Presented at CBA Lenders Conference
- Construction industry failure rates / margin compression / worsening financial status
- External factors that can affect a project, such as unsubstantiated liens and changes in laws
- Identifying creative ways to mitigate potential construction lending risks
It is a statistically proven fact that the construction industry has one of the highest failure rates of any industry. Although lenders perform a thorough qualification of the borrower, they are regularly presented with the additional challenge of assessing the contractor’s ability to complete a project. Some of the current challenges include the following:
- Contractors margin compression
- External factors that can affect a project, such as liens and new laws
- Identifying creative ways to mitigate potential construction lending risk
Just what is the contractor bringing to the construction project besides his tools? It has always been a standard practice in the construction industry for contractors to carry losses from one project to the next. In a market where construction has slowed, contractors have fewer opportunities to recoup financial losses caused by mistakes that had to be corrected and /or inaccurate or under bidding to keep crews and equipment working.
Unless a contractor has significant working capital or lines of credit, he or she most likely has impaired capacity, which could result in liens / or worse, legal action in the form of a levy to satisfy a judgment against a contractor. One key indicator, which provides a snapshot of the health of a business, is a contractor’s current work in progress log. The lender should always request a contractor’s work in progress report and thoroughly review it. One question to ask is, can the working capital and/or credit facility the contractor has in place support the contractors work in process based on a four-to-six week payment turnaround time?
In our company, we are seeing contractors asking for more frequent draws and some are seeking weekly payments. A contractor’s need for frequent payment is another key indicator that he or she may have a lack of adequate funds to meet job payment needs.
Lenders should be cognizant of external factors, such as unsubstantiated liens and laws or code changes that may affect the projects. In 2004, a law was enacted (Section 7031 of the Business and Professionals Code) by the State of California, which in essence mandates that all contractors, including subcontractors, keep their license in good standing at all times during the performance of a contract. There cannot be a break of any duration during the construction period. If a contractor or sub-contractor is not properly licensed even for a day, they lose their right to recover any money for their work, even for work performed on a contract, while it was licensed.
Many construction projects require a bond. The surety, knowing that there is a lender involved, would require the lender to provide a letter of guarantee. This represents a guarantee of payment for a completed and accepted scope of work. As a prudent measure, the lender should freeze the funds to pay for the specific bonded scope or phase and require a sign off or acceptance and return of the letter of guarantee upon completion and acceptance by the municipal or governing entity, prior to releasing the funds backing its letter of guarantee.
A surety bond, unlike an insurance policy, will not pay out against a loss without subrogating a guarantor (the issuing lender). The surety would look to the lender (who provided the letter of guarantee) for reimbursement or restitution against any claim filed by a municipal or governing entity. One way this obligation has been previously dealt with has been to add a release clause in the lenders letter of guarantee, requesting the municipality or governing agency provide written acceptance of required improvements within 15 days of completion of said improvements.
Who has the responsibility to create a solid risk mitigation plan? The lender, as primary risk taker, has the responsibility of developing a proper risk mitigation plan. Part of underwriting a construction loan is assessing the level of risk and developing a plan that best suits the project needs. There are different levels of risk mitigation tools just as there are varying levels of risk. Here are some key components for consideration:
- Ensure that the project budget is not front loaded or, in other words, do not allow the developer or contractor to be over-reimbursed up front
- Match the sophistication of the inspector to the background and experience of the contractor
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Determine what level of oversight is required
- Should there be a monthly draw meeting?
- Should the lender and/or its inspector be present at the draw meeting?
- What information does the lender consider key in making funding decisions? (Ensure that the inspector updates this information monthly)
In conclusion the above described challenges are ever present in the construction industry. However, they are magnified when economic conditions are less robust. Therefore, it is recommended that lenders take extra precautions during these times to raise the level of awareness and to enhance or bolster risk mitigation practices, where applicable.
