2023 Construction Outlook

Local Touch. National Strength.™

JANUARY | 2023

2023 Construction Outlook

Resilience and Perseverance It’s that time of year where we summarize the performance of the Canadian construction industry over the past year and look into our crystal ball to offer perspective on the year ahead. In our company’s 43 years, we have not been witness to as tumultuous and erratic a year as 2022, nor as challenged a task as offering a forecast of what may lie ahead.

Inflation - higher labour costs, material, equipment, and other price increases - has cut into contractors’ gross margins, and supply chain and labour shortages continue to hinder productivity and extend schedules, further exacerbating pressure on profit margins. Meanwhile, surging interest rates and the resultant ballooning carrying costs of borrowing has added a new element of risk and profit erosion to the great proportion of construction businesses reliant on debt. All told, these challenges – and in particular their confluence all at the same time - would have spelled doom were it not for the continued healthy demand for construction services, and the generally robust backlogs prevalent in the industry.

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2023 | Construction Outlook

So, what’s in store for 2023? Here follows some commentary from a diverse group of PWA clients, who offered their perspective beyond the crisis in Ukraine, possible further Covid waves, continued impacts of inflation on cooling the economy, and all the micro and macroeconomic issues surrounding their businesses: “2023 will bring some stabilization in terms of the wild inflationary pricing. Volumes will remain high as most companies are still working down their backlogs.

I foresee bidding opportunities slowing down and certainly project budgets are going to get tighter and I think many projects will be cancelled. The fact that inflation is still an issue poses a greater risk to the overall economy than the [construction] industry.

The industry as a whole won’t be affected as much as the greater economy, most [general contractors] have already built in additional risk factors into their pricing.

Access to human resources is going to continue to be an issue for most of the construction industry in terms of limiting what we can actually get done and certainly will limit overall growth. I believe as interest rates increase, we are going to see a significant number of failures in the subcontracting industry, most trades cannot handle the increased lending costs and I suspect a lot of the lending institutions are going to start paring back their facilities so the trades are going to get pinched.” – Institutional General Contractor “2023 will certainly be a better year than 2022. The pricing escalations and supply chain issues of 2022 have been settling down and we feel the worst Is behind us. 2023 barring any worsening of the issues in Ukraine and Covid should see stability in pricing and as we’re still in the first year of the labour contract, labour pricing is a known quantity…. The talk of a recession seems to be mostly just talk, there seems to be a lot of people working, low unemployment and people are still spending…” – ICI Mechanical Contractor “We are expecting 2023 to be a better year than 2022…. Although there are lingering issues from the pandemic years - especially supply chains the pricing volatility has stabilized. This volatility was unprecedented. Supply chain issues are being mitigated but most contractors were fully exposed to the pricing increases in 2022. I think most will

indicate a more optimistic forecast for 2023 due to a large backlog of projects in some markets, whereas other markets may not be the case, as interest rates rise and the potential for a recession looms. Suppliers are our greatest concern; supply chains are still plagued with issues and manufacturers and suppliers simply can not meet current demands” – Industrial and Commercial Electrical Contractor “My sense is that most contractors are still working through a fairly healthy backlog of work, so I would guess that most would expect to see similar results to last year. For our business, we are most concerned with over leveraged sub trades. I think there are a large number of trades who have used the recent high volumes of work to take on debt and over leverage themselves believing that this level of activity is normal. If for some reason we see a down turn I think we may see many subs experience issues” – Institutional General Contractor “Ours is a healthy backlog and we’re comfortable with the way 2023 appears to be playing out. We’ve carried a good deal of contingencies in our bids - for fuel, equipment, labour, and other materials, but for the first time in a while, believe we may not need all of these contingencies, and they may turn to a modest increase of gross profit, which is the opposite of what happened in 2021-2022. That said, we’re concerned about the rising cost of construction, the mismanagement of our provincial and federal financial affairs, and the ability of public entities to pay for the necessary infrastructure investments” – Heavy Civil contractor In our humble view, a fair number of contractors with less resilient balance sheets (modest working capital and/or significant dependence on debt) who have suffered financial setbacks through 2022 will face a very real risk of succumbing to those injuries in 2023, and that will have a consequential ‘domino’ impact on their customers and suppliers.

So our recommendation would be to pick your partners and projects carefully in 2023. That said, the year ahead will likely see some settling of interest rates, labour shortages, and supply chain challenges, and present unique opportunities for nimble and financially resilient contractors. And one thing is for sure; contractors have developed a keen ability to adapt to change and challenge.

Petrela, Winter & Associates

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Insurance Market Update For the last couple of years, our annual insurance update illustrated the challenges of the hard insurance market which began in late 2019.

The pandemic, one year into the hard market, led to significant supply chain disruption and soaring inflation, both of which increased insurance claims costs and Insurer loss ratios in 2022, compounding the issues for Insurers.

Despite these rather severe economic headwinds, Canadian Insurers were reaping the rewards of more diligent underwriting and rate increases of the two prior years, so their demand for rate increases in 2022 was tempered, with more modest but steady increases through the first half of 2022.

Our experience in the latter half of 2022 was even better, with a reduced ask for rate increases in respect of contractors who had a good claims history, and even some rate decreases for the first time since early 2019.

We’re far from a return to a ‘soft market’ though.

Insurers continue to exercise discipline, seeking modest rate increases on renewals without claims (3-6%), pushing for higher deductibles, and offering only modest capacity for certain classes of business like Builders risk insurance, making it more challenging - and time-consuming - to place insurance on larger projects.

