Housing and Construction Cost Escalation: A Focused on Saudi Arabia - Case Study Example

Topic:  Housing and Construction Cost Escalation: A Case Study Focused on Saudi Arabia 2. LiTERATURE REVIEW: 2 Introduction This chapter would befocused on providing information gained from different sources and authors in order to gain insight regarding the housing and construction cost escalation in Saudi Arabia. This literature review section focuses on providing information regarding the GCC countries and aims to identify the importance and position of KSA in GCC. To do so, an overview of the GCC construction industry is provided along with PESTLE analysis of the KSA i.e. Kingdom of Saudi Arabia. Furthermore, the KSA’s construction industry is compared with the rest of the GCC countries to identify which country has the most potential to grow. This comparison also provided with information regarding the construction cost in KSA and the rest of GCC countries along with the level of profits earned by these countries. In addition, certain factors were evaluated and analyzed to identify the major reasons for the cost escalations in housing and construction industry in KSA. The factors that were analyzed includes economic factors, geographic factors, demographic factors, social factors and other environmental factors to provide accurate and reliable information regarding the cost escalations in the KSA’s construction industry. In the end, some strategies are proposed that could help the KSA’s construction industry to reduce its construction and housing cost. 2.2. Overview of the GCC Industry With UAE, Saudi Arabia, Qatar, Oman, Bahrain and Kuwait being a part of GCC, it was observed that construction contracts worth USD 50 billion were awarded to contractors in the very first quarter of 2011 (Deloitte, 2012a). The breakup of these contracts is given in the image below: (Deloitte, 2012a) The Gulf Cooperating Council (GCC) flourished from the year 2003-2008 due to the spectacular increase in the oil prices. With an increase in oil prices, the cost of construction also increased to about 60 percent particularly in Dubai (Meed Cost Indices, 2012a). In order to stabilize the economy to create a more balanced state, several projects were initiated with construction the major priority of GCC. The major hurdles for these projects were observed during the global economic crisis of 2008 where most of these initiated projects had to be cancelled or kept on hold. However, with the recovery of the economy it was predicted that the construction sector would be provide with outstanding growth opportunity in the forthcoming years (Meed Cost Indices, 2012a). With the passage of time, the construction sector has shifted its focus from small and simple projects to more sophisticated and complex projects that require billions of dollar investment. Such projects involve complex civil work, electromechanical systems and vital infrastructures to attract foreigners and investors. With such complex projects, the construction companies rely on specialized and experienced sub-contractors as such projects have attracted several customers to take interest in the completion of projects that could lead to an increase in their expectation. During the year 2006-2010, it was observed that in UAE the percentage of construction sector in GDP increased from 8.9 percent to 11.5 percent in the year 2010 (Alpen Capital, 2012), this is reflected in the image below: (Alpen Capital, 2012) With about investment of USD 9 billion, UAE is the second largest market of construction sector in GCC. On the other hand, Qatar has shown tremendous improvement in its economy due to which Qatar is regarded as the fastest growing economy in GCC region with about 8 percent share of the total value of projects i.e. USD 500 billion (Deloitte, 2012). In the year 2011, it was observed that complex construction projects were still the top priority of GCC even after double-dip recession and challenging economic environment. Even after being affected with such an environment, the GCC was able to remain stable at USD 1.8 trillion (Alpen Capital, 2012). It is also worth mentioning that the construction and real estate projects occupied around 51.8 percent share in the overall value of the top 100 projects in the GCC region (Alpen Capital, 2012), as shown in the image below: (Alpen Capital, 2012) In the same year, UAE ranked the highest country in GCC followed by Saudi Arabia. The total worth of project in UAE was USD 319.1 billion and in Saudi Arabia the figures were comparably less i.e. USD 218.9 billion (Alpen Capital, 2012), as shown in the image below: (Alpen Capital, 2012) 2.3. Overview of the KSA Industry 2.3.1. Overview of the industry KSA being the largest economy of GCC industry has been provided with the leading investment in the construction sector followed by UAE. The construction sector in the KSA accounts for almost 8 percent of the GDP. The major construction activities are taken into consideration in Riyadh, Jeddah and Dammam. These three countries account for almost three-fourth i.e. 75 percent of construction activities in KSA (Al-Nagadi, 2010). 