Surety Outlook 2019: The Peak of the Cycle
Reposted with permission from constructionexec.com, January 17, 2019, all rights reserved. Copyright 2019.
By the end of 2018, the construction and surety industries remained robust and resilient. For most contractors, backlogs are as strong as they have been in over a decade, margins have returned to pre-recession highs and work is abundant. For surety companies, profits are at an all-time high, loss margins remain low and demand for bonding, along with total spending in the building industry, continues to grow across the nation.
According to the U.S. Census Bureau, total construction spending in 2017 was $1.24 trillion and is expected to grow to over $1.35 trillion by the end of 2018.
Along with construction spending, the surety industry’s historic results have continued to improve. Since 2012, the direct written premium for the industry has grown from $5 billion to over $6.2 billion at the end of 2017, an increase of over 23 percent. And the industry does not appear to be slowing down any time soon, with projected direct written premiums of more than $6.5 billion in 2018.
The continued results and positive forecast for both underwriters and contractors have many wondering, “When is the market going to reach its boiling point and how do I prepare for the inevitable decline?” Many subcontractors, overextended with work opportunities and thin on resources, have started to show signs of struggling and an increase in defaults. This growing frequency of subcontractor defaults has resulted in some of the industry’s largest sureties experiencing significant general contractor failures domestically and internationally.
Rather than speculate, surety reinsurers are beginning to institute firmer underwriting compliance standards for front-line sureties. In response, surety underwriters are depending even more on their clients and agents to proactively manage their operation and risks associated with growth in an expanding economy. “Best-in-class” contractors are using the market’s positive growth and outlook to focus on what they do best and intelligently grow their backlogs, rather than over extending themselves by taking on work far outside their abilities and capacity. As growth continues, three main questions continue to be at the top of all contractors’ and underwriters’ minds: labor shortages, material costs and governmental policies.
CONTINUING LABOR SHORTAGES
The ability to attract and retain skilled labor is the number one concern of general contractors, subcontractors, suppliers and vendors. Although the quantity of skilled labor has increased in recent years, it has not kept up with the increase in construction spending. As a result, the industry is experiencing one of the largest labor shortages in history.
The 2008 recession saw backlogs shrink and contractors were focused on managing overhead and ensuring sustainability. To survive, many had to make difficult decisions to lay off key employees, opting to keep only the most vital roles filled. Many of the employees who were laid off were unable to find work and forced to retire or seek employment in other industries. At that time, training and developing the construction industry’s future work force and leaders were non-existent. In addition, high schoolers became more focused on four-year college placement as opposed to joining the workforce immediately upon graduation or learning a trade.
Today’s contractors are feeling the long-term effects of this mass exodus in the construction labor market and, now with demand at an all-time high, contractors simply don’t have the supply of skilled labor to match the need. The year 2018 marked that largest gap in growth between new construction employment and construction spending since post-recession.
To meet demand, many companies are hiring new employees who might not have the experience needed, or simply don’t meet the company’s culture and standards for employment. Regardless, these new employees are needed to ensure that companies can take advantage of the current market and meet their growth plans. This is a principle issue, and continues to emphasize the importance of partnering with or employing a high-level human resources professional who not only can ensure companies are hiring the right employees, but also ensure these employees are retained and developed into future leaders in their respective fields.
To sustain the construction marketplace and ensure growth as an industry, it’s up to business owners to hire and develop the right talent. If companies fail to do this, the industry could experience a wave of subpar construction that could have significant and potential long-term consequences.
RISING MATERIAL COSTS
The cost of materials has always been a key concern for contractors, but in today’s market it seems to carry even more weight. Even without rising tariffs, material costs have increased significantly over the past 12-24 months.
