, there was a feeling of cautious optimism among contractors despite difficulties with the operating environment and costs. However, the recent rapid decline in the price of oil has made what looked like an inevitable period of unparalleled growth a little less certain.

Given that petroleum accounts for 92.5% of state budget revenues, according to Deloitte, the government-led construction programme could be derailed by global conditions and geopolitics. “For 2015 we believe the government budget has already been set, so we don’t see any major changes of plan for this year. It will be a different story in 2016; some projects planned to start construction in 2016 might be postponed or cancelled,” Ra’ed Tahseen El Jarrah, manager of project development and controls at Saudi Binladin Group, told OBG.

In May 2014 the IMF predicted that economic growth in the Kingdom would remain above 4% for 2014 and 2015 as a result of “government spending and robust private sector activity”. However, with the oil price losing half its value in the second half of 2014 and at one point dipping below $50 per barrel, analysts are beginning to revise their estimates. In May 2015 Jadwa Investment estimated that real GDP growth would fall from 3.6% in 2014 to 3.3% in 2015 and 2.1% in 2016.

It is certain that the government is going to take a substantial hit on its revenues. When oil prices fell as a result of the global financial crisis in 2008-09, Saudi Arabia ran a budget deficit of $66bn. The current scenario could create a similar situation. Jadwa Investments has calculated that the government would need an average Brent crude oil price of $97 per barrel to meet its spending commitments for the 2015 fiscal year.

Many contractors, however, seem sanguine about the prospect of this having a knock-on effect on the construction industry. Nagib El Alam, the vice-president of construction at the Saudi Arabian Trading and Construction Company, for example, told OBG he does not think the decline in the oil price will have a dramatic impact on the project pipeline in the foreseeable future. “All projects in the Kingdom are calculated on a barrel of oil price of $40 to $45,” he said. “The government is extremely conservative in its estimates.”

Proceeding With Caution

The government’s cautious fiscal approach during the years of high oil prices is protecting it in these more challenging circumstances and giving it room to continue its expansionary programme. Indeed, the country has achieved a buffer of $1.2trn in surplus since 2010, enabling it to absorb the fall in the price of oil. In December 2014 the minister of finance, Ibrahim Al Assaf, told Saudi TV, “Despite the deficit, we will continue to spend on development projects.... We have the buffers to bear the drop.”

In line with this philosophy, the government announced record spending of SR860bn ($229bn) for the 2015 fiscal year – up from SR855bn ($227.9bn) in 2014 – a move that has led to a projected deficit of $38.6bn ($10.3bn). Given a track record of overspending, the actual deficit could be even bigger.

For construction firms, however, this is good news. In the short term, at least, it means that the government has no plans to roll back its ambitious development and building agenda so contractor order books will remain healthy. “Demand for contractors is much higher than supply,” El Alam told OBG. “Most of the good contractors are overloaded. There are few highcalibre contractors, and a lot of projects have been put to re-bid three or four times because there are not enough bids coming to the tender.”

In spite of these setbacks, the Saudi project pipeline is impressive. The value of projects planned or under way in the Kingdom increased by 19% in the year to April 2014, with a combined value topping $1trn for the first time, according to a report from Middle East Economic Digest (MEED). The $1.07trn of projects marked Saudi Arabia as the most active construction market in the region, well ahead of its closest rival, the UAE, which has $727bn worth of projects.

It is not simply the depth of projects that is notable; the range of contracts across the industry is also broad. According to MEED, the largest number of contracts by value is in the residential segment (29%). However, contracts are being awarded across the board, including in health care (21%), mixed-use (12%), education (12%), hospitality and leisure (11%), cultural (9%) and commercial projects (7%).

Spanding Plans

The government’s 10th Development Plan, which runs from 2015 to 2019, also lays out a vision for spending across a number of sectors that should offer plenty of opportunities to construction firms. For example, the document outlines investments worth SR969bn ($258.2bn) in the real estate sector; SR568.83bn ($151.5bn) in the petrochemicals segment; SR475.29bn ($126.7bn) in electricity, gas and water; and SR153.77bn ($40.98bn) in transport and communications over the five-year period of the plan. Overall, SR4.44trn ($1.18trn) is expected to be invested in the country’s non-hydrocarbons sector.

