Reduce construction risks related to cost and supply chain issues
That is true. All we hear about today is the record rise in material prices. With the rise of the US economy, the demand for materials such as steel and lumber quickly outstripped its supply. Now add to that the tariffs imposed on imports of products like steel which eliminate the ability to be competitive. It’s no secret that the construction costs of projects will increase if orders for materials have not been secured.
Unfortunately, this is not where the risk of construction ends. A domino effect of having too little supply has resulted in an extraordinary supply chain event for contractors and suppliers. Not only are the materials more expensive, but manufacturing and delivery times have been severely affected. Construction projects are now at high risk of going over both budget and schedule, and this is not expected to be resolved in the next few months, but will last for at least the rest of the ongoing contracts and those in the pipeline.
So what can you do It’s really about doing due diligence: being very thorough and hyper aware of all the elements of your project and the current economic climate. Below are some suggestions on how to go about pre-closing and post-closing construction loans.
PRE-CLOSURE OF CONSTRUCTION LOANS
Document and cost reviews. A thorough third party review of all project documents is crucial, especially the review of construction contracts, including any assumptions and clarifications attached. Lenders and investors should understand the basics of the construction contract and not assume that they are in agreement just because it is already signed. Paying special attention to the following can help mitigate risk:
- Contract amount. Understand the basis of the contract amount, how the amount was determined and how much of the contract value is actually guaranteed by buyouts from subcontractors. How locked are the numbers, if at all?
- Allocations and benchmarking. It is important to research contractual allocations, review and obtain clarification on how these allocations were developed. Contractors add allowances for items such as lumber and steel, or set benchmarks for potential increases or decreases when purchasing materials. This makes developers (rather than contractors) responsible for any changes in actual costs that exceed the benchmark price used as well as any costs above the allocation. Before COVID, allowances and referrals were not used as they are now and are potentially costly risks to consider. All parties should collectively decide whether the allowances and benchmarks for these elements are acceptable and understood.
- Deposits, pre-purchase and off-site equipment. To secure costs and ensure materials can be delivered on time, contractors increasingly rely on deposits, pre-purchase of materials, and payments for materials stored off-site. It is important to discuss these strategies and their timing before entering into the loan, as careful planning is required. The developer and lender should understand the risks and requirements of prepayments for materials, which include the risk of theft, the cost of storage and security, and concerns about design changes relating to material selections. In addition, in the event of default by the contractor, down payments may not be recoverable.
- Auction shelf life. It becomes necessary to act more quickly when making decisions with suppliers, as many have shortened their price guarantee window due to fear of price movement and market fluctuations; this can be a significant problem for entrepreneurs and the estimated cost of their project. Will commercial offers take place at the time of contract negotiation and the eventual start of construction?
- Notice of contract to continue. Does the contractor’s planned contract assume that it begins on a certain date? Are the promoter and lender aware of these assumptions in the notice of lawsuit? There can be cost and time ramifications if not understood. In fact, it can affect both labor and material availability.
Entrepreneur assessments. Now more than ever, any investor or lender looking to build and finance a project really needs to delve into the assessment of the contractor, contractor team, and developer to fully qualify them. This goes beyond examining the qualifications and previous experience of the entrepreneur. Extensive third-party underwriting work should be done to verify the contractor. Due diligence of the contractor, with particular attention to the following, is essential:
- Quality and Finances. What is the quality of the entrepreneur and what is his financial capacity to secure the project? Entrepreneurs with a good balance can handle most of the problems that can arise.
- Labor and supply chain. It is important to know more about their subcontractors and their resources. How do they see the project in terms of labor shortages and supply issues? How do they alleviate supply chain issues and secure materials and labor?
- Risk management. What risk mitigation tools do they use in the event of subcontractor / contractor failure? Do they use performance and payment guarantees, or do they have a subcontractor default insurance program?
AFTER CONSTRUCTION LOANS CLOSED
Communication. First of all, before and during the start of construction, there must be a high level of open and honest communication between all parties (lenders, developers, contractors and third party consultants). Identifying issues early allows the entire team to work to resolve issues before they become more difficult to resolve.
Construction progress monitoring. Regular updates on the progress of any construction project are important. However, the current climate of cost and supply chain issues requires even more in-depth third-party reporting. Know the project’s compliance with the schedule, assess the suitability of materials and labor, verify the suitability of the contractor’s payroll request and identify construction changes (even potential change orders or in progress). expectation) are the bare minimum of a good progress report. Consultants must be vigilant and maintain regular communication, in particular on the following points:
- Materials and supplies. Check and question regularly whether materials have been assigned and / or fabricated. Monthly discussions of supply issues should be conducted, as delays in these items can not only create substantial cost overruns, but can also delay your certificate of occupancy.
- Delays and labor. It is essential to examine items such as anticipated delays and / or subcontractor buyout statuses. Missed buyout targets can affect labor availability, which can further delay the project. It will be important to ensure that delays and buybacks are addressed and taken care of to ensure that the project can be completed on time and within possible budget.
- Construction costs. If there are no material allowances or construction cost increase clauses, do contractors consume the overruns? Entrepreneurs may already be squeezing their margins to maintain a workload, but you shouldn’t want your entrepreneur to fail due to extraordinary circumstances. A project priced last year and now restarting will have higher costs and consume project contingencies. Developers may want to consider allowing payment adjustments or changing orders for increased materials and supply chain costs to avoid contractor or subcontractor failure.
Control of funds / Disbursement of funds. Although it is usually done in conjunction with monitoring construction progress, monitoring funds is an excellent tool to avoid mismanagement of project funds. It ensures that funds are approved based on the work actually performed, that errors or discrepancies in payment requests are detected, privilege waivers are collected, and change orders are followed. More importantly, this ensures that funds are flowed to the appropriate parties and are not diverted to other financially difficult projects that the entrepreneur can work on. Since projects may now require a high level of initial deposits and prepayments, the risk is high for lenders and investors, warranting careful consideration of the project’s accounts.
Replacement materials. Contractors should keep in touch with suppliers about system warranties that require the use of their branded parts. Due to the uncertainty of product availability, some manufacturers allow other manufacturers to supply parts such as fasteners to complete a system while still meeting their warranty. Any substitutions should be reviewed by the official designers to confirm compliance with the original design and required warranties.
While today’s entrepreneurs are expected to fully understand the challenges of the marketplace, many practices and processes are now executed differently from a year ago. There will always be resource and supply chain issues, but investors, lenders and entrepreneurs need to reassess their perception of risk. Diligent risk management practices, clear communication between all parties, and a thorough understanding of all aspects of a construction project are required to mitigate the increased risks of the current economic climate and its impacts over the life of construction projects. construction.