The past months have seen notable increases in building material prices, especially those required for structural, roofing, building closures, technical facilities and finishing works. What exactly is driving this surge, and how long will it last? While the latter question remains a game of chance, experts have pointed to post-pandemic shocks and overwhelming demand for construction, supply-chain disruptions linked to the Russia-Ukraine crisis, high costs or lack of labour and logistics issues as some of the main culprits.
But long before the recent energy crisis pushed commodity costs up, contractors had already raised the alarm on price escalations that intensified shortly after the start of the global pandemic. Luxembourg real estate prices in the first quarter this year saw the third highest jump (131%) in the EU compared to 2010, according to Eurostat. The trends in the construction sector are not isolated but indicative of skyrocketing inflation rates on a global, European and national scale--at 6.8% at the time of writing--but massive alterations in construction costs in Luxembourg’s already pricey housing market are consequential. Will construction companies manage to accommodate costs extra to those stipulated in contractual agreements at the expense of their shrinking margins?
The contractor’s dilemma
Several events have unfolded rapidly for the sector in the past months, says Gaston Trauffler, head of industrial policy at industry federation Fedil. He explains that during the pandemic, most companies had to cut their production capacity as demand was low. Before the energy crisis, demand was high--as countries invested in recovery funds to kickstart the economy--but there wasn’t enough building material offer. The number of apartments under construction in Luxembourg rose by 7.7% at the end of last year, attesting to a strong rebound. Now that production of building materials has ramped up, Trauffler reckons the situation has improved. “It's not that you come to the construction site and there is no building material. The problem is that they have to pay more [for] raw materials than calculated [in the budget].”
Steel, iron, wood and cement are part of sanctioned products from Russia--the largest lumber exporter globally, according to Wood Resources International. Wood cluster manager at Luxinnovation Ralf Köhler explains that while “there was a global peak in wood prices around the third quarter of 2021, prices are stagnating a little bit for some kinds of woods.” However, they remain higher than pre-pandemic levels.
Adding to the construction sector’s costs are high energy prices. The sector needs a lot of energy-intensive materials. Trauffler explains that cement, glass and steel, for example, require high temperatures for production, powered by either gas or coal--gas prices have multiplied, and Luxembourg is one of 10 EU countries declared coal free as of 2021. “Oil and petrol prices are [also] high, and so transportation becomes more expensive, affecting [all] that needs to be transported, which is everything. So you can imagine that at the end of the day, these [costs are compounded for the] final consumer which is the guy that wants to do his construction,” says Trauffler.
It's not that you come to the construction site and there is no building material. The problem is that they have to pay more [for] raw materials than calculated [in the budget].
Between a rock and a hard place
Contractors’ options are quite limited. Renegotiation or termination of private construction contracts in Luxembourg are not a given, even in the event of unforeseen difficulties. Contracts remain legally binding, except in cases where provisions in the initial agreement allow contracting parties certain flexibilities. “If you have a private contract with a fixed price and no contractual provision allowing for a price adjustment such as an indexation or a hardship clause [for example], the contractor cannot renegotiate the price. So it's your risk as a property developer if there are any price increases in building materials,” explains Philippe Eicher, senior associate at law firm Allen & Overy.
“Some property developers have agreed to delete indexation or price revision clauses for their ongoing projects, and now they regret it. Before the current crisis, a majority of the construction agreements were fixed price contracts. Nowadays, construction companies try to avoid fixed price contracts or add a significant margin in order to anticipate any future price increase in construction costs or building materials,” adds Eicher. “For public markets, however, there are specific provisions in the law allowing for an adaptation of the contract in case of unforeseeable events (e.g., unforeseeable variation in price or wages since the submission of the offer). Currently, there are no similar provisions for private contracts in Luxembourg,” he explains.
France--and more recently Belgium starting in 2023--have introduced the hardship clause, allowing contracting parties to come back to the negotiation table should there be unforeseeable circumstances that may arise which could not have been anticipated when the contract was concluded. Belgium took it a step further, allowing the intervention of a judge when an impasse is reached or in cases of a refusal to renegotiate by one of the parties.