While not all of this investment will trickle down to the construction industry, the government’s commitment to the development and diversification of the wider economy should ensure that the construction project pipeline remains healthy.

“The Saudi construction market will be attractive over the next several years thanks to the vast amount of government projects coming on-line,” Mohamed Alsayed, the general manager of Riyadh-based contractor A.S. Alsayed & Partners, told OBG. The sector has already become an important engine of economic growth in its own right – its contribution to GDP increased to 4.8% in 2013, up from 4.3% in 2011.

The sector’s performance in 2014, however, was down on the record-breaking performance in the previous year. The total value of awarded contracts during 2014 was SR220.8bn ($58.84bn), a 25% decline compared to 2013, according to a report by National Commercial Bank. While the first half of the year was relatively healthy, contracts began to dry up in the third quarter, with the value hitting the market dropping by 77% compared to the same period of 2013.

Project Areas

It is perhaps too early to tell whether much can be read into this value decrease. There is still a lot to satisfy contractors in terms of existing and upcoming projects. While the infrastructure segment has garnered much attention through projects such as the Riyadh metro and the country’s nascent rail network, there will also be a considerable focus on real estate moving forward. Mohamed Abu Samak, general manager of Arabian Tile, told OBG, “The construction business will continue with decent growth due to inertia from the current mega-projects, but things are starting to slow down because we are not seeing any new mega-projects come on-line.”

Both residential and retail developments are eliciting interest as a result of the demand dynamics in the country. In terms of the former segment, the Ministry of Housing’s (MoH’s) plans to reduce the housing deficit are likely to provide the best opportunities for construction firms. A lack of home ownership and a shortage of affordable accommodation for middle-class Saudis has been a chronic issue in the Kingdom.

According to a research report by JLL, there is an affordable housing shortage of 400,000 units. In 2011 the late King Abdullah bin Abdulaziz Al Saud announced a $67bn plan to build 500,000 housing units across the Kingdom to address this issue.

Challenges surrounding land availability and problems of assessing needs have hampered the roll out of the programme. However, in March of 2014, the MoH launched a new scheme, Eskan – the Arabic word for housing – to simplify and streamline the process of applying for housing relief. Under the scheme nationals can use an electronic platform to apply for an interest-free SR500,000 ($133,250) loan to build or buy a house. According to Mohammed Alzamea, public relations director at the MoH, there is a mismatch between government estimates and the number of Saudis actually eligible for this support. “Currently we only have a budget for 500,000 people but there are 750,000 eligible people,” Alzamea told OBG. “So we’re working with banks to provide loans to citizens and we’ll share the interest rate costs with them.”

Land Grants

As well as supporting demand in the market, the ministry is working on supply-side issues through land grants to real estate developers. The MoH hopes to release 306,000 plots over the next four years and is in the process of tendering packages for the design, marketing and building of mid-income apartments with a minimum size of 180 sq metres. For example, in February 2015, the ministry concluded a tender for 26,000 apartments in Jeddah, Dammam and Al Hofuf in the Eastern Province.

“Each developer can apply to build a block or several blocks. Once qualified, he has to market his design to the customer,” Alzamea told OBG. “If the end user accepts his design, price and timeframe, he can go ahead with the building and the MoH releases the customer’s loan to the developer.”

Developers will be allowed to increase the unit price on a case-by-case basis and market units more broadly outside of Eskan participants for a certain percentage of each project. The ministry is also eager to offer incentives such as direct loans and expedited licensing approvals for developers that are willing to use their own land bank to build affordable housing units. This should help to ensure a large-scale building programme over the next few years.

The MoH is pushing hard to resolve supply constraints and clear the way for a huge residential building programme. For example, in conjunction with the consultancy firm McKinsey, the ministry has sent a proposal to the Council of Ministers for a tax on private land that has been held without development for a certain period of time. The time after which the levy is imposed would vary depending on the size of the plot and the availability of land and infrastructure in the area. However, across the board, landowners would have a limited number of years to complete a development or to show intent to develop the land.

The levy went into effect in March 2015 and has had a negative impact on the market, according to local brokerage firm AlJazira Capital. In May 2015 the firm told local press that the real estate development sector index dropped by 9.04% the day immediately following enactment of the new fee. The company reported that the sector was “significantly affected by regulatory reforms, and the decision to impose taxes on urban lands will change the market dynamics”. AlJazira Capital, citing figures supplied by the Ministry of Justice, said that the total value of real estate deals had fallen by 38% year-on-year in the second quarter of 2014.

