Reducing Construction Risk from Cost and Supply Chain Issues

It’s true. All we hear about today is about the record high materials price increases. With the U.S economy ramping up, the demand for materials such as steel and lumber has quickly outpaced its supply. Now let’s add to that the tariffs placed on the imports of products like steel that are eliminating the ability to be competitive. It’s no secret construction costs for projects will be going up if materials orders haven’t been secured.

Unfortunately, that isn’t where the construction risk ends. A domino effect from having too little supply has resulted in an extraordinary supply chain event for contractors and vendors alike. Not only are the materials more costly, but the lead times for both the fabrication and delivery have become severely impacted. Construction projects are now at high risk of going both over budget and beyond schedule, and this is not expected to be resolved over the next few months, but will last at least for the balance of the contracts in progress and those being entered into now.

So, what can you do? It’s really all about doing your due diligence: being very thorough and hyper aware of the all elements of your project and the current economic climate. Below you will find some suggestions on how to do this during both the pre-closing and post-closing of construction loans.

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PRE-CLOSING OF CONSTRUCTION LOANS

Document and Cost Reviews. A thorough third-party review of all project documents is crucial, especially the review of the construction contracts including the attached assumptions and clarifications. Lenders and investors need to understand the basis of the construction contract and not assume that they are okay just because it is already signed. Paying particular attention to the following items 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 really secured by subcontractor buyouts. How locked in are the numbers if at all?
• Allowances and Benchmarking. It is important to look for contract allowances, and review and get clarifications as to how those allowances were developed. Contractors are adding allowances for items such as lumber and steel, or, setting benchmarks for potential increases or decreases at the time of materials purchase. This makes it so that developers (rather than contractors) become responsible for any change in actual costs that are over the benchmark pricing used as well as any costs over the allowance. Prior to COVID, allowances and benchmarks were not used to the extent they are now and are potentially costly risks to be aware of. All parties should collectively decide if the allowances and benchmarks for these items are okay and understood.
• Deposits, Pre-Purchasing, and Off-Site Materials. To secure costs and guarantee materials can be delivered on time, contractors are increasingly relying on deposits, the pre-purchasing of materials, and off-site stored material payments. It is important to discuss these strategies and their timing prior to closing the loan, as careful planning is required. The developer and lender should understand the risks and requirements of pre-payments for materials, which include risk of theft, the cost of storage and security, as well as concerns for design changes relative to material selections. In addition, in the event of contractor default, deposits may not be recoverable.
• Bid Shelf Lives. It is becoming necessary to move more quickly when making decisions with suppliers, as many have shortened their price guarantee window due to fear of price movement and market fluctuation; this can be a significant problem for contractors and their project’s estimated cost. Will trade bids be held at both the time of contract negotiation and eventual construction commencement?
• Contract Notices to Proceed. Does the contractor’s anticipated contract have an assumption to start by a certain date? Are the developer and lender aware of these assumptions of the notice to proceed? There may be ramifications of cost and time if they are not understood. In fact, it can affect both labor and material availability as well.

Contractor Evaluations. Now more than ever, any investor or lender looking to build and finance a project really needs to dive deep into evaluating the contractor, the contractor’s team, and the developer to fully qualify them. It goes beyond just looking at the contractor’s qualifications and prior experience. A thorough third-party underwriting job must be done to vet the contractor. A diligent review of the contractor, with special attention to the following items, is critical:

• Quality and Finances. What is the quality of the contractor and what is their financial ability to secure the project? Contractors with a good balance can support most issues that may arise.
• Labor and Supply Chain. It is important to learn more about their subcontractors and resources. How do they look at the project in terms of labor scarcity and supply issues? How are they mitigating supply chain issues and securing the materials and labor?
• Risk Management. What risk mitigation tools are they using in the event of subcontractor / contractor defaults? Are they using performance and payment bonds, or do they have a subcontractor default insurance program?

POST-CLOSING OF CONSTRUCTION LOANS

Communication. First and foremost, prior to and during construction commencement there should a high level of open and honest communication between all parties (lenders, developers, contractors, and third-party consultants). Early identification of problems allows the entire team to work to resolve the problems before they become more difficult to solve.

Construction Progress Monitoring. Regular updates on the progress of any construction project is important. However, the current climate of cost and supply chain issues necessitates even more thorough third-party reporting. Knowing the project’s conformance to the schedule, assessing the material and workmanship adequacy, verifying the appropriateness of the contractor’s pay application, and identifying construction changes (even potential or pending change orders) are the bare minimums of a good status report. Consultants need to be vigilant and keep in regular communication, with special regard to the following items:

• Materials and Supplies. Regularly verifying and questioning whether the materials have been awarded and/or manufactured. Monthly discussions of supply issues should be conducted, as delays of these items can not only create substantial cost overruns but can also hold up your Certificate of Occupancy.
• Delays and Labor. Reviewing items such as anticipated delays and/or subcontractor buyout statuses is essential. Missed buyout targets can affect labor availability, which may further delay the project. Assuring delays and buyouts are addressed and taken care of will be important to make sure the project can be completed as on time and on budget as possible.
• Construction Costs. If there are no material allowances or construction cost increase clauses, are the contractors eating the overruns? Contractors may already be reducing their margins to maintain a workload, but you should not want your contractor to fail because of extraordinary circumstances. A project priced last year and now re-starting will have higher costs and consume the project’s contingencies. Developers may want to consider authorizing payment adjustments or change orders for increased materials and supply chain costs to avoid contractor or subcontractor failure.

Funds Control / Funds Disbursement. Although typically done in conjunction with construction progress monitoring, funds control is an excellent tool to prevent mismanagement of project funds. It assures that funds are being approved according to actual work completed, that errors or discrepancies in payment requests are caught, that lien waivers are collected, and that change orders are being tracked. Most importantly, it ensures that funds are being given to the appropriate parties and not being diverted to other financially stressed projects the contractor may be working on. Since projects now may require a high level of up-front deposits and pre-payments, risk is elevated for lenders and investors, which warrants a careful review of project accounting.

Substitute Materials. Contractors should keep in communication with vendors about system warranties that require the use of their branded parts. Due to uncertainty of product availability, some manufacturers are allowing other manufacturers to provide parts like fasteners to complete a system while still honoring their warranty. Any substitutions should be reviewed by the designers of record to confirm conformance with the original design and required warranties.

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Although today’s contractors are expected to fully understand the challenges of the market, many practices and processes are now being done differently than they were a year ago. There will always be some degree of resource and supply chain issues, but investors, lenders, and contractors alike are having to reevaluate how they look at risk. Diligent risk management practices, clear communication among all parties, and a thorough understanding of all aspects of a construction project are necessary to mitigate the increased risks of today’s economic climate and its impacts over the full term of construction projects.