However, it is not the first time that a hardship clause is being proposed in Luxembourg. PwC Luxembourg had hinted in an article that the hardship theory has struggled for years to be recognised by case law in the grand duchy. So it remains to be seen whether there will be a change in Luxembourg law to enable renegotiation possibilities for private contracts. Otherwise, construction companies stand at risk of continuing to lose funds on existing projects, and future clients risk bearing the brunt of losses incurred.
Beyond contract renegotiation
In addition to modifying contracts--by applying the hardship or force majeure clauses, suspending penalties, postponing execution deadlines and including a price revision clause in all future contracts--the European Builders Confederation (EBC) in an open letter to the European Commission proposed several other measures that could be explored to help counter fuel and material price increases, especially for micro-, small- and medium-sized companies.
These measures include the provision of temporary financial aid; the setup of an energy cost cap at the European level to combat speculation and further increases; direct compensation to companies under existing contracts; the prioritisation of payments to construction SMEs by public authorities; lowering VAT rates to boost renovation and construction activity across the EU; the postponement of any planned measures to ban the use of certain fuels or to tax fuels for the construction sector; and temporal suspension of the EU steel safeguard measures and EU anti-dumping duties on steel products.
In response to a question by European parliament member Iskra Mihaylova on potential measures to manage the increase in building material prices and help European manufacturers remain competitive, the European Commission had indicated in March that prices were “stabilising” and that it is closely monitoring the supply factors affecting construction material prices. Following its letter, the EBC confirmed a follow-up response from the European Commission directorate (DG GROW) director Gwenole Cozigou indicating that the “Commission is closely monitoring the impact of high prices on industrial ecosystems, including construction.”
In the context of the Russia-Ukraine crisis, it has approved state aid “loan” programmes targeting various sectors, including a €500m guarantee scheme for the grand duchy under the so-called Temporary Crisis Framework. Luxembourg has also adopted other aid schemes, and the share of loans and benefits granted to construction works may contribute to receptiveness to budget renegotiation proposals.
Some property developers have agreed to delete indexation or price revision clauses for their ongoing projects, and now they regret it.
No one-size-fits-all solution
If demand drops, prices are expected to follow suit. The European Central Bank (ECB) increased interest rates in a bid to raise the borrowing costs, reduce demand and eventually cool down inflation. Low interest rates and shifts in housing preferences--fuelled by the share of teleworkable jobs and a desire for more space--were also said to have contributed to higher housing prices.
According to Statec’s construction price index, the price of construction rose 8.6% over a seven-month period, and in residential property this was higher, 13.9% over a one-year period.
But decreasing prices is not a one-size-fits-all solution, and it would need to be done cautiously and progressively. Luxembourg Chamber of Commerce director explains that “a big decrease of housing prices would not be a good sign because it would mean that [the market] is not attractive anymore, and demand is going down too quickly--and that would be a disaster.” The ECB has also warned that an abrupt repricing in the market--due to a reversal in housing demand or significant increase in real interest rates--could produce spillovers to the wider financial system and economy.
Still make hay while the sun shines
Drawing parallels with the 1973 oil embargo on the US by 12 OPEC members, University of Luxembourg professor François Koulischer explains that central bankers have already understood that the costs of inaction surpass the benefits, and the elasticity of supply versus demand will impact real estate prices and the possibility to continue passing on construction costs.
“Part of this increase in energy [prices] can be put into your end price but not eternally because, someday, your customers won’t pay anymore and they’d say: well, I can postpone my project also and wait until the prices come down again,” explains Trauffler.
Even if bigger players could afford to buy materials in bulk or have a stake in supply chain networks, others without the same capacity remain exposed to price fluctuations. 47 small construction companies went bankrupt in the first half of 2022, and the possibility of bigger players following cannot be ruled out--Aquinnotec and Instaltec were two such examples this year.
Thelen explains that the Chamber of Commerce, together with business association UEL are working to ensure more predictability for companies and banks. However, this is difficult because “we have an imported inflation due to energy prices.” He estimates that Luxembourg will nevertheless remain attractive for investors and immigrants, which would sustain the housing markets allure.