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10 Warning Signs for Construction Lenders that Problems May Be on the Horizon

In the current environment of high demand for labor and materials combined with a high risk of government intervention, construction lenders need to detect warning signs of a borrower’s financial difficulty at the earliest opportunity.

Requiring best practices for reporting, compliance, payment, and other construction functions is the best way to minimize losses. The following situations are red flags warning that something may be amiss.

1. The absence of a clearly defined project scope.

It’s imperative for all parties involved in a construction project—owners, contractors, and subcontractors—to understand and agree to the project scope upfront. Without a clear scope, excessive change orders are inevitable, which will lead to project delays. For many construction projects, delivering both on time and on budget remains a challenge. Delays in execution leave all parties involved subject to potential damages and liability.

2. The owner is not retaining the appropriate holdback amount in accordance with relevant legislation.

Construction liens are intended to protect and provide some financial relief to any person who delivers services or materials to a site. An increasing number of liens on a property are a huge problem for any project and a warning sign to both a lender involved in financing the construction and an owner looking to convey clear title.

Assuming the owner retains the appropriate holdback amount in accordance with the governing legislation or terms of the contract and does not make further advances in the face of liens, their liability to a subcontractor should be limited to the holdback amount.

3. Funds received are not being held in trust for workers and suppliers.

All amounts received by owners, contractors, or subcontractors for the project are subject to a trust for the benefit of persons who supply work or materials to complete the project. If these funds are used for another purpose by any of these parties, or by a financial institution in receipt of advances provided by an owner or contractor, they can be held liable for breach of trust.

Failure to pay may not be an issue for the owner who has retained the appropriate holdback, but rather for the contractor who has failed to pay his subcontractors on a timely basis from funds provided by the owner.

When a lender receives a request for information with respect to advances made or mortgage details from a contractor/subcontractor (a right available to parties in some jurisdictions), this can be a red flag that there may be a problem with parties not getting paid.

4. Payments are not tied to verifiable milestones.

Other than holdback requirements, contractors and subcontractors are entitled to timely payment if they fulfill their contractual obligations and meet project milestones. From the contractor’s perspective, certain early milestones are needed to cover the cash costs of mobilization. From an owner’s perspective, paying out too much too soon can cause a problem at the back end of the project, when the contractor may need to be incentivized for timely completion. 

In some instances, such as when work defects are identified, owners may exercise their right to withhold payment. In times when the industry is under stress because demand for services exceeds the supply of labor or materials, withholding payments can result in contractors or subcontractors stopping work. When work delays put the project behind schedule, there can be significant impacts on the project’s profitability.

5. A failure to check for outstanding litigation against the client.

In addition to lien and trust claims, there may be other matters that could lead to litigation and impact the finances of the borrower or parent providing a guarantee. 

A lender should look carefully at financial statements for signs of any litigation outstanding against a client and ask questions of the senior officers regarding outstanding claims, overdue payables, and other potential liabilities. 

6. The client is not in compliance with government regulations or contract terms.

Failure to adhere to local, provincial/state, or federal government regulations as well as contract terms could seriously impact the timely completion and profitability of a project. 

It’s critical for the contractor to have full knowledge of regulations (environmental, health and safety, etc.) and permit requirements that will affect the project, as failure to comply can result in project delays and, in extreme cases, termination of a project.

An independent engineering review of the status of the project on a regular basis can provide valuable and timely insight.

7. The contractor has not secured sufficient skilled labor for critical path activities.

Increasing construction activity tends to lead to skilled labor shortages, which can result in quality drop-offs, project delays, and increasing costs.

The construction industry has one of the highest employee turnover rates among all industries. Failure to provide sufficient labor for critical path activities is likely a sign that the contractor is having financial difficulties or is in a dispute with its subcontractors. 

Coordination of various activities is important to staying on time and on budget. The loss of workers or failure to provide sufficient labor at a key time creates delays and increasing costs. Thus, lenders should pay particular attention to ensure that the company has an appropriate strategy to manage any labor issues arising from turnover and/or shortages.

A number of cities that recently hosted the Olympics experienced the impact of falling behind schedule. With hard-and-fast deadlines set for the games, organizers had to do whatever was required, no matter the cost, to complete venues, athlete accommodations, and other infrastructure projects.

8. An absence of monthly schedule updates.

Unexplained delays often result from poor scheduling updates.

The contractor should update its critical path schedule monthly to show both progress and delays. If a project delay is not the owner’s fault, contractors often try to conceal the issue by not providing the proper schedule update.

A review of matters discussed at monthly meetings involving consultants and other contractors, as reflected in meeting minutes, is likely to highlight future schedule problems long before they occur.

9. An absence of third-party consultant reports.

It is impossible for a lender to stay on top of all the necessary documentation and compliance during the course of a project. An independent engineering review of the status of the project on a regular basis can provide valuable and timely insight. 

In this regard, it is important to review the third-party consultant’s monthly or quarterly progress reports to gain insight into scheduling delays, cost overruns, and regulatory and contract compliance.

10. A lack of timely and accurate financial information.

When various projects are held within one legal entity, a breakdown of revenues and costs by individual project is essential to identify project winners and losers. 

Inaccurate or inadequate financial records can significantly contribute to project failure. Lenders should be aware of potential unprofitable contracts before further construction loan advances are made. On larger projects, separate legal entities may be set up for each project. Different lenders may finance different projects, and one lender may not know what is happening on other projects. In these situations, it is important to regularly review the parent company’s financial statements in addition to the project financial statements to see if the parent (which provided a guarantee for the loan) is funding another subsidiary that may be in financial distress. 

Watching for Signs

Paying attention to the warning signs that a project is at risk of incurring delays and cost overruns can alleviate some of the stress felt by owners or the capital providers involved in the project.  

Any reference to relevant legislation should not be construed as legal advice. Readers are encouraged to seek their own independent legal advice with respect to compliance with the law in their jurisdictions. The author would like to acknowledge the support and input in preparing this article of his former colleagues at Duff & Phelps.

Brian Pawluck

Brian Pawluck

BKP Advisors

Brian Pawluck is president of BKP Advisors, where he provides turnaround and financial restructuring services to companies, their boards, and creditors. Most recently, he was a managing director at Duff & Phelps and prior to that a partner at PwC LLP. Pawluck has been involved in the real estate and construction sector in a number of capacities and has overseen the completion of condominium projects, pipelines, and mechanical and hospitality projects.

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