2.3.2. PESTLE Analysis of KSA industry In order to gain insight regarding the KSA industry, it is essential to conduct PESTLE analysis. The PESTLE is an acronym for Political, Economic, Socio-cultural, Technological, legal and Environmental. The PESTLE analysis of KSA industry is as follows; Political Government’s commitment is a crucial factor in the success of KSA construction industry. It was observed that during the economic crisis the government of KSA remained committed to enhance the construction sector by providing the sector with investment of USD 80 billion. The aim behind such investment was to tune up the growth of the development and diversification program in KSA (Ventures, 2011). Economical The stabilized economic situation in KSA is another major positive factor for KSA construction industry. Lower inflation costs and raw material costs are some of major elements of such economy. With government’s commitment and financial backing, the KSA construction sector is sure to grow (Asad, 2012). Socio-cultural The KSA construction industry embraces socio-cultural factor. This could be observed as the younger individuals are entering the construction business. The growth of native people is another growth factor for the country as such population demands for the construction industry to develop in the long-run (Ventures, 2011). Technological With latest technology available at the side of KSA construction industry, the growth of this particular sector is inevitable. With such technology, the KSA has allowed to attract several investors that are particularly interested in the growth of the construction industry in the forthcoming years (Ventures, 2011). Legal In order to promote the construction sector, laws and regulations at KSA were simplified so that the businesses could start their constructions without any further delays due to complex laws and regulations. The KSA government also provided the businesses with a green light and allowed them to open up businesses with 100 percent of foreign investment. Mortgage law is another law long awaited at KSA aimed to boost the demand of residential segment along with other activities such as home financing (Ventures, 2011). Environmental With an intention to take environmental factor into consideration, the KSA government aims to spend about USD 39.9 billion to for the construction of building that would promote long-term sustainability along with reduction in dioxide emission. Through the construction of such smart-building, the KSA government aims to reduce the level of waste and lower water consumption (Ventures, 2011). 2.3.3. Market Size and shares As per January 2011, the market size of KSA construction industry based on budget total is reflected in the following image: (Ventures, 2011) It was observed that 50 percent of the total budget was allocated to buildings. This indicates that half of the budget was directed towards the construction sector. On the other hand, the budget allocation for oil and gas construction was around 17 percent followed by industrial construction with an allocation of 13 percent of the budget. It was also observed that infrastructure; power and water, pipeline and marine had single digit budget allocation i.e. 9 percent, 8 percent, 2 percent and 1 percent respectively (Ventures, 2011). Regarding the market share, it was observed that the market share declined to a great extent from USD 110784 million in 2011 to USD 99546 million in 2012. It was also observed that the year 2011 was the most positive year for the KSA construction industry in terms of market share. The market share continuously increased for about four consecutive years but somehow declined in 2012 (Ventures, 2011), as reflected in the image below: (Ventures, 2011) 2.3.4. Market Forecasts It has been forecasted that KSA construction sector, being the major industry, will be awarded with increasing number of contracts. It has been forecasted that the KSA construction industry will be provided with about USD 102,069 million worth contracts for the growth of this particular sector. (Ventures, 2011) It has been also forecasted that the oil and gas construction sector would be provided with around USD 15.4 billion worth awards in the year 2013; being the last year for the completion of construction project, the market size would be reduced from 17.5 billion in 2012 to 15.4 billion in 2013 (Ventures, 2011), as shown in the image below: (Ventures, 2011) Regarding the market size and forecast for KSA power and water desalination construction, it has been forecasted that this particular construction sector would be provided with an increase in contract awards from USD 15.09 billion in 2012 to USD 16.3 billion in 2013 (Ventures, 2011), as shown in the image below: (Ventures, 2011) For the construction of Saudi building, it is forecasted that the building sector would be provided with high importance along with continuous increase in contract awards. It was observed that the building sector rose from USD 30.6 billion in 2008 to USD 47.1 billion in 2012. It is forecasted that the contract awards would further increase to a great extent i.e. USD 49.9 billion in 2013, (Ventures, 2011) as shown in the image below: (Ventures, 2011) The last construction industry sector; infrastructure sector, was provided with USD 16.5 billion in the year 2012 and it is forecasted that the contract award would increase to USD 17.3 billion by 2013 (Ventures, 2011), as shown in the image below: (Ventures, 2011) 2.4. Comparison of KSA and GCC Countries To compare KSA