The construction industry is one of the most volatile and failure-prone.
With razor-thin margins and a complex and cash-hungry payment structure, construction companies can be among the first to feel the effects of economic uncertainty, or poorly made bets in an economically volatile market.
This is especially important to note and pay specific attention to in the current climate. With market uncertainty following the recent election, construction companies should be on the lookout for potential pitfalls and protect themselves from any fluctuations (good or bad) in the construction market.
While everybody knows that businesses fail during poor economic times, historically construction industry participants are three times more likely to fail during an economic recovery than they are during an economic downturn. This means that if campaign promises of huge infrastructure projects materialize, the participating construction industry participants better cross their “Ts” when it comes to securing extensions of credit.
In that vein, it’s important for construction industry companies to be aware of the risks associated with both robust and faltering economic realities, and plan carefully to protect themselves in either scenario. That’s fine to say, but how can it be put into practice?
- Don’t bite off more than you can chew. Whether this means business in a good economy, or risky debt in a bad one, it pays to be careful.
- Understand that customers are navigating the same risks, so make smart credit decisions underscored by that knowledge.
- Protect and perfect mechanics lien rights and promote visibility and fair play.
Respect the Risks
Construction companies face financial risks in any economic climate; believe it or not, the risks are very similar whether the economy is good or bad. At least part of this stems from the fact that the construction payment structure is cash hungry and convoluted no matter what else is going on. Floating cash while waiting for payment can be a problem both because a company over-extending itself is dangerous, or because waiting for payment from a party that is struggling to pay is hard to do.
Research has shown that construction companies are more likely to fail in a recovering/growth economy than they are in a stagnant/downturn one. However, this does not mean that sluggish economies are good for the construction business. Less construction isn’t good, either. Companies should note the following, and take steps to avoid related issues.
- Wary credit markets mean less access to cash.
- Due to the interconnected nature of construction and construction payment, one failure on the project can have a domino effect of triggering other defaults both up and down the contracting chain.
- Both over-extended growth and other parties’ failures can lead to significant costs.
Use Security Built Into the Law to Smooth Volatility and Uncertainty
Mechanics liens (the remedy primarily available for private projects) and bond claims (the remedy primarily available for public projects) are built into the law of every state to provide security to construction industry participants. This security can be used to smooth the potential variances from a volatile economic climate, and assure payment on every project. Despite each having a different overlay of requirements and a different underlying security, both are involuntary security interests provided to parties in the construction industry to provide protection from the risk of nonpayment. If parties improve real property, they are granted security rights by statute. This is powerful payment protection.
A security interest is basically a right to an asset that may be claimed in the event of nonpayment. It’s collateral. This means that whatever is bound by the security interest may be claimed and/or sold to satisfy the debt. In private construction projects, the improved property itself (and for public projects the bond) is the collateral for payment of the amounts due. If the necessary required steps are followed, a construction industry participant can make a claim against the collateral to get paid.
Secured debt is much more likely to get paid than unsecured debt. Nobody wants to have his or her property burdened or encumbered by somebody else having the ability to take it. Because true secured debt is rarely ever avoidable by the indebted party, its use can virtually guarantee timely payment. And, timely payment means no more suffering at the whim of volatile and uncertain economic times. A little more security is probably a good thing, no matter the economic climate.