Sustaining Supply

Taxes on urban land would help address the space issues that are impediments to the building of affordable homes. Historically, the government has used land grants as part of its welfare programme. However, there is now a shortage of available land on which to build in urban areas because much of it is tied up in private individual ownership. This lack of availability has driven up land costs and changed development calculations for many builders, meaning land can account for as much as 50% of the cost of constructing a housing unit. However, the MoH is also aware that the issue of land remains a sensitive topic. “This is an important issue in the Kingdom because most people have their wealth in these lands,” Alzamea told OBG. “This regulation will affect their investments. In conjunction with this tax, we realise that these people need to be able to find good channels for their investments. If they have good investment opportunities, they will go with this rather than with the land.” The regulation will also stimulate building activity and provide a boon for the construction industry.

Continued Opportunities

Even in the existing environment of limited access to land banks, there remain many commercial opportunities in several segments of the real estate market. One of the most prominent, and one that is expected to bring a whole range of construction contracts to the market, is the Jabal Omar development in Makkah. Even though Makkah has recorded some of the highest land prices in the world – valued at $133,000 per sq metre in 2011 – Jabal Omar is building a large mixed-use development in the city next to the Al Haram Mosque. Largely driven by the burgeoning religious tourism industry, which is forecast to bring in SR230bn ($61.3bn) by 2020, the project includes 38 residential towers, a retail concourse, a conference hall, a hotel, 208 villas, as well as public parks, all on 230,000 sq metres of land. The high-density nature of the project should help its financial calculations and profitability. The built-up area of the development will reach 2m sq metres.

While government policy is putting housing on the radar of developers and contractors, retail real estate is experiencing substantial growth on the back of high market demand. “Retail is the driving force in real estate in Saudi right now,” Ahmed Bakarman, the CEO of Raseel Properties, told OBG. The country’s demographics, coupled with rising incomes, are leading many developers to consider mall space. With the residential sector in flux, opportunities in this segment should continue.

“Government plans for housing will stimulate demand for mall space, while upcoming malls are already 50-70% occupied,” Suresh Srinivas, the head of marketing for franchise holder and mall operator Landmark Group in Saudi Arabia, told OBG.

Shopping Around

The rationale for building additional shopping centres and malls looks strong. Rates of return for the latest retail developments can range from 9% up to 17%, depending on whether the land is leased or owned. Given these healthy figures, it is hardly surprising that the supply pipeline over the next three years is substantial. Indeed, the gross leasable area (GLA) of retail space in the capital, Riyadh, is expected to grow by 63.8% (893,000 sq metres) up to 2017, according to JLL. Jeddah will not experience an increase quite as rapid, but even in the Kingdom’s second city, GLA should expand by 32.1% (296,000 sq metres). As such, there should be plenty of contracts in the offing for construction companies.

Beyond the private real estate sector, social and transport infrastructure are likely to remain mainstays of the construction industry for the foreseeable future. At the beginning of 2014, infrastructure accounted for 36.8% of all ongoing construction work in the Kingdom, compared to 30.1% for energy and 27.3% for real estate, according to Kuwait Finance House. The scope of work in the Kingdom is illustrated by the workload in the education sector alone. Tatweer Buildings Company, the development agency of the Ministry of Education, is currently overseeing the construction of 2100 educational establishments in the country, a building programme that will continue to engage consultants and contractors up to 2016.

On The Move

Yet this programme pales in comparison to the projects under way in the transportation sector. Indeed, the top five projects in the country by contract value are in transport, according to MEED. The projects – lines 1 to 6 of the Riyadh metro (in three parcels), the Haramain High-Speed Rail Network and the first phase of the King Abdulaziz International Airport – have a combined value of $35.4bn.

The contracts are likely to keep coming. For example, the $16.8bn Makkah Public Transport System is in the early stages of development. The first phase of the Makkah Metro will comprise two lines and 22 stations, spanning a network of 45.1 km, which is expected to be complete by 2019. The total network, across three phases, will extend 114 km over four lines and consist of 62 stations. In March 2014 the Development Commission of Makkah and Mashaaer issued a pre-qualification invitation for the phase one rail systems work of the Metro Public Transport Programme. This includes tracks, signalling and station work. As such, there is likely to be a raft of sub-contracted work on the project over the coming five years.

