By Jase Hamilton and Oliver Craig
This article initially appeared in the ASA Just Briefly Newsletter.
Global, national and local economies are being tested. At this point, it’s safe to say that both businesses and individuals have felt some sort of impact from the inflationary environment, a historically tight labor market, volatile financial markets, supply chain challenges… and the list goes on. Combine that with the current political environment, which could be considered one of the most divided in recent history, and the construction industry may be on the precipice of one of the most challenging economic environments we’ve seen in years.
With all this uncertainty, surety underwriting guidelines have continued to evolve and adapt to market conditions. Some of these changes have resulted in a more rigorous underwriting process, and today more than ever, underwriters are taking a comprehensive approach to their underwriting. This makes it critical that business owners not only understand these evolving expectations, but proactively formulate a plan to meet them to ensure uninterrupted support from their surety.
Supply Chain Delays / Material Price Increase:
Since the onset of the Covid-19 pandemic, business owners have experienced unprecedented delays and price escalation on goods and materials. These same challenges will continue into 2023, with global uncertainty from the continued war effort in Ukraine and further instability in products and goods manufactured in China. To combat these challenges, businesses should look to expand their supplier network, especially for materials and products being sourced outside of the country. Contractors should also evaluate pre-purchasing of commonly used materials to mute the impact of volatile prices, and be more selective on material-intensive projects that will likely have lower margins than experienced in prior years.
The unemployment rate has returned to historically low levels in 2022; however, it still seems contractors cannot hire or retain enough employees to support their growing backlogs. This pattern will continue in 2023 and beyond as the industry works to educate the next generation of workers of the vast amount of career opportunities in construction. “Best-in-class” business owners are not only finding new ways to incentivize employees and/or prospective employees, but also utilizing new technologies to increase efficiencies and ensure production goals can be met.
Infrastructure Investment & Jobs Act (IIJA)
The $1.2 Trillion IIJA was passed in November 2021; however, minimal bid letting for projects funded under IIJA has been seen in the first three quarters 2022. Procurement activity is expected to pick up in Q3 of 2023, and contractors should be focused on retaining working capital within their company now to grow aggregate capacity with their surety and capture increased opportunities.
Rising Rate Environment
Additional rate hikes are expected into 1Q 2023 to combat inflation, meaning the Prime Rate could meet or exceed 8.00%, causing increased lending rates from banks. Businesses should look to reduce balances on variable rate debt immediately, especially credit cards. Owner’s should also consider consolidating variable rate loans into amortizing, fixed-rate loans to not only protect against future rate increases, but provide a boost in working capital. To partially offset increased borrowing costs, companies should evaluate savings or money market account options which in some cases, are now paying two percent or more. It is also important that contractors understand their subcontractors’ exposure to increasing rates, which should be vetted as part of prequalification processes. Lastly, as changing rates continue to cause volatile financial markets, contractors should preserve cash in lieu of riskier alternative investments.
California Air Resource Board (CARB)
The California Air Resources Board’s (CARB) proposed Advanced Clean Fleet regulation aims to require regulated fleets to only purchase zero emission vehicles beginning in 2024, and incrementally convert existing fleets to zero emissions by 2035 (10% per year). Contractor’s should review the proposed regulation, and develop a capital expenditure plan to identify what will need to be replaced, costs, and what kind of financing is needed to ensure the change will not have a major impact to the company’s overhead and project margins. The regulation is being contested by various industry coalitions, so it is important that companies get involved in the conversation to ensure any regulation passed is fair and reasonable.
Increase in Subcontractor & Contract Specific Risks
Enhanced prequalification processes for subcontractors is paramount as economic challenges persist, and contractors should review their internal bonding back policy to help mitigate subcontractor risks. Companies should also be thoughtful in negotiating a contract’s Schedule of Values to ensure adequate project cash flow for general contractors and subcontractors alike. Contract provisions for material escalations, damages and/or shared-savings clauses should be discussed with project partners for all jobs, which will help alleviate potential profit fade down the road.
Continuity, Succession & the Transition of Knowledge
Many owners are approaching retirement, with research indicating nearly five of ten small to mid-size construction firms are expected to have an ownership transition in the next five years. Those who develop and formalize a Continuity & Succession plan early on will be in the best position to transition on preferred terms, keeping in mind it can take five to seven years to fully execute a transition. In addition to the exit strategy, companies should also be evaluating mentorship programs with senior employees and the next generation of workers to position themselves to retain talented key employees after the plan has been executed.
Surety Terms & Conditions
The surety industry experienced notable growth in 2022, with most loss ratios decreasing, some of which can be attributed to early challenges brought on by COVID now dissipating. However, sureties have continued to pay careful attention to growing risk factors, and there was increased claim activity in the second half of 2022. Adequate labor forces continue to be a frequent discussion point as backlogs grow, driven primarily by two factors – inflation/material price increases resulting in larger contracts, and delayed mobilization due to procurement challenges. More stringent surety requirements for projects outside of a company’s existing program limits should be expected throughout the coming year. Contractors should put additional emphasis on their company’s financial management and planning in order to grow balance sheets and maintain and/or grow program capacity.
It is becoming increasingly important that business owners not only evaluate their internal business operations, but also recognize the growing number of external factors that could have a material impact on the business. Most companies put together a “Business Plan” when they first start, but is the economy (and world for that matter) the same as when you started your company? If contractors haven’t already, revisiting and updating their business plan will help a surety and other credit partners develop a better understanding of how evolving risks are being addressed, and provide them comfort maintaining and growing program limits. 2023 will continue to present challenges for construction and the economy as a whole; however, those that have thoroughly evaluated these risks and how to address them will be poised to grow as construction spending is expected to grow at a double-digit pace in 2023.