Sunday, March 15, 2009

State of the Construction Industry - A Surety Broker's Perspective

By Michael Strahan CCIFP
KPS Insurance Services

As most of us have experienced over the past year the financial crisis has had a significant impact on the construction industry. With what seems like the demise of residential construction, a significant slowdown in commercial construction, and state budget issues impacting public works construction, the industry is facing significant challenges that we have not seen in some time.

As a result of the financial crisis and the impacts on construction, we have seen a change in the makeup of bid lists. Larger construction firms, even some national firms, have been bidding on work that in the past would have been considered too small to pursue. This could be due to the fact commercial project pipelines have been drying up and large firms are finding gaps in backlog. Conversely, we have seen smaller construction firms trying to bid projects that are probably larger than they would generally consider routine. Some of these firms are trying to elevate away from heavy competition. And lastly we have seen significant numbers of residential firms that never pursue public works projects coming over and bidding as well. As a result we have heard of pre-bid meetings having in excess of one hundred firms attending and it is not unusual to get bid results with more than thirty bidders.

We have also seen a significant change in the make-up of backlogs. Generally speaking, most backlog reports have become much more concentrated. We rarely see firms with large backlog reports of work in various stages of completion. It is not unusual to now see a construction company’s backlog being made up mostly of four or five projects. This naturally has led to a concentration of risk and a lower months in backlog ratio. Months in backlog measures how many months of work a firm has on hand at any one time based on historical, average monthly revenues recognized. One bad job today can have a much larger impact than what was historically the case.

Sadly, the surety industry is also to blame for part of the current competition problem. With so many construction firms coming to the public work environment they need to secure bonds. While some of these firms are financially strong and have had prevailing wage experience in the past, many do not come with prior experience or the financial strength to learn the hard way. Many of these firms need to be reviewed more stringently for credit than they are currently being evaluated. As a result, some of these construction firms are hurting the overall marketplace by taking work too cheaply. They will likely encounter financial hardships at some point in time if they are securing multiple jobs near or possibly below cost. Meanwhile, responsible bidders are not getting work which is also impacting their ability to run operations normally.

In addition, it is understood the stimulus package will include changes to the small business administration bond guarantee program. This change will increase bond guarantee limits on projects from two million dollars up to five million dollars. While this is a noble cause to help small businesses, it will also cause an increase in competition on larger projects by less qualified firms.

With increased competition for less work, profit margins have been decreasing. Naturally with a decrease in margins the overhead coverage ratio has also been decreasing. The overhead coverage ratio measures how many months of general and administrative costs are being covered by existing work on hand. All in all construction firms these days are more exposed to potential financial hardships due to concentrations of risk, lower margins, and simply less work to cover fixed costs.

With all the changes in the construction industry, it is inevitable that certain things will occur. We have already seen an increase in filings of stop notice and liens. It seems as if the ability to secure change orders, whether a general to owner or subcontractor to general, is becoming more difficult to secure. Payments appear to have also slowed, again whether from owner to general or general to subcontractor.

We will have construction failures most likely by the second half of 2009, definitely during the first half of 2010. In concurrence with construction failures, the surety industry will also begin to have an increased frequency in losses. While these are not good things the overall result may be somewhat healthy. Hopefully the strong construction firms survive and market competition starts to return to a healthier balance. The surety industry, with an increase in losses, should also tighten underwriting standards. This should further help limit bidders on jobs to more qualified firms.

A complete wildcard at this point in time is how and when the pending stimulus package will impact the construction industry. Conceivably when the federal government passes the stimulus package and states get assistance with budget deficits via government loans, more construction opportunities should present themselves. With the infrastructure spending the federal government wants to support, other construction related opportunities tied to green and alternative energy construction, and hopefully the ability to sell local municipal bonds again the number of opportunities should increase. This again will hopefully lead to less competition on projects as more work will be on the street to be bid.

While the times are clearly tough right now we do see some light at the end of the tunnel. We are hopeful more work will hit the streets in the near future. Coupled with less competition due to construction failures, surety industry tightening underwriting standards, and with a hopeful return of the real estate market, we can get back to a more traditional list of bidders and profit margins in the very near term.

Fact -

States are facing a great fiscal crisis. At least 46 states faced or are facing shortfalls in their budgets for this and/or next year, and severe fiscal problems are highly likely to continue into the following year as well. Combined budget gaps for the remainder of this fiscal year and state fiscal years 2010 and 2011 are estimated to total more than $350 billion.

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