The ninth annual Construction Lenders Risk Management (CLRM) Roundtable Conference was held last month in Los Angeles. Developers, investors, and lenders from across the country attended the two-day conference to share ideas and learn about current construction industry challenges and solutions. After last year’s digital event, participants enjoyed returning to the in-person format which allowed for an engaging discussion of today’s market with its unique opportunities and risks. Below is a summary of the most significant takeaways from the roundtable.
The economy is expected to grow about 4% this year, even after accounting for interest rate increases and global conflicts. In an overview of the UCLA Anderson Economic Forecast, their Senior Economist, Leo Feler, noted that the economy has already recovered from the brief recession experienced at the beginning of the pandemic, in contrast to the years-long recovery efforts following the great recession. Growth since the recession has been nearly double our normal rate, already overcoming the negative impacts of the downturn and resulting in what the Federal Reserve thinks of as full employment. Increased costs and availability of goods continue to be a challenge but result more from unusually high volumes than manufacturing difficulties. As additional manufacturing or production capacity comes online, inflation is expected to return to a more normal pace and goods should become more available.
Construction lending has outperformed other real estate lending despite uncertainties in the market. According to Justin DeDerea, National Bank Examiner, Office of the Comptroller of the Currency (OCC), construction lending is one of the strongest performing sectors of commercial real estate lending, with record lows in loan charge-offs throughout the system. In part, this could result from the offset of increased costs by increases in demand and property values, but banks have also acted on lessons learned in the last recession in which rapid growth and lack of controls were a direct cause of the failure of about 25% of institutions. Careful monitoring of projects to stay aware of cost increases and delays; management of construction loan concentrations; staying aware of value and absorption; and proactive management of problem loans remain high on the OCCs indicators when evaluating construction lending portfolio risks.
The balance of contracting risk is changing. True guaranteed maximum price contracts are becoming rare. Budgetary allowances and material escalation clauses have become more common as contractors attempt to shift related risks to developers – a shift which has been largely successful as a result of market demand. Cost and delivery have become incredibly difficult to predict, and it is sometimes impossible to obtain a final cost until material is ready to be shipped.
Increased focus and flexibility can help to overcome challenges resulting from increasing costs and delayed delivery of materials. Historically, contractors have been able to order most construction materials with short lead time to arrive at the project just before they are needed. In the current market, though, it has become commonplace to order materials far in advance, sometimes storing materials off site or even at the manufacturer’s warehouse until needed at the project site. Using alternative suppliers or being willing to change specified materials can also be critical to helping projects move forward. In some cases, material may even be purchased before permits have been issued.
Flexibility is important, but so are controls. In a world in which materials may be purchased and stored long before needed at a property, suppliers may require deposits, and cost and availability of goods is unpredictable, it is critical to be aware of and manage risks carefully. Among other things, inspecting materials stored offsite, verifying that ownership of the material is clearly marked, and monitoring the incorporation of stored materials into the project can help offset risks. With increased uncertainties, is also become increasingly important to evaluate the experience and capacity of the general contractor. When there is a significant delay before the start of construction, a reality check of the original pricing and schedule can also be important to make sure projects have not drifted off track.
Tough deals can still get done, but often require innovative risk management and significantly greater attention to detail. The experience and past performance of the developer and contractor are more important than ever. Sometimes a general contractor can get better pricing from subcontractors without a guaranteed maximum price, but it is important to have confidence in the contractor to determine how budget overages will be handled. Increased contingency budgets, completion guarantees, letters of credit, liquidity requirements, and completion insurance like SureBuild can help to mitigate risks.
Refining contracts can also help control risks. Contractors are pushing more risk to developers and owners, but careful attention to contract details can help to minimize the impact. Lisa Glahn, partner and vice chair of the construction practice at Foley and Lardner, noted that some clients have moved away from guaranteed maximum price (GMP) contracts altogether in hopes of lower overall pricing. In GMP contracts, she advises clients to carefully document materials escalation clauses, pricing benchmarks, and to clarify force majeure clauses to make sure there is agreement on what does and does not trigger force majeure. Where uncertainties and cost increases have forced clients to suspend projects, she has also developed protocols for a standstill agreement to ensure projects resume smoothly in the future.
Property resilience and Environmental and Social Governance (ESG) are becoming increasingly important. Along with concerns about increasing sea levels and coastal erosion, the increasing frequency and severity of flooding, hurricanes, and wildfires has caused property owners and investors to take a closer look at how properties may be affected. The Securities and Exchange Commission and OCC have also published draft guidance that may require additional monitoring and reporting of exposure to climate risks, greenhouse gas emissions, and more. There is no standardized method of dealing with these risks at this point, but Tony Liou, President of Partner Energy, has been working with developers, investors, and lenders to design and implement appropriate systems. Hazard models can be useful in identifying risk exposure at a high-level, but the assessment of site-specific risks generally requires on-site observations to evaluate how specific building components are likely to be affected by climate-related hazards. Before construction, an evaluation of plans can help to identify resiliency measures that can be incorporated at minimal cost.
Renewable energy is being incorporated into projects at an unprecedented rate. Rooftop and carport systems account for a majority of commercial real estate installations. Challenges in the construction market extend to renewable energy installations, but the performance of these systems is even more critical to project success since their return-on-investment hinges upon the offset of future energy costs or sale of excess energy. Prior to construction, an independent engineering review helps to assure that the energy output overtime will satisfy the project objective. In some cases, utility companies will even agree to rent roof space to install their own system, which can enhance the cash flow of properties.
CLRM was formed in 2013 to provide a place for construction lenders, developers, and investors to discuss concerns, share best practices, and stay abreast of developments in the industry. In addition to the annual meeting, CLRM hosts periodic calls on developing issues as well as regional meetings in financial hubs around the US. Next year the CLRM annual meeting will be in New Orleans. For more information, or to participate in future calls or regional meetings, click here to explore the CLRM website.