Heading into 2023, we feel specialized knowledge of the construction industry will be required to assist contractors with the evolving risk landscape.

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Steady inflation, rising interest rates, and the resultant increased cost of material and labour are making it more difficult than ever to select an appropriate limit for property insurance (Builders risk, buildings and equipment), since pegging the values wrong can result in severe co-insurance penalties.

cyber insurance to protect your business is more difficult than ever due to continued increasing claims payouts, and the much more sophisticated underwriting and rating being deployed by underwriters, but internal risk management strategies can mitigate such risks.

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Liability insurance for contracting operations that are seen as “higher hazard” such as Roofers, Plumbers, and Winter Maintenance Contractors continues to be challenging. We have countered this by forging strong bonds with some creative and entrepreneurial underwriters who are now taking advantage of the market by offering innovative new solutions to specialized brokers such as PWA.

We believe our sector expertise not only helps design better insurance programs so contractors avoid landmines in this heightened risk environment, but also serves as a competitive edge when navigating renewal negotiations to achieve a better outcome than our generalist industry peers.

Due to the steady improvement of underwriting results, we see opportunities ahead for contractors in 2023 as numerous insurers appear ready to grow, something we have not seen since the onset of the hard market - when insurers tend to cull their portfolios. We’re seeing the re-emergence of a select few “sleeping giants” in the construction insurance space, and although we don’t expect these insurers to throw caution to the wind and press the growth button “carte blanche”, we are optimistic. We see them looking to grow in select industries within the construction sphere, with contractors who show above average risk management characteristics and practices, and through professional brokers who know the space well and add value to the process.

This more disciplined “profitable growth” mindset will result in the market slowly opening up toward the end of 2023, absent any unpredictable forces which could reverse or delay this trend.

Cybercrime is more prevalent than ever, and the size of these breaches is growing. Purchasing Petrela, Winter & Associates

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Surety Market Update While the surety industry is generally a business with predictable results, there have been periods of turmoil over the years. When those rough waters hit and contractors suffer meaningful financial setbacks and surety losses mount, sureties will turn to more stringent underwriting to restore stability.

Certain economic indicators may have given cause for the surety community to tighten their appetite for risk in the last couple of years, however, we continue to see a marketplace that is surprisingly ‘friendly’, and surety bonds are still being provided on a generally supportive basis. A key reason for that is the continued influx of new entrants into the Canadian surety space, ensuring abundant capacity.

But there are other factors: first, new procurement models which offer better support to a contractor’s downside risk are gaining traction. And second, contractors are increasingly sophisticated, with a deeper understanding of their risks and costs, and an unprecedented ability for gathering real-time project information and analytics. What can be measured, can be managed, and contractors are getting better and better at knowing where their risks lie, and are now quicker than ever in responding to manage them.

In our introduction, we outlined some of the economic forces at play that are producing mixed economic forecasts. Sureties, who are traditionally good students when it comes to predicting worsening construction climates, anticipate that interest rates and general uncertainty will mean opportunities in the private sector will likely diminish. But even public work is suffering due to affordability issues – the number of over budget or cancelled tenders is unprecedented. The pent-up demand for necessary infrastructure is growing and will need to be addressed at some point.

Most surety insiders expect that the frequency of claims will rise in 2023 (one senior surety executive commented to us that there is clear historical evidence of claims trending upwards within a year or two of a spike in interest rates). The severity of claims is an issue of concern too, as inflation is already having a meaningful impact on the cost of settling surety claims.

So, the question becomes what can contractors do to avoid financial risk in this tenuous climate? The answer remains quite fundamental: 1. To the degree possible, reduce debt loads to avoid the impact of an increasing burden on cash flow and the inherent loss of control that comes with significant dependency on outside financing.

2. Monitor the financial health of your customers and business partners (owners, GCs, and trades), and mitigate counterparty risk by seeking proof of financing from owners you’re unsure of and subtrade bonding from larger critical path trades whenever possible.

One final observation. We’ve noticed that while contractual disputes and payment issues are more common than ever, the use of prompt payment mechanisms and arbitrations (where statutorily available) remains uncommon. This may be an under-utilized tool for contractors to leverage regulation to their potential benefit (for a change).

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2023 | Construction Outlook

PWA Update

2022 was a busy year for PWA and its team!

We opened our new Toronto head office in May, a bright and newly renovated space at Yonge and York Mills.

We also moved into our new branch office, in Sudbury with Jocelyn, Tara and Judy.

WE CELEBRATED SOME ANNIVERSARY ‘MILESTONES’…

WE WELCOMED SEVERAL NEW COLLEAGUES…

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1st anniversary: Kristena, Kelli, Joel, Julia, and Tara

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Linda Ponte Bond Services Associate

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5th anniversary: Alexander

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15th anniversary: Rohini

Jennifer Ryan Senior Insurance Account Manager

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Derrick MacLeod Senior Insurance Account Manager

FAMILIES ARE GROWING… •

Arielle and David welcomed their first son, Aaron

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Christa Ouimet Insurance Services Associate

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Peter also welcomed his first son, Hunter

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Julia got married

Sheldon Patten Surety Advisor

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Denise got engaged

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Judy Armstrong Insurance Account Associate (Sudbury)

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Shanice Pottinger Administrative Support Specialist

BENEFIT FROM OUR SPECIALIZATION

Visit us us at Visit at www.petrela.com www.petrelawinter.com

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Local Touch. National Strength.™