Navigating Construction Contingency in 2024

Navigating Construction Contingency in 2024

By Kyle Gustafson, National Client Manager, Partner Engineering and Science, Inc.; and Kendra Vincenty, Senior Vice President; Chief Credit Officer, SVP, First Bank of the Lake

Originally Published in the 2024 CLRM Journal

As we embark on the journey through 2024, there is a collective hope for a return to more predictable times. The past three years have been marked by unprecedented challenges globally, especially in the construction industry. The ramifications of the pandemic, supply shortages, escalating costs, shortages of skilled labor, high interest rates, and rising inflation have been significant. Looking ahead, the goal is for economic stabilization and a flourishing construction market across all sectors—public, private, residential, and commercial. A robust construction market is indispensable for fostering a resilient economy, where the demand for new houses, buildings, and infrastructure fuels ongoing economic growth in our communities?

Challenges and Impact of Increased Contingencies

In response to the tumultuous recent times, many financial institutions, particularly banks and credit unions, have implemented policies requiring increased contingency. Some lenders have insisted on contingency amounts surpassing the previous standard of six to ten percent and reaching levels exceeding twenty to thirty percent. One lender notably raised their contingency to thirty percent on all ground-up construction loans exceeding a million dollars. While the increase in contingency percentages in recent times aims at guarding against cost overruns, supply shortages, change orders, and delays in construction delivery, it’s essential to assess whether this approach aligns with the best interests of borrowers. Some banks have adopted a broad-brush approach, which may not serve the specific needs of individual projects. This article seeks to pinpoint significant factors indicating when contingency adjustments are warranted and advocates for best practices to prevent overbuilding budgets or overburdening borrower contingencies.

Before delving into the subject, it is essential to define contingency in the context of a construction budget. On a construction project, a borrower’s contingency is an earmarked sum in the project budget designed to cover unforeseen events or circumstances that may arise during construction that may lead to additional costs or changes in the project scope. The purpose of contingency is to offer a financial cushion to address unexpected challenges without significantly derailing the project timeline or budget. It’s worth noting that contractors may also have a contingency amount; however, contractor contingencies are intended to address issues such as pricing shocks and are not accessible to borrowers.

Impact of Contingency Adjustments on Borrowers

Let’s consider an SBA 7A loan for a real estate purchase and ground-up construction of a retail franchise. Lending institutions often require a minimum equity or project infusion, with rates typically variable based on WSJ Prime plus a spread, with a term and amortization of 25 years. This example highlights the importance and consequences of adjusting contingency levels. Increasing contingencies directly affects the financial dynamics of the project, leading to potential increases in both the project and the required equity infusions by the bank to accommodate the heightened contingencies. As a result, not only are down payment amount and loan amount affected, but potential increases in debt service or income required to maintain a Debt Service Coverage Ratio (DSCR) of 1.25 percent become evident. This ratio is a common condition in loan covenants for small businesses, emphasizing the need to maintain a specific DSCR of $1.25 of income for each dollar of debt service. Notably, a lender could credit any surplus contingency back to a loan upon completion and re-amortize the loan, changing the payment down to a more tolerable level.

As highlighted by the example above, an increase in contingency can add financial strain to the borrower despite being intended to safeguard borrowers. This heightened contingency necessitates a larger down payment and increased cash flow to support the elevated debt levels. Within industry norms, equity injections—such as down payments— are commonly utilized to ensure borrowers have a vested interest (aka ‘skin in the game’) in the success of their projects. For the purpose of this discussion, we’ll use a 10% equity injection. However, it’s important to recognize that lending institutions may adopt varied approaches, particularly with the SBA moving away from mandating specific equity contributions.

Increased contingencies can add significant financial stress on a business, especially for those looking to establish a new location or even their first location. Delays in completing a project or obtaining necessary certificates of occupancy—whether complete or temporary, depending on the region—can cause seasonal businesses to miss their intended opening dates, resulting in a loss of revenue during prime operating seasons. This not only prompts a reconsideration of credit, but also has adverse effects on financial projections and stability, stressing small and large businesses alike. Moreover, if construction costs increase, it may disrupt the valuation method, causing discrepancies with market values. Compounding these challenges are factors such as interest-only periods or discrepancies in internal rate of return (IRR) calculations based on previous projections, which can lead to working capital being out of sync with the time required to ramp up the business. These issues can present both short-term and long-term problems, leaving businesses highly vulnerable during construction. A domino effect can occur if too many vital aspects of construction such as costs, construction schedules, critical systems, FFE, permitting, and materials are delayed or interrupted. Borrowers have faced all these challenges since the onset of the COVID-19 pandemic in January 2020. Adding to the complexity, increasing interest rates have intensified the pressure on these loans, potentially leading to early defaults and specialty servicing actions.

Despite the somber picture painted, construction conditions are showing signs of improvement in 2024. Optimistic lenders have been discussing lowering contingency on their construction loans as more projects are finishing almost or on budget, on time, and with fewer delays.

Recommendations for Effective Risk Management

The challenge then arises: How do lenders determine whether, or on which loans, they should lower contingency in 2024? Lenders who opt for a simplistic approach may set a fixed twenty or thirty percent contingency for all construction loans. However, given the fluid nature of contingencies at present, we recommend a data-driven approach. Using construction data to forecast labor or material delays and analyze market factors—such as construction trends, concentration, and demand in specific markets—helps lenders determine the likelihood of cost overruns or schedule delays. This often assists in predicting whether a contingency can be adjusted to mitigate cost overruns and determine additional contingency amounts for a city or region. Using this innovative approach to set contingency requirements appropriately allows lenders to stand out as borrower-friendly while still minimizing their risk exposure.