and other GCC countries few factors would be evaluated. These factors would highlight how and why KSA significantly differ from Oman, Qatar, Kuwait, Bahrain and U.A.E in GCC. 2.4.1. Comparison of Economic conditions of KSA and GCC Countries With high oil prices in the past years and stabilized economy, the GCC countries have shown greater development over the years. Due to such conditions, the countries are provided with low interest rates with greater fiscal and external surpluses, moderate consumer price inflation and greater and positive opportunities for growth in the forthcoming years. With the passage of time, the real GDP growth in 2011 outdid all the previous year’s GDP growth rate. In 2011, the real GDP growth rate went high up at 7.5 percent – the greatest real GDP growth since 2003 (IMF, 2012). In 2009, the total real GDP of the GCC countries witnessed a decline but this situation was soon stabilized in the year 2010 with around 6 percent. In addition, the year 2011 remained prosperous for GCC countries as the real GDP rose to 7.5 percent (IMF, 2012), as shown in the image below: (IMF, 2012) The non-oil real GDP growth of the GCC countries i.e. Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and UAE shows extra-ordinary results. In the year 2011, Qatar was the leading GCC country with highest growth rate followed by Saudi Arabia, Oman, Kuwait, Bahrain, and UAE, as depicted in the image below: (IMF, 2012) Qatar has been leading all GCC countries in term of non oil sector real GDP growth since 2008, and only in 2010 the real GDP growth rate of non oil sector declined to single digit but still remained the leading country among the GCC countries (IMF, 2012). 2.4.2. Comparison of costs of KSA and other GCC countries According to EC Harris (2012), the construction costs in KSA are the cheapest as compared to other countries in Middle East. On the other hand, it was also observed that Bahrain’s construction costs are the highest as compared to any country in Middle East. It was indicated in the research that the difference in the construction cost is almost half in between KSA and Bahrain. In the research presented by EC Harris (2012), it was mentioned that the construction cost were quite similar in Gulf and Europe. In addition, KSA was regarded as cheap country in terms of construction cost. According to EC Harris Regional Head of Cost and Commercial Management in Middle East, Nick Smith: “As compared to other countries in GCC, KSA has the most competitive market in terms of construction costs, this is due to high profit and low overheads With steel factories available in KSA along with abundance of raw material, KSA’s government is able to keep the construction costs lower than 10 percent as compared to other GCC countries in the region.” The research conducted by EC Harris (2012) provided with an overview that the construction cost of Bahrain are quite similar to those in UK whereas, the construction costs in Qatar near to those of Bahrain with only difference of 6 percent. It was an interesting finding that the construction costs in Qatar are even greater than larger and developed nations including China, U.S.A and Russia. According to this research, U.A.E lacks only 9 percent behind from Bahrain and only 3 percent from Qatar in terms of construction costs. The United Arab Emirates is ranked as the third most expensive country in Middle East while KSA is ranked as the cheapest in terms of construction costs. On the other hand, Oman ranked fourth after Bahrain, Qatar and U.A.E with only 11 percent in difference between the construction cost of Bahrain and UK (EC Harris, 2012). 2.4.3. Profit margin of KSA and other GCC countries Cement being the major element for the construction industry is directly responsible for the growth of the construction industry. It was observed that the after severe economic situations the revenues for the GCC countries declined but with the passage of time the economy gradually recovered. The revenues for the GCC countries increased to about USD 4.6 billion in 2011; increase of 14.2 percent. It was also indicated that the after the stabilization of economy, KSA led the cement industry followed by the rest of the GCC countries except for Qatar and Bahrain. The other countries that followed the KSA were Oman, U.A.E and Kuwait respectively (Ventures, 2012). For the first time since 2008, UAE had an increase in its sales revenue after the total collapse of cement industry due to the economic conditions. Even after increase in sales in the current economic conditions, the sales revenue of U.A.E’s cement industry shows negative net profit. With KSA’s ability to produce cement with low fuel and raw-material costs, the country is able to gain an edge over other cement markets (Ventures, 2012). This is because of the increasing cement consumption in KSA, as shown in the image below: (Al Jazira Capital, 2011) With the availability of natural resources, KSA is able to produce cement comparatively cheaper than any other GCC country (Al Sheikh, 2012). The low cost of production in turn contributes towards the increasing profit margins. The cost of production of cement per tonne for KSA in the year 2011 was USD 30.9. This was the lowest cost of production of cement per tonne as compared to other countries. With such low cost, the profit ratio KSA is