With the ever-growing concern of rising construction costs, it is imperative to understand what’s happening in the market, the impact it can have on your next deal and how to mitigate the risk. According to a recent analysis by the Associated General Contractors of America, construction material costs have increased by 20% year-over-year from January 2021 to January 2022. This is the largest recorded material cost increase since 1970. Due to recent geopolitical events, persistent demand and the continuing supply chain issues, the trend of inflation and rising construction costs are projected to continue for the foreseeable future. In this time of uncertainty, it is more important than ever to properly structure CRE transactions with a focus on industry best practices and risk mitigation to move deals forward.
Rising Costs & Price Volatility
Since the start of the pandemic, a multitude of factors have been attributed to the material cost increases the industry is experiencing today. To better understand how to identify and mitigate this risk, let’s look at some of the main contributing factors:
- Inflation: Costs for construction materials, like most other goods today, continue to rise. Take lumber for example: over the past year, lumber experienced record highs followed by sharp drops; however, costs have climbed back up 40% from pre-pandemic levels. With demand remaining strong, suppliers continue to hold the upper hand.
- Supply Chain Disruption: Material availability and delivery lead times continue to challenge project teams. From PVC to roofing material, steel, appliances and even paint, these disruptions continue to persist. With most facilities having to shut down or slow down at some point during the pandemic, the demand never wavered. This in turn led to supply not being able to keep up with demand, creating a feeding frenzy for materials, ultimately
driving costs higher.
- Labor Shortage: Labor also plays a large role in the volatility of the market. While labor concerns were already plaguing the construction industry, the pandemic compounded the issue. Project slowdowns, concerns over health risks and government subsidies drove the workforce to stay home in lieu of reporting to work during the pandemic. With fewer workers available to put work in place, labor costs began to rise. The construction industry is experiencing a major shortage of skilled labor. With 20% of the construction workforce over the age of 55 and the number of workers between the ages of 25-54 decreasing by 8% over the past decade, there are concerns over how the age of the workforce will affect the industry long term.
While the market environment is rife with volatility, the housing crunch and historically low interest rates through the bulk of the pandemic kept the demand for new project starts at an all-time high. This seeming paradox currently has credit departments tightening requirements and pushing prospective borrowers to take on the risk of rising costs post-closing. To keep deals moving forward in these uncertain times, risk mitigation is of heightened importance. Mitigating this risk, much of which is unknown, requires diligent underwriting, learning from the mistakes of others and implementation of sound industry practices. Below you will find a two-part recommendation for assistance in identifying and ultimately mitigating risk currently involved in CRE transactions.
The two-part solution refers to identifying and mitigating risk pre-closing (loan underwriting) as well as tracking the risk post-closing (loan servicing).
Identifying risk and implementing mitigating efforts during the underwriting phase are nothing new to the CRE world. What has changed over the last 18 to 24 months is the focus of the due diligence review and underwriting process. Below you will find a current list of what to focus on and industry best practices that have proven to be successful in the face of extreme uncertainty:
- Contractor/Project Team Qualifications: Contractor selection can make or break any CRE project. In today’s market, selecting the right contractor is imperative to a successful outcome. Pre-pandemic it was customary to review the corporate resumes and financial statements of contractors. In today’s environment, we must take the analysis one step further. Not only is it good practice to underwrite the corporate entity, but it is also extremely important to identify and vet the individuals who are proposed to manage and supervise the project in the field.
This is accomplished by reviewing resumes and interviewing those who will be tasked with the daily operations on site. This step is recommended to ensure the proposed field team has adequate experience with similar projects and understands the risk that exists in today’s market.
- Contract Language: When dealing with unprecedented market volatility, being proactive is the best solution. Current industry practices are trending toward a fair and equitable share of cost increases that are out of the control of project teams. Inserting language into construction contracts that dictates what happens in the event of an unexpected cost increase and who will be responsible for the cost is of utmost importance. This language should also include a cost threshold (i.e., dollar amount or percentage of contract value) that must be reached
prior to an equitable sharing of the risk. Not only should the contract include explicit language regarding cost increases, but it should also address potential time increases as well as provide a clear definition of force majeure.
- Thorough Review of the Budget: After review and approval of the contract terms and conditions, the next step is to thoroughly review the project budget. Gone are the days of using historical costs as a basis for budgeting or creating guaranteed maximum contracts. Construction costs are evolving so rapidly that the historical cost method is no longer accurate. The budget should be comprised of true and current (within 30 days) market pricing, backed up with supporting documentation from subcontractors and vendors. Overall project budgets should be vetted against recently completed projects of similar size, scope and location. In addition to the standard evaluation of the overall cost, the budget should be analyzed on a line-item basis, comparing itemized
work scopes to similar projects in a specific market. Due to the fluidity of the market, this additional layer of cost evaluation often requires the assistance of a third-party cost consultant.
- Procurement Process: Gaining a deep understanding of the project team’s procurement process has recently taken on greater importance during the underwriting phase. Understanding the intended purchasing strategy sheds light on multiple aspects of the project including the following: the number of outstanding subcontracts, the potential for stored materials, the required material deposits and even anticipated material lead times. To gain
this understanding conversations must be held with the project team regarding their intended timing and methods for project purchasing and relationship with the market. It is important to note – as a lender, it is wise not to dictate the procurement process, as this would encroach on a borrower’s means and methods, which can lead to placing the undue risk on a lender.
- Tying Loan Terms & Contract Terms Together: The final and most important step is to leverage the loan terms in concert with the construction contract. As simple as this sounds, this final step seems to be the one most often missed or overlooked prior to closing.
Once the loan is closed, it is not safe to assume that a well-structured deal will simply run itself and stay out of trouble. Monitoring the progress of the project is equally important to track project metrics and report pending or looming issues. For without timely information, the lenders run the risk of receiving untimely “surprises” that can potentially derail a project or prevent the lender from making timely business decisions.
The second piece of the risk mitigation solution includes monthly monitoring of each CRE loan. Monitoring includes
employing a third-party consultant to visit each site monthly for reporting on the following:
- Project Cost: Is the project tracking on the original budget? Are proposed cost changes warranted and in line with the contract language? Will any potential cost increases require a loan increase? Will the borrower be required to obtain additional funding?
- Project Time: Is the project tracking on the original project schedule? Are proposed time extensions warranted and in line with the contract language? Will any potential time extensions require a loan increase or extension?
- Project Quality: Is the project being completed in accordance with the project documents? Will potential cost increases require scope changes or reductions to keep the project within budget?
Having “boots on the ground” representing the lender’s best interest is paramount in understanding where each deal is in the process and where the measured risk lies.
Moran Construction Consultants is a nationally recognized construction consulting firm with services ranging from initial due diligence assessments to construction loan monitoring to owner’s representation. With more than 250 years of combined experience, they mitigate the risk of investments for lenders, syndicators, investors, and owners while adding value to the project team.