Experienced SBA lenders are familiar with the persistent challenges of construction loans due to the gradual disbursement of funds as work progresses. As mentioned earlier, construction delays can lead to missed preferred start dates for businesses. This start date, however, often forms the basis of projections in the proforma, and any delay may result in a shortfall of working capital, especially for seasonal businesses reliant on timely revenue generation to carry them through to the next season. It’s crucial to anticipate potential cost overruns to determine when the business can begin generating revenue. Delayed revenues may necessitate working capital support, making it paramount for businesses to manage these timing delays effectively for success in their marketplace.

It’s important to reiterate that one of the most important aspects of a prudent lender is to meticulously memorialize the construction loan file as the project progresses. This documentation ensures that discussions related to any unforeseen anomalies and decisions made to support the business are clearly recorded for future reference. Providing borrowers with a voice in their project’s progression is essential, especially as we continue to define aspects such as the projected opening of the business, marketing strategies leading up to revenue generation, and more. The borrower is the best guide on alterations of the project timeline or shifts in how it is managed. Their contributions to this discussion are crucial to ensuring that the project remains on track and that revenue projections continue to support the project’s underwriting. Enabling readers to later identify, understand, and follow the trail of events is paramount for loan servicing, liquidation, and in the event that an SBA guaranty is called upon.

Strategies for Construction Cost and Risk Management

This prompts the question: What does the construction cost data say or forecast for 2024? Particularly, based on the earlier discussion, how should lenders protect their borrowers from construction costs and unforeseen events in 2024? During an interview we had with Lawrence P. Spaulding, Jr. an expert and seasoned professional at Partner Engineering and Science, Inc., he shared valuable insights on the topic. With over twenty-seven years of experience in construction risk management, reviewing and evaluating construction costs for large premier properties across diverse global real estate markets, Mr. Spaulding challenged the traditional one-size-fits-all or simplistic approaches adopted by some lenders. When discussing the increase in contingency percentages, he questioned the rationale behind charging twenty to thirty percent contingency. He recommended that construction lenders assess project risks and understand the scope of each project individually, utilizing preconstruction due diligence and conducting a detailed evaluation of a project based on its own merits. This includes examining the contractor’s qualifications—their experience, credit history, and track record of completing projects on time and on budget. Furthermore, the contract plays a critical role in determining allowances and sound subcontractor bids, while avoiding contracts laden with allowances, general bids, and incomplete subcontractor and supplier bids, which could lead to significant cost overruns.

In Mr. Spaulding’s recommended approach, construction lenders should review each project on an individual basis, starting with an assessment of the contractor’s qualifications and scrutinizing the contract for detailed plans, budgets, and allowances. By understanding the project’s scope and assessing risk on a case-by-case basis, lenders can make more informed decisions regarding contingency amounts. This perspective challenges the notion of a broad-brush approach, cautioning that raising contingency may be causing or overlooking more problems than it solves. He likened these generalized practices to having a boat with plenty of life preservers, but the vessel’s hull is full of holes. While those life preservers are great in the event of a problem, it is better to start with a sturdy boat and sound hull, minimizing the need to use them. A lot of great tips were offered, which have been summarized into the below 2024 top ten construction recommendations list.

1. Develop the project thoroughly on paper and fully document all disciplines before proceeding to the construction phase.
2. Check permitting, ALTA surveys, zoning reports, and geotechnical reports prior to closing.
3. Review the scope of the project, including hard costs, plans, contract, and construction schedule.
4. Review the amount of soft costs (architect fees, permitting, tap fees, cash injection).
5. Ensure the hard cost budget, construction schedule, and contract documents reconcile regarding project scope.
6. Scrutinize allowances as they represent the risk of change orders and the most significant risk to contingency.
7. Review the Contractor’s qualifications (experience, credit, references, subs, and suppliers).
8. Identify where the risk or potential issues exist in the project—pinpoint critical areas to build the box.
9. Track change orders, cost overruns, each draw, and verify them with a construction progress assessment as construction commences.
10. Identify long lead materials that may cause delays or cost overruns, such as electrical switch gearbox, generators, HVAC, roofing, concrete, windows, and any specialty products.

Construction contingency serves a vital purpose in safeguarding borrowers from market fluctuations during their construction lending period. As markets begin to recover from the COVID-19 pandemic, along with the challenges posed by rising inflation and interest rates, informed decisions regarding construction contingency become paramount. By leveraging data, best practices, and insights provided in this article, lenders can set appropriate contingency levels tailored to the specific risks of each project, thereby alleviating unnecessary stress on borrowers. Effective risk management remains essential in both favorable and challenging times. For those overseeing multiple construction projects or facing with staffing shortages, consider outsourcing preconstruction services, pay application verification, and construction assessments to reputable third-party construction risk mitigation firms. Trusted partnerships can alleviate the burden, offering valuable expertise and support in navigating the complexities of construction projects.

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[1] Borrower Injection calculated as 10% of Loan Amount

[2] P&I calculated using SBA’s 7A Loan Calculator. https://www.sba7a.loans/sba-7a-loan-calculator-amortization-schedule/