Constructing Opportunity for Asset Based Lenders
Assessing opportunities and risks for asset-based lenders serving the construction and building materials industry
Date April 2018
By Jim Burke, Director, Commercial & Industrial; Blair Nelson, Managing Director, Corporate Development; Alex Sutton, Managing Director, Industrial Valuation; and Rick Wilichowski, Managing Director, Machinery & Equipment Valuations.
The past eight years have seen significant growth in the construction industry. However, that growth story consists of winners and losers across sectors and asset types. Construction loans currently represent only a small fraction of asset-based lending activity, about 1-2 percent. This disconnect between strong industry performance, the asset intensiveness of construction, and the small penetration of asset-based lending to the industry represents untapped value for investors. But capitalizing on that opportunity requires careful consideration of the sources of value, positive and negative.
Understanding the optimal timing for liquidation, the costs required to do so, and other factors that impact performance and recovery values will ensure lenders can succeed. Major drivers of construction asset values include overall market activity; trends within subsectors supported by construction; seasonality; asset specificity; equipment manufacturer preferences; commodity cost exposure; liquidation costs, and the viability of other soft assets that complement hard assets, such as rental streams.
The construction industry is currently in mid-cycle expansion with steady activity at current levels expected in most regions. Since reaching a cyclical low in 2010, the construction industry has enjoyed a steady increase in the value of construction put in place, a measure of construction industry output. Total construction spending in 2017 as reported by U.S Census Bureau was up 53 percent from 2010 levels. Over this period, many construction companies and their lenders have seen positive returns. Based on current industry forecasts, this performance trend will likely continue.
The Architectural Billings Index ("ABI"), a leading indicator of expected activity based on a survey of architects, remains at elevated levels for the coming year. Architects of all specializations (commercial, institutional, and residential) have reported an increase in both billings and design contracts, as well as increasing levels of inquiries. On a regional basis, business conditions are strong across the U.S., with the exception of the Northeast where the outlook dropped through the last quarter of 2017.
Another indication of industry stability and growth is the increase in construction pricing as indicated by the Turner Building Cost Index. The cost index records U.S. non-residential building construction costs. Since 2010 the index has increased 32 percent, reflecting steady growth in construction material and labor inputs.
While these leading indicators point to continued near-term growth, lenders need to consider the potential for a downturn and what this would mean for the underlying collateral.
Lenders also need to have a good understanding of the key drivers of their clients’ activity and what sector exposure they might have. Even with increasing construction activity, there can be areas of strength and weakness based on sector variations. Residential construction, having reached historic lows through the recession, has performed well through this cycle with activity levels up over 100 percent. Nonresidential construction growth has been more subdued, representing total growth of 27 percent since 2010.
Within nonresidential, sectors such as office, lodging, manufacturing, power, communication, amusement, and recreation have overperformed, while other sectors such as education, healthcare, and water infrastructure have underperformed. As a result, construction companies serving the lodging or power sectors may have experienced growth over this period, while those serving the education sector may have struggled. Some mitigating factors include having long-term service contracts and orders booked through the targeted loan period.
As in any asset-based loan, understanding collateral dynamics is critical. Unsurprisingly, building products and construction is a very seasonal business; April through October is typically the high selling period during which time as much as 70 to 80 percent of sales may occur. However, variations in weather can shift this timeframe from year to year, which is why a high-low analysis is always recommended as part of the appraisal scope. Depending on the asset type, values can swing by as much as 5 to 15 points between seasons.
A longer construction season in warmer parts of the country creates more stable demand in those regions. Elsewhere, demand is seasonal with major purchasing of equipment happening in late winter and early spring, after builders have contracts lined up. Because of these fluctuations in the asset base, lenders may consider a more conservative advance rate on assets located in the Midwest or Northeast where seasonality is more pronounced.
Lenders need to consider how easily their collateral can be repurposed if needed. While some equipment is multipurpose and can be redeployed to other uses, some is job-specific. Recovery values on job-specific or customized assets can be impacted by industry downturns as demand for those assets shrinks. For example, during the post-recession oil and gas boom, demand for construction equipment rentals surged. When oil prices declined in late 2014, utilization of rental fleets serving the oilfield dropped, causing portfolio exposure for lenders.
