A recent survey of more than 500 construction companies uncovered widespread optimism about industry growth throughout the rest of the year.

The 2022 Construction Cash Flow and Payment Report explores a variety of industry topics, including slow payment speed, low mechanics lien use, and lingering cash flow concerns. However, despite pervasive problems with on-time payments and cash flow, the overwhelming majority of construction businesses are hopeful about their prospects in 2022.

For example, nearly half of companies rated their current financial optimism as an eight or higher on a scale from 1 to 10. This positive outlook correlates strongly with expectations about financial growth: 75% of respondents expect growth or significant growth in revenue whether they work on residential, commercial or public projects.

In fact, across a variety of companies—including general contractors, subcontractors, material suppliers and rental companies—fewer than 10% expect declining revenues in 2022. Around 25% of companies expect steady revenues, but more than 50% of construction businesses expect some growth this year.

However, economic forecasts paint a different picture, with rampant inflation, shifting demand and materials shortages leading to financial woes across some segments of the construction industry.

The changing landscape of construction demand

The lingering effects of the COVID-19 pandemic have shifted demand from commercial construction to residential buildings and infrastructure projects. Taking a closer look at inflation-adjusted volume data for different construction segments, several key trends emerge.

For example, in commercial construction, the steady growth in the years leading up to 2019 led businesses to stake their fortunes on projections that signaled that 2020 would be another strong year. However, the pandemic upended forecasts and led to two years of dramatic declines for the commercial sector: A 4.6% volume decrease in 2020 followed by a precipitous 11.2% volume decrease in 2021.

While survey data suggests many commercial construction businesses are hopeful for a rebound in 2022, economic forecasts suggest that total volume in the commercial space will continue to decrease for the rest of this year and into 2023.

Meanwhile, construction in the residential space has experienced an unexpected boom in the two years following the initial pandemic lockdowns. After the residential construction market had suffered losses in 2018 and 2019, that sector saw remarkable volume gains of 12.4% and 11.5% respectively in 2020 and 2021. That growth represents a real dollar spending increase of nearly $100 billion in the period from March 2020 to March 2022.

However, even though home construction has experienced unprecedented growth in the past two years, the optimism among residential construction businesses may be misguided. Volume projections from Cumming Insights suggest stagnation in the residential space in 2022 followed by volume declines in 2023.

Inflation, materials shortages and productivity decreases are all possible culprits for market contraction in the coming years.

How inflation could devastate the construction industry

Those working in the construction industry would be forgiven for mistaking the early signs of inflation as positives. For example, material suppliers are commanding record prices, equipment rental companies are witnessing record demand and construction workers are taking home increased wages.

However, the current economic situation is very problematic for two reasons: the immediate economic impact of inflation as well as the likely government response.

First, it’s important to get a sense of what inflation is and where it tends to come from. In an economy with high inflation, the spending power of money is reduced. For instance, the same tank of gas costs twice as much now as it did last year. Inflation results from increased demand or reduced supply—and the changing costs that follow. In the construction industry, record-high demand and record-low supply are dramatically reshaping costs for materials, equipment and labor. There is too much demand and not enough available.

While short-term revenue increases may look appealing, the economic effects of inflation are damaging to everyone—construction companies included. For instance, construction businesses seeing record revenues in 2021 may see their hard-earned cash quickly evaporate as they calculate new—and higher—budgets for projects based on 2022 costs.

Economic research on the effects of inflation on construction projects shows that the cost of building materials accounts for 35% to 60% of a construction budget. With the Producer Price Index for construction materials continuing to rise—up 12% in the last year—budgets will need to adjust accordingly. Economists report that increased costs for materials, labor and equipment tend to be absorbed by construction businesses, which experience lower profit margins as a result.

Since widespread inflation has been uncommon since the 1980s, many current construction businesses are unaware of the likely consequences of government interventions. After historically high inflation through the 1970s and early 1980s, the Federal Reserve Bank, led by economist Paul Volcker, pioneered an approach to combating inflation through high interest rates. This approach has proven to be effective monetary policy, but it can also lead to self-imposed economic recession.

Raising interest rates helps to combat inflation by reducing how much money people borrow. In other words: The more expensive it is to borrow money, the fewer people will do it. For consumers, high interest rates mean that people are less likely to take out a mortgage or a car loan. In the construction industry, higher interest rates could make it more difficult to secure financing for materials or equipment—or make it less likely that a project even gets financing in the first place.

The Federal Reserve has already started to raise interest rates, and Fed Chair Jerome Powell has said they will continue to raise rates “until we feel we’re at a place where we can say financial conditions are in an appropriate place, we see inflation coming down.”

While fighting back against inflation is essential, the short-term effects on the construction industry could be devastating. A smaller number of projects will likely lead to companies having to shrink their workforces or go out of business entirely. For some period of time, costs will remain high even as borrowing money becomes more expensive, making it difficult to secure materials or laborers to complete projects.

In short, the process of decreasing inflation—while necessary—is likely going to hurt many construction businesses.

How construction businesses can prepare for the future

Even in the midst of high inflation and a possible recession, now is the time for construction businesses to prepare for the future. Construction executives should be quickly looking at existing liabilities and contracts, long-term costs, and opportunities for streamlining and automation.

Businesses that are able to lock in long-term fixed interest rates for debt will be more likely to weather the storm as the prime interest rate creeps higher. Similarly, businesses that are able to negotiate long-term contracts with customers and suppliers can help offset the uncertainty in the coming economy.

Additionally, construction professionals should do a spending deep dive. Focusing on profit centers while eliminating non-strategic or unnecessary spending can help keep a business lean and able to navigate economic hardship.

Finally, construction businesses need to consider how they will maintain volume and revenue as the economy shrinks during a potential recession. As bidding becomes more competitive with fewer projects available, savvy businesses will negotiate lower-margin contracts that remain sustainable.

The optimism that many construction companies have for 2022 is likely misguided, but the long-term prospects for the construction industry are excellent. Adjusted for inflation, the construction industry adds more than $3 trillion in value to the U.S. economy every year. Looking forward, construction will continue to be a vital part of economic growth. So while there may be bumps ahead with inflation and recession, the long-term forecasts for the construction industry remain optimistic.