comparably higher than others in the market. The cost of production of cement was USD 37; slightly higher than KSA, followed by U.A.E and Kuwait with production cost of cement per tonne at USD 47.8 and USD 59.2 respectively (Ventures, 2012), this is shown in the image below: (Ventures, 2012) On the other hand, the gross margins of KSA were the highest. With USD 30.9 as cement cost per tonne, the country’s gross margin was around 51.80 percent in December 2011 followed by Oman, Kuwait and U.A.E with gross margin 45.70 percent, 26.00 percent and 15.50 percent respectively (Ventures, 2012), as shown in the image below: (Ventures, 2012) 2.5. Factors that lead to cost escalation in housing and construction industry There are certain factors that could affect the cost to escalate in housing and construction industry. With the increase in complexity of the building, there lies a probability of increase in the construction cost. There can be different economic factors responsible for the increasing housing and construction costs. For instance, the increasing oil prices serve as the major cause behind the rising housing and construction costs. Apart from this the increasing construction cost are also because of the increasing prices of other resources like labor and other construction resources. Hence, shortage of labor and other construction resources also tend to increase the overall construction cost (Omoreigie and Radford, 2005). Apart from this the low supply of housing also directly influence the construction and housing cost. This is further supported by the increasing inflation rate. Aibinu and Jagboro (2002), revealed that the government policies and regulations also directly influence the construction and housing costs. Apart from this, according to TELL (2002) the corruption and other fraudulent practices on the part of the government, suppliers, and contractors also directly affect the housing and construction costs. This was further supported by the research studies of Husseini (1991) and Frimpong, Oluwoye and Crawford (2003). The demographic factors like increasing population level results in increasing the cost of constructions as this leads to increasing demand of the houses and other buildings. Some of the factors that lead to cost escalation in housing and construction industry in Saudi Arabia are as follows: 2.5.1. Economic Factors Oil being the major commodity of the GCC countries indicated that the non-oil real growth rate would decline to some extent. According to a forecast, it was expected that the non-oil real GDP would remain strong but would slightly fall below from 7 percent in 2011 to 6 percent in 2012 and would further decrease to 5.5 percent in 2013 (IMF, 2012). This decline in the growth rate indicates lower level of spending from the government along with weaker external condition. Even the income from the sale of oil looks suspicious and unpromising due to the uncertain economic environment and long-term challenges. It was predicted that the crude-oil price per barrel would fall below USD 100 per barrel by 2015. It was also forecasted that the increase in government spending along with fiscal and external surpluses would turn to deficit, if the policies of GCC countries remain unchanged. Labor costs were another major reason for the cost escalation in construction industry. The increase in labor cost would directly influence the construction cost to boom upwards resulting in greater cost requirements for the completion of projects. According to a research conducted by MEED; business service intelligence, Saudi Arabia has the highest labor construction cost in the whole Gulf (Meed Cost Indices, 2012b), this research further indicated that the labor construction costs in KSA are average (Mesbah, 2012). The increase in government spending is another major reason for the cost escalation in the construction industry. Along with such increase, the breakeven price of oil has continued to grow which eventually led the cost in the construction industry to escalate even higher. The increase in costs reduces the profit margin to a great extent of GCC countries as oil makes the most of the country’s revenue. In order to enhance Saudi Arabia’s position in the market, the government of KSA has decided to provide its citizens with employment opportunities by constructing four economic cities namely King Abdullah economic city, Prince AbdulAziz bin Mousaed Economic City, Knowledge Economic City, and Jazan Economic City. By constructing such four economic cities, the government of KSA aims to enhance the GDP as these cities once completed would provide the Saudi nationals with employees to work for the reduction in construction costs (Alpen Capital, 2012). 