An Unsteady Outlook: Financing in the Construction Sector

With 2024 well underway, construction and engineering businesses may be primed for growth. But first, businesses and their ownership groups should understand the multitude of factors, on both a macro and micro scale, that lenders weigh when financing companies in the construction sector with heavy, project-based revenue streams. 

From a macro perspective, dark clouds have receded, but the waters remain a bit choppy — the current rate environment is generally regarded as an unfavorable factor for commercial and residential construction. The impact of “higher-for-longer” interest rates is yet to be seen; however, the possibility of such a stance by the Federal Reserve has undoubtedly impacted new building activity and cooled lender interest in the space. 

Amidst declining inflation but mixed economic signals, the Federal Reserve remains unclear about reducing the federal funds rate. The multi-decade high of 5.25% to 5.5% is expected to be the peak rate as the Fed dot plot suggests multiple cuts in 2024. Still, even with a 0.75% to 1.00% rate reduction, the benchmark rate will remain at the highest level since 2007. 

Several questions persist: Has the rate environment stabilized, possibly greenlighting previously postponed projects? How will builders adjust after the initial shock of rapid rate hikes and the prospect of rate cut(s)? Will they make peace with the state of the game and push forward with projects, or remain hesitant? Will a reduced inflationary environment provide operational and/or margin relief?

However, the decision to finance a construction company is backed by more than just broader economic elements. Each job is unique, and it is essential to consider factors such as project/portfolio diversification, new construction exposure, financial performance and surety bonding, among others.

Diversification of Projects & Relative Profitability 

When it comes to underwriting a company in specialty construction and engineering, lenders focus heavily on the relative percentage of the revenue and how well the business is diversified.

Project size often fluctuates significantly, and it is important to consider concentration. If a company produces $100 million in revenue, is that spread over ten jobs or thousands of jobs? Similarly, the relative profitability of each job or contract can vary dramatically, too. A company may have ample diversification from a topline basis, but profit is earned on a select subset of projects. 

Lenders almost always prefer a large number of smaller projects over a project portfolio consisting of a small number of large jobs. Should a construction or engineering company be weighted toward fewer projects (as measured by either sales or earnings), lenders will be increasingly focused on historical margins and bid versus actual to gain comfort with future cash flow.

Evaluating Recurring Revenue

When evaluating a construction company, one of a lender’s first questions centers on the mix of revenue associated with new construction versus maintenance/repair and remodeling (R&R). 

Companies in the specialty construction and engineering space will frequently have recurring revenue from consistent, reliable, ongoing repair and maintenance. Furthermore, R&R exposure is viewed as insulated from macro forces such as interest rates. The magnitude of reoccurring revenue or emphasis on R&R can have a dramatic impact on the ability to obtain financing.

Similar to the relative percentages of projects outlined in the previous section, increased diversification, as well as the ability to project cash flow with a higher degree of certainty as afforded by reoccurring revenue, allows for more leverage and flexibility.

The Pros & Cons of Project Bonding

An integral part of many construction and engineering subsectors, lenders generally regard surety bonds as a necessary evil. In many instances, surety bonds are required by customers, acting as a safety net, ensuring compensation should a contractor back out or go out of business mid-project, leaving the customer with an unfinished product. While bonding does not completely preclude debt financing, it certainly adds complexity.

Different lenders have different perspectives on bonding. Many lenders view surety bonds as debt, especially considering the bonds’ collateralization and priming position in the capital structure. Other lenders view surety bonds as a cost of doing business and are comfortable structuring financings and their loan documents around them. Some take more of a case-by-case posture, requiring a careful examination of the individual surety programs and contracts. Many institutions — both banks and direct lenders alike — will not consider a financing involving surety bonding above a nominal amount. 

Considerations

When a contractor or subcontractor is contemplating the next steps for financing, it is crucial to understand how lenders will evaluate not only these concepts but also other factors, including geography, end markets and local/regional competition. As demonstrated by Configure proprietary data, financing involving new construction and/or meaningful surety bonding achieve 1 to 1.5 times less leverage and price 200 basis points (bps) higher on average. Helping to mitigate this extra cost is highly advantageous. 

In order to obtain attractive financing, companies could take steps to properly position the facts to garner the maximum consideration from lenders and, ultimately, the most optimal financing solution offered by the market.