For assets that can be repurposed but require modifications, the costs to do so need to be carefully considered. For example, many crawler cranes coming out of the oilfield lack booms and other features civil contractor buyers might want. As a result, those buyers will pay less for cranes serving the oilfield knowing modifications will be needed to make the equipment productive.
For equipment that has many uses, it’s still important to consider variations within the category. For example, mobile cranes have wheels and can drive on the road, which makes remarketing the assets easier as the equipment can be readily relocated or grouped with similar assets to attract a larger pool of buyers. Crawler cranes, on the other hand, are not road-ready and need to be trucked. Costs to tear down and trailer the cranes increase recovery expenses. Additionally, a crane's age, capacity, and accessories are all major value drivers. Lenders should expect appraisers to list these detailed specifications and auxiliary equipment as these specifications affect the asset’s marketability.
In a small number of cases, highly specialized equipment may recover better because the asset is of strategic importance to a competitor. For this reason, it’s important to work with appraisers that understand the nuances of different equipment types and the forces affecting the industry.
EQUIPMENT MANUFACTURER PREFERENCE
Lenders should also be cautious of the recovery implications of different original equipment manufacturer ("OEM") brands and their acceptability in the marketplace. While the assets may be of high quality and condition, appraisers and liquidators also consider the brand loyalties of prospective buyers. For many, the OEM brand can be a benefit if their employees are pre-trained and experienced in using that equipment. It can also be a significant drawback and lead to reduced recoveries if re-training requirements exist for the buyer. Other softer factors, such as preference and manufacturing origin may also affect recoveries of various equipment. This consideration applies most heavily to equipment leasing borrowers.
COMMODITY COST EXPOSURE
Another area of consideration lenders should assess is whether borrowers may be exposed to fluctuations in commodity values. Building materials distributors, equipment manufacturers and civil or commercial contractors may be vulnerable as they require commodity inputs or maintain commodity inventories. The prices of commodities fluctuate based on market conditions, which are in turn affected by regulatory and geo-economic changes.
Within the last twelve months, a major trade case related to soft wood lumber was decided, increasing lumber prices. The current renegotiation of NAFTA may potentially affect other building products as well. At the time of this writing, new steel tariffs imposed by the Trump administration loomed, likely causing price increases. As a result, borrowers may face unexpected cost increases that could compress margins. Operators that work on a project basis are most vulnerable as input prices may differ at the time materials are purchased from when the contract price was agreed. Recoveries on existing steel inventories on the other hand, may benefit.
While individual asset recoveries may be strong within certain segments of the construction industry, the costs to undertake a liquidation can be quite high. As mentioned previously, transportation costs for heavy equipment assets can be significant if relocation is required.
On the inventory side, while gross recoveries may be strong for building products distributors, liquidation expenses can be as high as 20 percent. Many of these companies sell to either retailers or professional builders, which rely on delivery of products to stores or job sites. In these scenarios, the costs to maintain the delivery fleet are typically included in the liquidation expenses and can be as high as seven percent. For companies that rely heavily on salespeople to maintain customer relationships and market products, an additional commission expense may be built into the liquidation assumptions. Depending on whether buildings are owned or leased, real estate may also contribute to the expense burden.
In addition to lending against hard assets, lenders should examine the possibility of evaluating contracts for equipment rental companies, which are often overlooked. Contracts range in duration from one to six months for short-term contracts, to one to four years for long-term contracts. Long-term contracts can have significant unexpired terms as of a liquidation or valuation date, which can produce substantial cash flow. Lenders to equipment rental companies should consider including the value of those rental streams. It's important to partner with appraisers that have experience valuing contracts to conduct this type of analysis.
While construction holds significant opportunity for asset-based lenders, it’s important to partner with professionals that understand the industry and can help identify risks and additional sources of value. There’s a wealth of collateral across the industry, but the assets can behave very differently in liquidation based on the factors detailed above, and more.