Securing material and trade buy-outs, post project award, has become vitally critical to the economic success of contractors. In a rising material cost environment, contractors that have not properly guaranteed project costs, from bidding through execution of work, have not only experienced a slippage of profits, but often a net loss of overall operations. Once a contract is in place and the project has begun, contractors have little to no ability to bill material cost escalations to a job. Proactively managing material costs and anticipating changes can have a significant impact on the success and profitability of a contractor.
Proactively managing cost means being able to anticipate increases in the price indexes and having a comprehensive understanding of specific contract terms and conditions. For example, “Buy American” provisions continue to become more common in construction contracts. These provisions usually require that a minimum amount of materials on a contract be purchased in the United States, which in some cases can increase the cost of a project dramatically. The purpose of these provisions is to help stimulate domestic material supply. In most cases, however, the provision actually increases costs and puts additional stress on domestic vendors and suppliers.
To manage these risks, “best-in-class” contractors lock in fixed prices with their vendors and suppliers before starting projects, thereby avoiding the uncertainty of the future costs of materials. Maintaining good relationships with vendors, suppliers and trades continues to be critical to success. In addition, as contracts become more and more onerous, it remains important to negotiate ideal payment terms with both owners and general contractors. For example, billing for materials upon purchase and storing them onsite or in a secured location allows the contractor to be paid upfront for the purchase as opposed to upon install. This allows the contractor to manage cashflow more effectively and sustain its profit margin throughout the job.
Like most businesses, the construction industry is significantly affected by monetary and regulatory policies. Today’s rising interest rates will have a major monetary impact on contractors. The Federal Reserve has strategically kept interest rates at historic lows, stimulating investment in our economy, which has resulted in a significant increase in residential and non-residential construction. However, as the Federal Reserve has been systemically increasing the interest rate, expect to see a tightening in construction lending from banks and a decrease in overall investment. This will have a direct negative impact initially on residential projects then on commercial construction and overall spending in the building industry.
Although there may be a decrease in the private construction spending as interest rates increase in 2019, there should be a flow of infrastructure spending under the Trump administration’s infrastructure plan to help support growth in the public sector.
To prepare for the rising interest rates, companies should continue to be aggressive with their lenders by locking in low rates now, aggressively paying down interest-bearing debt and avoiding the use of operating lines of credit. As always, “cash is king” in the construction industry. The ability to finance costs and retain liquid paying power will continue to be one of the most important factors in the success and growth of a contractor.
In 2019, most contractors will start to experience a wave of impacts on the regularity influence of the new revenue recognition requirements of the American Institute of Certified Public Accountants (AICPA). On May 28, 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers. According to the AICPA, the standard will eliminate the transaction and industry-specific revenue recognition guidance under current U.S. GAAP and replace it with a global principle-based approach to determining revenue recognition. This standard has the potential to affect every entity’s day-to-day accounting and, possibly, the way business is executed through contracts.
While public firms must already be compliant, private firms are required to start reporting their revenue compliant with ASC 606 starting 1Q 2019. The challenges are many, particularly for construction businesses — from setting up the right performance obligation contracts, handling one-time set up costs to factoring in costs of acquiring and tracking contracts. Not only the direct and indirect costs associated with complying with the new standards will be a challenge, but credit relationships with both sureties and lenders will be tested. Producing CPA financial statements in 2019 will not be as easy as in the past. As a result, it is anticipated that contractors will experience both longer times needed to produce conforming and reliable statements and that contractors will need to be prepared to positively explain the changes to their credit partners.
The construction market is cyclical in nature, and the current upswing will not last forever. Yet, despite of the fact that the market has been experiencing the longest expansion in history, there is little to suggest that the end is near. This past year has seen strong growth in construction despite a weakening labor pool, increasing material costs, and uncertainty surrounding governmental policies.
Many factors will continue to obstruct the construction industry in 2019 and beyond. However, wise contractors will continue to capture acceptable profit margins by proactively growing, developing and managing an appropriate level of highly skilled work force while driving the continuous improvement of “best-in-class” operating, accounting and cash management performance standards.