By Todd A. Feuerman, CPA, CCA, MBA, at Ellin & Tucker.
The construction industry, along with the surety industry, continues to thrive as 2022 completes its second quarter. As construction demand continues and the market sees the impact of last fall’s $1 billion Biden infrastructure spending bill, project backlogs are generally substantial and as a result, surety programs are needed to support the robust market. And according to the American Institute of Architect’s Construction Forecast, signs point to an even brighter future. The non-residential construction market could increase by up to 5% and the residential construction growth should exceed 9%.
But it’s not all good news. The surge in construction spending has strained an already limited labor pool, and unpredictable material prices have caused havoc in the construction market. In addition, as the Federal Reserve seeks to reduce inflation and stabilize a somewhat runaway economy, interest rates have, and will, continue to increase in 2022, creating a financial impact on all sectors of the economy. Construction will be no exception.
These key factors will continue to influence the remainder of 2022 and into 2023. And you can bet that the surety market will be watching, evaluating, and assessing bond programs for construction firms.
For the best-in-class contractors who exhibit operational excellence and effective risk management, surety capacity will be ample and continue to flow. But for less financially sound contractors, the surety and banking markets will be very hesitant to expand credit programs.
Construction Surety Concerns
While there are some very positive signs of a robust construction market, like everyone, sureties and other construction company financial partners are particularly concerned about several significant risk factors that have caused trepidation. They include the following:
- Labor shortages
- Rising materials prices
- Supply chain issues
- Ownership transition
One of the single biggest issues the construction industry continues to face is an extremely tight supply of skilled workers. The labor risk, especially its potential impact on domestic and international construction, has been a major issue when underwriting surety credit. If labor is not available to support project production, there could be a likelihood of project margin deterioration and exposure to credit losses by the surety firm.
Rising Material Prices
The cost of building materials, like all other sectors of the economy, has continued to increase and surging fuel costs have exacerbated the problem. As a result, surety firms are telling their customers to have systems in place that address adverse exposure to a rise in core construction goods and materials.
Supply Chain Issues
One of the lingering effects of COVID-19 has been a complete disruption to supply chains for almost every area of the economy, and the construction industry has been hit particularly hard. It has been a ripple effect of sorts in the materials area; building materials are in short supply while demand is extremely high, resulting in increased project pricing that has been rising with no real end in sight. Surety underwriters are constantly discussing innovative and alternative material delivery programs to control supply chain-influenced financial risks.
A central issue in 2022 for the global surety market is the area of ownership transition. Changes in ownership and related equity redemptions have resulted in significant adjustments to the debt and capital structure of construction firms. Since two of the key credit-underwriting factors in determining surety capacity include calculated net working capital and tangible equity, it is imperative that the structure of ownership transition deals are evaluated carefully to ensure a full understanding of potential changes to a surety program.
The Bottom Line
The construction industry, while faced with some significant pricing and production risks, is poised to have a very strong 2022. Surety firms will continue to provide bonding programs, and while they may vary in terms and conditions, the strongest, most well-managed companies will be rewarded with more generous bonding opportunities, while the contractors who have managed themselves poorly will face more controlled program options.