Michael Beaver: Building for the Future — New Realities in Construction Lending – ABL Advisor
Michael Beaver wrote an article for ABL Advisor titled “Building for the Future — New Realities in Construction Lending.”
Multi-million dollar building projects can take years to complete and are usually bid a few years in advance of before shovels hit the ground. Recently, this process has become more difficult for estimators given the steep rise in materials costs and the uncertainty of the construction labor market.
In fact, prices are rising well beyond the expected consumer price index, mostly due to tariffs on steel, aluminum and wood imports. Supplies such as HVAC equipment, girders and even nails are also being affected. The Trump administration’s 20 percent tariff on imported Canadian lumber, imposed in January, along with shortages due to the devastating wildfire season and additional marketplace factors have driven prices up by 40 percent since last year. Some, but not all contractors, are putting price escalators into their bids going forward that call for reimbursement by the client if the need arises. Price escalators in the current economy should be included into every lump sum contract.
Understanding the Backlog
A key consideration when lending into large construction projects is a builder’s business backlog. Let’s assume a project costs a hundred million dollars and is two years from completion. Then, within that time, frame material costs rise as much as 50 percent. The numbers being represented as backlog are now wildly inaccurate and you don’t want to get caught up in lending into a negative backlog situation. Every construction company’s financials are based on estimates; that is, a job is estimated to finish at X price that is the baseline of recognizing revenue. If that estimate is wrong and doesn’t match the real bottom line, the profit of the business will be misstated. Balancing the books given today’s fluctuating trade constraints and market conditions is a bit like predicting the future through a cloudy crystal ball — it can be pure fantasy.
At this point in time, construction companies, as well as their lenders and potential lenders, need to closely scrutinize project backlogs. Understanding the sustainability of the backlog shines light on the historical process of the business. If a contractor has had significant growth in their backlog, you’ll want to know, how they secured all of this future work. Lenders need to be asking questions about what has been factored into the backlogged projects. It is also extremely important to understand future cash flows of the contractor. Typically, lenders look at companies and think, ‘Okay, you have a really big backlog of projects and it’s going to generate X amount of profit over the next two years as you complete them.’ This equation becomes trickier when throwing in exponential rises in input costs. Asking the right questions when you are looking at applying backlog scenarios complicates the analysis, but must be addressed. Lenders should be asking, ‘Have you adjusted your jobs to account for the hockey stick like rise in material pricing? By the way, what is your factor going forward on those?’
Regarding the industry overall, we have not heard, dark tales of gloom and doom. At the same time, there does not appear to be a slowdown in material cost escalations that continue to erode profits. These were unexpected, and many were caught off guard. Looking ahead, one can only speculate on which way the current administration will trend on trade policy. Pricing may also be rising because of margin compression, other input costs on the supply side, or simple supply and demand. If they can’t grow their volume, they’ve got to grow through price increases to realize revenue targets. Additionally, labor costs for suppliers and contractors are rising.