How Construction Costs Impact House Prices - July 2024

By Guest Blogger, Pete Wargent, 

Next Level Wealth 

Construction costs surge

We’ve been through an unprecedented surge in construction costs over the past 4 years, with a combination of government stimulus and shortage of materials and labour pushing up the cost of constructing a dwelling by around 40 per cent.

Some brighter news was reported this week, with CoreLogic reporting that its index saw construction cost inflation slowing to a 22-year low of 2.6 per cent in the June 2024 quarter.

In tandem with a flattening out of rents, this is excellent news for the Reserve Bank of Australia in its battle to bring down inflation into the 2 to 3 per cent target range, particularly because rents and the cost of new housing were two of the key inputs into surging headline inflation (alongside energy, fuel, food, health, and insurance costs).

Despite this, CoreLogic hasn’t reported a decline in construction costs, only that they aren’t going up as fast as they were.

Indeed, construction costs tend to be very sticky, and rarely fall much, if at all.

The statistic show that construction costs have been going up considerably faster than inflation for more than half a century.

Source: IFM Investors

Why do construction costs go up?

Why does the cost of building a home go up?

The reasons for this are various.

More green energy requirements, higher specifications, more site remediation on brownfield sites, health and safety and other regulations all play their part.

One of the biggest factors is rising wages in the sector, given that building, development, and construction is one of the most powerful and heavily unionised industries in Australia.

This is a very hot topic in the Aussie news cycle right now, in fact.

Without going into the politics of it all, there will be some substantial increases in wages over the next few years, so it’s very unlikely that we’ll see construction costs come down in nominal terms.

The impact of higher construction costs

Developers usually only build at volume when housing prices are rising, and when there is sufficient profit margin for them to do so.

Investors and developers are willing to take a calculated risk of building a home or doing a development only when they are likely to see a good return on their investment, and when there is negligible risk of over-capitalising.

Unfortunately, with many developers operating on fixed price contracts, the recent surge in costs has sent insolvencies in the sector soaring to the highest levels in well over a decade.

Now many investors are hesitating about renovating, building, or doing anything involving trades or construction for fear of the unknown with the steepling costs.

With interest rates also much higher than they were (the cash rate target today is 4.35 per cent), it will likely take a combination of interest rate cuts in 2025 and significantly higher housing prices before we get a decent supply response.

In suburban Perth house prices have already exploded, so we will certainly see more construction teeing off there.

Unit prices are generally too low at the moment, except in some premium or coastal areas with ocean views, where downsizers and those seeking lifestyle changes are prepared to buy brand new.

With foreign buyers largely taxed out the market, don’t expect much of a supply response for units for 2 to 3 years, in my best estimate.

Construction slowdown

The interest-rate sensitive sectors of the economy - including household consumption and dwelling construction - have responded as expected to interest rate hikes, and building approvals are now running at the lowest levels in about a dozen years.

Approvals are particularly weak for units and attached dwellings in Sydney, Melbourne, and Brisbane, where projects simply aren’t stacking up for developers.

Dwelling starts were a fairly miserable 39,700 in the first quarter of 2024, down -14 per cent from a year earlier, and the third quarter in a row under 40,000. 

This is likely be at least 50 per cent below where commencements need to be in order for the government to hit its target of 1.2 million well-located homes over 5 years.

There is one bright spot in Perth, where a boom in prices has kicked off a spurt of new house building.

Dwelling completions were similarly slow at only 41,300, with many developers collapsing into administration, although the number of dwellings officially under construction remains fairly elevated.

While Melbourne seems to be faring reasonably well given the prevailing conditions, in New South Wales new attached dwelling commencements have plunged to the lowest level in around a dozen years, suggesting a major dwelling shortage looming as the pipeline thins out.

There is, on the other hand, quite a lot of unit construction activity happening at Gold Coast and other parts of coastal south-east Queensland.

Dwellings approved but not commenced in New South Wales rose to above 16,000.

The wrap

Overall, then, there’s fairly lacklustre homebuilding activity happening in 2024, while population growth is high, pointing to a major shortage of dwellings in Sydney over the next few years.

Perth has a detached house construction boom now underway, and with rising prices in Brisbane meaning that houses in Brissie will likely be next cab off the rank.

At the macro level, we're not going to get anyway near enough dwelling supply with interest rates at these levels.

With rental markets expected to remain extremely tight over the next few years, it’s no wonder than investors are coming back into the market now with gusto. Home buyers should also take note and consider getting into the market before the competition really heats up once interest rates start to come back down.

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