Proving Their Worth

With this many high-value contracts coming to the local market, it is unsurprising that competition within the industry is increasing. “We’re seeing more competition from local and foreign firms in the last year,” El Jarrah told OBG. In November 2014 Fahd Al Hammadi, the chairman of the National Committee for Contractors at the Council of Saudi Chambers told an investment forum in Seoul, South Korea, that “Saudi Arabia had around 115,000 registered contractors in 2013, with more than 2000 having valid classification certificates”.

Foreign firms are a growing presence in the Kingdom, not least because domestic markets in the developed world have been flat and stagnant for much of the last five years. Steve Scamihorn, the owner of Bear Project Management, a firm consulting for Italian companies entering the market, told OBG that many construction firms are interested in Saudi Arabia because the Kingdom continues to present opportunities. “If you can go to a place where your chances of making a project are higher, even if the risks are also higher, you will go,” he said. “Construction in southern Italy, for example, is completely flat at the moment.”

However, there have been specific challenges that have historically made market entry a laborious process. “Start-up costs can be significantly high and start-up time is longer than we would normally expect,” Scamihorn told OBG. The government is now taking steps to address this. In June 2014 the Saudi Arabian General Investment Authority (SAGIA) announced a new fast-track licensing system. Under the Government Tenders and Procurement Law, firms have had to have in place a foreign investment licence from SAGIA and a commercial registration certificate from the Ministry of Commerce and Industry before bidding on a public tender. However, under new rules published by the Council of Ministers in September 2014 aimed at expediting the process, these documents will no longer be required at the bid stage and construction firms can apply for a temporary licence from SAGIA. The official registration documents will now only be required before the project contract is signed, while other documentation regarding insurance and tax will be required within six months of signing the project contract.

Easing Entry

These measures should help smooth the process of market entry for foreign contractors and are an illustration of the government’s commitment to engaging foreign firms in the construction industry. Abdullah Ahmed Bugshan, the CEO of Arabian Bugshan Group, told OBG, “Public-private partnerships lend themselves particularity well to investors in the construction sector in many emerging markets. In Saudi Arabia, for instance, we are witnessing more and more build-operate-transfer schemes.”

In January 2014 Abdullatif Al Othman, the governor of SAGIA, told the Al Arabiya news channel that foreign investment was needed most in health, education and transport, all of which are high priorities for the government. The latter, in particular, is an area where foreign expertise is in demand. The country’s rail projects, for example, require a high degree of specialisation, which is not readily available from local firms. All the contracts for the capital’s metro system were awarded to foreign consortia. “They’re pushing for foreign companies to come in and they need this because they don’t have local expertise,” Scamihorn told OBG.

Beyond the headline contracts won by consortia, however, foreign companies have also often gained market entry for supply and subcontracting services through joint ventures with local firms. For example, the Saudi Binladin Group has been active in establishing a number of subsidiary joint ventures with foreign companies to service its contracts. This includes Al Salem Johnson Controls, a joint venture with the US firm Johnson Controls, which specialises in heating, cooling and energy-efficiency systems.

No matter the mechanism, it seems that the Kingdom is now firmly on the radar of foreign firms. “The market is big and demand is high so there are a lot of contractors thinking really seriously about coming to Saudi Arabia that would usually want to work in the UAE, Qatar or Bahrain,” El Alam told OBG. This trend will likely make the sector more competitive. “Profit margins are becoming a little bit squeezed on certain projects,” El Alam said, though he does not believe that margins will be driven down below 5%. This is occurring mainly on the big showpiece projects such as the Saudi Landbridge rail project or the Riyadh Metro, where 16 consortia were bidding. However, given the value of these contracts, companies can easily make a handsome profit on a margin as low as 6%. The segments with the highest profit margins remain the specialised fields, such as oil and gas and mining, where as few as 15 companies operate successfully.