2.5.2. Geographic, Demographic and Social Factors Demographic Within the last decade, the construction industries in the GCC countries have witnessed an increase in the population. It was observed that the population in the GCC countries witnessed a great boom during 2003-2009. The population within these years grew to 3.5 percent as compared to global growth of 1.3 percent within the same time-frame. Urbanization was another factor that was witnessed in the GCC countries. According to a research conducted, it was observed that GCC countries such as Kuwait and Qatar have 90 percent of their population living in urban areas whereas; only 10 percent of the population lives in rural areas. This indicates that there is still room for growth in GCC countries and more growth opportunities for countries like U.A.E and KSA that have higher population as compared to other GCC countries (Alpen Capital, 2012). With 50 percent of the population between the ages of 15 to 65 years, it was observed that in the forthcoming years the GCC countries would have higher number of young and energetic workforce. It was also observed that changing lifestyle and shift from single to nuclear families is on rise and with such shifts; the housing demand would eventually increase. This shift in the demographics has major contribution in the cost escalation of construction industry (Alpen Capital, 2012). Geographic Most of the GCC countries are located in hot environment but at the same time enjoy quite advantages over other countries. The GCC countries are provided with abundance of oil reserves that makes the most of the country’s GDP and revenue. Along with such abundance of oil reserves, the GCC countries are blesses with natural resources such as gold, copper, limestone etc. Due to such abundant availability of natural resources, the construction costs in such countries are quite less as compared to other countries like USA and UK. With KSA being the cheapest country in terms of construction cost, the profit margin of this GCC member country is quite high as compared to other countries. With comparable higher profit margin, KSA is able to reduce its construction cost to a great extent whereas, the construction cost in UAE, Kuwait and Qatar are quite high as these countries have higher raw material costs. Due to favorable geography of GCC countries, the member countries enjoy favorable policies from government and strong attraction for foreign companies in construction industry. This attraction has allowed the GCC member countries to handle large and complex construction projects by either entering into partnership with foreign companies or joint ventures. Social Factors To successfully meet the high and complex demands, it is essential to have skilled labor. In the case of KSA, the situation is quite opposite. As KSA has constantly attracted diversified workforce in construction industry, the number of skilled and qualified labor has gradually decreased making it comparably difficult for the KSA government to meet the never ending demands of complex structures. Due to skills shortage, the construction cost is expected to grow in the forthcoming years (Deloitte, 2012b). KSA and Abu Dhabi being a social hub has provided an opportunity for the government. By using such diversified labor, there is wider opportunity available for the KSA government to turn the country into a major social and economic hub. By doing so, the construction cost would gradually decrease to great extent (Deloitte, 2012b). In 2010, to narrow the gap that was created and to develop the human resources by providing them with vast opportunities, the KSA government approved five year development plan worth (USD 384 billion). This development plan was aimed to enhance and develop human resources, education and skills of labor. This plan has gradually decreased the cost escalations in the construction industry as this development plan would create job opportunities in the industry. The greater availability of job, the greater there is a chance to reduce the cost escalations (Deloitte, 2012b). 2.5.3. Finance and Funding factors Construction depends on quality of planning for complex and large projects but due to shortage of skills at KSA in the construction industry, there are great chances for cost escalations. Planning is the most crucial stage that could gradually reduce the cost of construction. To do so, contractors must keep themselves aware of current happenings and events along with the resources that would be required for the project. In order to reduce the cost of construction, the contractors should be provided with only the resources they require. By doing so, the resources would be used in an efficient manner. Planning and scheduling both are crucial to reduce the cost of construction. When done properly and accurately, the project cost could be reduced to a great extent. Poor financing control is another factor that could gradually increase the cost of construction projects in KSA. With lack of skills, controlling the entire project financially is another problem for the KSA construction industry. If the projects are not financially controlled, the cost for the construction project could increase to great extent. For eliminating such factors, the KSA government should use proper and quality management tools and proper resource planning aimed to reduce the cost to escalate. With greater restrictions in KSA the construction companies are finding it quite difficult to acquire funds for the completion of projects. The source of these restrictions is the tighter control of the government on the monetary supply. In order to acquire funds, the construction companies are more inclined towards financial markets to fulfill the needs and requirement. This is the major reason for the cost escalation. Bonds and payments are another source to acquire funds in Saudi Arabia. These financial sources in KSA are issued by commercial banks and are considered as additional