It’s no secret that the construction industry is volatile and fraught with high failure rates and financial risk. This is true no matter the economic outlook; even a recovering or growing economy can spell trouble for construction firms.
Prudent construction financial managers and executives should be mindful of the unique risks presented by the construction industry regardless of the current position of their company. With that in mind, and with construction projects on the rise, it’s a good time to take a look at five potentially disastrous challenges that may present themselves in the coming year.
1. Cash Crunch – Economy Grows Too Fast
A rapidly growing economy with growth opportunities is generally desirable, and in many industries, would not even be on the radar of potential problems. Why is subcontractor failure three times more likely in a recovering economy than during an economic downturn?
The simplest explanation for any failure in the construction industry is that the failed business ran out of cash. There are many reasons for this, but in the case of failed subcontractors, they generally are expected or required to float substantial project costs. This is due to the unique nature of the construction payment chain. The subcontractors must pay for all materials used, pay laborers weekly, have 10 percent of their revenue withheld for retainage, and then wait for payment from the parties at the top of the chain for 30, 45, 60 days or longer. For companies that are not flush with capital, these painful realities of construction payment can be deadly.
2. Tight Capital Access – Lenders Are Scared
It is difficult for a company that is not already flush with cash to navigate a construction payment process that routinely requires companies to float large amounts of cash and then wait around for payment. This is a double-edged sword. Not only can the large capital requirements and messy payment process lead to construction company failure after starting a project, but many companies are unable to get the necessary capital to start work.
Because the construction industry in general, and subcontracting in particular, is such a risky and cash-hungry business, it is difficult to get capital access from traditional banking sources. This is an especially thorny problem and even more true in a recovering and growing economy. Lenders are more gun-shy about construction investments than ever. The result is that construction companies may lack access to affordable capital. When lender funding is obtained, it may be at an exorbitant cost.
3. Scaling Problems – Is The Industry Ready For Growth?
With an increase in the number of projects and number of companies in the industry vying for a piece of the pie, substantial burdens are placed on the infrastructure of not only the construction companies themselves, but also on the municipalities where the construction is taking place.
Many municipal building departments may be unprepared for the increase in construction projects on the horizon. Permitting offices, in particular, may have reduced staff during the last few years, which can lead to bottlenecks. Such a permitting delay can disrupt financial aspects of the project and cause work delays, among other issues. Construction projects are difficult, multifaceted and messy to begin with; added delays and problems that are not the direct fault of the parties on the project itself are never welcome.
More projects mean that more workers are needed. Until the number of available laborers catches up to the number or laborers needed for new construction, companies may have to accept work that may be tricky to accomplish or turn down good business opportunities.
4. Changing Popularity of Project Types
Public-private partnerships (P3s) are rapidly gaining popularity. President Obama recently took steps to expand the market for P3 transportation projects. This national trend means it’s likely construction companies will be encountering many more P3 projects soon.
While the underlying construction tasks performed on a P3 project are the same as those on any other project, the regulations, contractual obligations and legal rights available for protection may be very different. P3 projects are not a new project type; they are generally classified, for the purposes of remaining in a secured position, as “actually” either private or public in nature. If the underlying project is private in nature, the security availability is generally the same as any other private project: mechanics liens. If the underlying project is public in nature, the security availability is generally the same as any other private project: surety bonds.
Just because the underlying nature of the project has been determined does not mean a potential claimant can relax. If a mechanics lien is the appropriate remedy to secure payment, there is a separate question on P3 projects as to what interest the mechanics lien may attach, if any. It’s unfortunate, but in some instances, this project type can leave project participants with no ability to secure their extensions of credit, making the financially turbulent construction industry even more difficult.
5. Don’t Be Blindsided by Unpredictable Problems
These potential problems can be predicted, and to some extent, planned for. The reality is, the construction industry can be drastically affected by outside forces. Within the last few years, exceptionally rough winter weather put some serious brakes on construction projects. Problems of this type, while understood as a possibility, are much harder to predict with any real accuracy. Companies can be strained and stressed by such issues, especially if costs like payroll (or rental or lease agreements) remain fixed while available cash drops with the lack of actual work. These unpredictable problems may not be accurately known ahead of time, but that doesn’t mean they cannot be considered.
The construction industry’s high failure rates and high financial risk do not go away when the construction economy is growing, and in some cases, can even expand in such a scenario. Prudent parties should keep these unique risks in mind, regardless of the current position of their company. By thoughtfully and truthfully analyzing a business’s susceptibility to the five risks outlined above, the company will be better prepared to thrive in the coming year.