Labour Issues

Though the past few years have brought with them many successes, the industry is not without its difficulties. A series of government measures in the last 18 months, including a clampdown on illegal labour, a push for greater Saudi participation in the workforce, and penalties for employing too many expatriates, have presented operating challenges to industry players (see analysis). Labour costs pose another challenge. According to a 2012 report by MEED, costs for construction workers in the Kingdom were on average 18% more expensive than in the UAE and 51% higher than in Qatar. The clampdown on illegal workers – who are often used on a temporary basis to meet short-term requirements – and Saudiisation policies have increased the pressure in this regard.

However, the biggest problem is not necessarily the cost of labour itself, but rather the obstacles related to its unexpected price escalation. Indeed, one of the greatest challenges for contractors is managing the risks associated with systemic changes to the procurement and cost of labour. The majority of contracts in Saudi Arabia are on a lump sum basis. While there are remeasurable provisions within public sector contracts, the value of a contract cannot be increased by more than 10%. As such, construction firms bear considerable risk for price escalation during the term of their contract.

Reducing Delays

The difficulty of sourcing labour also has potential implications for project delays. Under the procurement law of 2006, the government has significant power to terminate contracts if delays are not rectified and to impose a penalty of 10% of the value of the contract for delays. Consumers are still primarily price sensitive, and the lowest bids can often trump offers that provide superior technical quality, which can lead to delays and cost overruns in the future.

In January 2015, the government introduced further rules to combat the issue of delays in the market. According to the new regulation, contractors will not be eligible to bid on new contracts if they are overdue on an existing project by more than 10% of the duration scheduled in the terms of the contract. While this is likely to help improve the standard of contractors in the sector, some delays in the market are the result of other factors. Project delays can be caused by a lack of planning, changing design specifications and issues pertaining to planning permission and land clearance.

Good Relations

Given the potential pitfalls of cost escalations and contract delays, the issue of financing takes on even more importance in the Saudi market. “Having a good relationship with banks is key for running smoothly when there are delays in payment, which unfortunately is quite common,” Alsayed told OBG. Bank credit to the sector has been increasing strongly, growing from SR44.7bn ($11.9bn) in 2009 to SR76.6bn ($20.4bn) in 2013, according to the Saudi Arabian Monetary Agency. “The expensive new projects that are currently being built will need to have adequate financial commitments to maintain them in the future. This hasn’t been the case in the past, but we are hoping to see a shift in mindset towards this,” Alsayed told OBG.

However, with future economic conditions looking less certain the commercial banking sector may become more reticent moving forward. “After the drop in the oil price, banks’ calculations are really different. There are still facilities available, but they are not the same as before and they want more guarantees and security,” El Alam told OBG. The price of financing has also increased slightly, according to El Alam.

Despite a potential softening in building material prices (see analysis), construction costs in Saudi are relatively high in regional terms. According to Aecom, the cost of an average multi-unit residential high rise in Riyadh was $1580 per sq metre in 2014. This is the same price as Doha and above rates in Dubai ($1360 per sq metre) and Bahrain ($1300 per sq metre). In terms of office space, it costs $2100 per sq metre to build a prestige office tower in Riyadh, compared to $1850 per sq metre in Dubai and $1280 per sq metre in Bahrain. In terms of shopping centres, Riyadh is the second-mostexpensive place to build out of GCC cities covered by Aecom’s survey, commanding rates of $1370 per sq metre, compared to $1400 per sq metre in Dubai.

Outlook

There are undoubtedly obstacles to be negotiated for the Kingdom’s construction sector players. The general upward price pressure is a concern, and despite the construction price escalation (with a 12% increase in costs in the two years to September 2013), margins for contractors remain under pressure. Moreover an increasingly competitive landscape and wage price escalation are likely to translate into a more challenging operating environment moving forward. There is also a need to reform some of the sector’s regulatory framework. The Riyadh Economic Forum in its Final Recommendations of the Sixth Session’s Studies advised “drafting an executive plan to develop the government procurements and bids law, contractor classification law, and classification of engineering firms”.

However, optimism across the sector does remain strong. With material input costs easing and the pipeline of projects in the market showing no sign of dimming in the short term, the opportunities for contractors to sustain a positive workbook are numerous – a situation that has been rare in many markets over the last half decade. Margins may be slimmer overall, but both local and foreign contractors will likely be keen to capitalise on the work still to be had in the Saudi market.