The Great Recession ended in 2009. Absent the whipsaw economic data caused by the reaction to COVID-19 in 2020, the United States has not experienced an extended recession in over thirteen years.
Separately, while harder to define, many would say that the surety marketplace has been soft since 2004. Through technological advancements and sound underwriting, surety carriers have experienced a long stretch of consistent profitability. In turn, it has become relatively easy to obtain bonds, especially for smaller and newer contractors.
A Shifting Financial Landscape
The recent bank failures are a reminder that macroeconomic factors can cause localized and individual problems very quickly. The massive infusion of stimulus money doled out by federal and state governments in 2020 and 2021 caused extraordinary inflation, and the Federal Reserve responded by dramatically raising the federal funds effective rate. This increase in rates has caused banks to suffer when forced to liquidate their low-interest rate bond holdings to cover deposit withdrawals.
Further, most commercial real estate loans require refinancing every five to seven years. Bloomberg recently published an analysis by Morgan Stanley that $1.5 trillion of debt is coming due by the end of 2025 (which represents more than half of the total market). If owners can’t pay off this debt or refinance (at a much higher rate), there will be a spike in foreclosures on commercial property.
These foreclosures will force banks to tighten their lending standards and reduce the amount of capital that flows down to contractors.
Implications on the Construction Industry
Conversely, there are significant federal dollars that have been assigned by the Infrastructure Investment and Jobs Act and the poorly named Inflation Reduction Act. The projects and money associated with these Acts have just begun to be released and the trades that operate in civil sectors will surely benefit.
So, what happens next? If the private, commercial construction sector suddenly contracts, construction firms will look to win jobs in the public sector. This will create more competition and reduced margins, and you will find desperate business owners becoming “creative” by expanding their geographic reach, scope of operations, and project type.
These increased risk factors may then correlate with banks reducing lending capacity for equipment, lines of credit, and term loans. This will only make it harder to run a successful construction company. I am finding that surety carriers (and savvy general contractors) are recognizing these concerns and are looking to insulate themselves from future losses with tighter underwriting requirements.
The Opportunity for General Contractors
So how do we cope? The good news is that firms with established bonding programs have already taken many of the steps necessary to ensure they can weather a downturn and maintain access to surety credit. This includes obtaining CPA-prepared financial statements on an annual basis, establishing a bank line of credit, and refining internal controls to manage cash flow and ward off problems before they become catastrophic.
Regardless of the sophistication of the contractor, I believe there should also be a focus on the “nuts and bolts” of surety underwriting.
- Personal credit scores of the owners should be top of mind, and corporate credit scores from Experian and Dun and Bradstreet should not be an afterthought.
- Maintain a strong cash balance but pay your suppliers on time. Be conservative in selecting projects with the highest profit margin (which are not always the largest projects).
- Spend time with your trusted business advisors (CPA, banker, attorney, and surety agent and underwriter). These advisors will be able to show you areas where you can improve your operations and lower your risk.
The contractors and developers that survive this next downturn will be able to capture more market share and profits during the next upswing, and will be wiser for it.