Construction Lenders Get Creative To Fund Projects, Reduce Risk During The Labor Shortage

Rising construction costs and competition for high-quality labor have shifted how borrowers and lenders finance projects. While construction firms are focusing on retention and improved job safety, financiers and borrowers are shifting their efforts to accommodate the rising construction costs and to lock in quality labor.

Construction costs continue to rise each year. On an annual basis, labor costs are increasing by 1.9% to 2.9% while bulk materials are increasing by 4.7% to 5.7% annually, according to Compass International.

The Turner Building Cost Index, which considers labor rates and productivity, material prices and competitive conditions, has steadily risen over the last four years. Though construction starts are expected to slow, the damage may already be done. This year alone 404,000 apartment units are expected to deliver, up 61,000 units compared to 2016. 

The pace of construction starts has caused subcontractors to be more cautious and selective in their bids, which has led to an increase in prices, according to Turner Construction Co. Vice President Attilio Rivetti. 

The active hurricane season also is not helping matters.

“Each hurricane that comes through makes the labor shortage more and more dire,” Trimont Real Estate Advisors Managing Director Thomas Wise said. “To offset the labor shortage [contractors] are doing more with less.”

The industry is already doing more work with prefabricated panels that require fewer workers on-site. 

Wise said the labor shortage has more to do with a lack of high-skilled labor than the actual number of workers. Many highly skilled workers left the industry during the recession. When new contractors came into the industry during the economic recovery, these skilled workers did not come back, leaving a gap in the skill level.

“In terms of actual people doing the work, there isn’t an actual shortage,” he said. “There is a difference in quality.”

Those with technical skills know they are sought after and will charge more for their services. With so much competition for labor, contractors are picking jobs that can pay more regularly, but lenders do not always provide funding that fits pay schedules, according to Wise. Instead borrowers are setting up capital accounts that can allow payment every two weeks.

A Shift In Construction Financing

Major investment banks also re-entered the industry following the recession, but have become more cautious with how much construction lending they have on their books. This has led to a rise in private equity funding, debt opportunity funds and foreign capital, according to Wise.

Private equity has been particularly interested in the market because it is chasing yields that it cannot get in the stock market. These alternative capital markets are becoming more mainstream, but the capital is not as experienced as in the past. This has led to a rise in demand from third-party consultants and servicers, such as Trimont, to evaluate risks related to a project.

Trimont currently manages over $25B in construction related client-committed capital, including projects with budgets as large as $3.5B and as small as less than $1M, according to Wise. The firm has worked on projects in several metros, including New York City, Atlanta and San Francisco, and has offices in Atlanta, Seal Beach, Dallas and in the Netherlands and London.

Reducing Financial Risks

To minimize potential financial risks, lenders now require a certain percentage of the contracts to be executed, meaning subcontractors have signed an agreement for a specific price, before lenders will commit funding to a project, Wise said.

This works well for a foundation subcontractor who will likely lay foundation within the next month or two, but adds additional risk to a drywall subcontractor or other subcontractors who may provide work further along in the project's timeline, Wise said. It can also cause problems with trying to secure subcontractors. If they feel like they will lose money on a job, they will not take it.

Lenders also require performance bonds or subcontractor insurance, which provides additional financial security. A performance bond provides a bond from a bank or an insurance company that guarantees that a job will be fulfilled by a contractor while specialized insurance, such as Subguard by Zurich American Insurance Co., protects general contractors from financial and reputation risks.

To better estimate the costs of a job, technology is being used by subcontractors, but the industry has a long way to go.

“I still don’t think the construction industry made advances in productivity as much as other industries around the world,” Wise said.