support for the contractors. The biggest hurdle for construction companies in KSA is that the government requires bank guarantees from contractors even though the companies have the ability to complete the project timely with cash. The loans provided by the banks for the completion of projects are backed by high interest rates making it quite difficult for the contractors to acquire loan for the completion of projects. Changes in the material cost are another factor that could gradually increase or decrease the cost of construction in Saudi Arabia. With abundance of availability of natural resources the KSA government is able to meet the demands of the construction but the economic recession in the earlier years had created quite problems for such companies. Due to the economic recessionary period, the cost of material has increased leading to great change in construction cost. In the forthcoming years, it is expected that the KSA government would be able to reduce the material costs so that the construction companies could take full advantage with abundance of natural resources available in KSA. 2.5.4. Other Factors (Environmental factors) Weather is the primary environmental factor that could lead to the cost escalations in Saudi Arabia. KSA has one of the most extreme climatic situations due to which there is a constant loss of productivity and inefficient use of resources. Furthermore, the maintenance cost in such extreme climatic situations has gradually increased due to constant maintenance. Contractors avoid working in such climatic situations as the summer in this particular region is extremely hot and working in such situations has always been difficult for the contractors and the workers. Corporate social responsibility is another major environmental factor that could enhance the cost in construction industry. Being blessed with natural resources and oil reserves, the KSA government is focusing on preserving the natural resources so that the future generations could also benefit from such resources. In order to provide the construction industry with resources, the KSA government purchases the resources required from vendors at comparably high cost. Due to such factor, the cost of the construction industry has gone quite high in the recent years. 2.6. Strategies to Minimize Cost According Master Builders Director of Housing Policy, Paul Bidwell “the biggest problem for the construction industry is continuous rise of cost. These changes in the cost have substantially reduced the construction activity”. He added further that, “there two major elements that have greatly influenced that cost are; land cost and construction cost.” (Master Builders, 2012) By keeping in mind, what has been observed, few strategies are presented with an aim to minimize the cost of construction. These strategies are as follows (Cooke and Williams, 2003; Mbachu and Nkado, 2004): a) By ensuring efficient time management. By doing so, the contractor would be able to effectively plan for the resources and could better develop and control the whole process. This would enable the contractor to reduce the costs by managing the resources being used and would reduce additional work allocation for which workers charge additional costs. b) By ensuring adequate supervision, the contractor would be able to manage the whole construction accordingly and this would eventually reduce the possibility of errors and mistakes which would eventually help in the reduction of cost. Adequate supervision would also provide the contractor with an additional advantage as by doing so, the contractor would remain aware of the whole process and would be able to reduce idle time during construction process. c) For the construction of complex and large projects, it would be better for the contractor to hire experienced and qualified workforce. The quality of work required for the construction of large and complex projects can be maintained by hiring experienced workforce and the chances of mistakes would be near to zero which could cause the construction cost to rise. d) By bringing in innovative solutions for problems could also provide the construction industry to reduce its cost. To do so, experienced and talented contractors should be provided with the projects that are aware of the environment and how things work. The contractor should also be provided with sufficient time and resources by the government along with the government’s full support to reduce the construction cost in KSA. References Aibinu, A.A. and Jagboro, G.O. (2002). The Effects of Construction Delays on Projects delivery in the Nigerian Construction Industry. International Journal of Project Management, 20, 593 – 599 Al Jazira Capital. (2011). Saudi Cement Sector. Retrieved February 6, 2013, from http://www.aljaziracapital.com.sa/jaziracapital/report_file/ess/SEC-12.pdf Al Sheikh, S. (2012). Saudi Cement Sector Review: Comparative Energy costs and expansionary fiscal policies are fuelling the Saudi Cement Sector. NCB. Retrieved February 6, 2013, from http://www.menafn.com/updates/research_center/Saudi_Arabia/Economic/NCB040612.pdf Al-Nagadi, M (2010). Saudi Arabia – Concrete construction industry – Cement Based Materials and Civil Infrastructure (CBM&CI). CBM-CI International Workshop, Karachi, Pakistan. 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