By Nick Reynolds, Vice President/Credit Services Manager of CU Business Group, LLC
The risks associated with business lending differ significantly from those associated with traditional consumer lending. While consumer information is still an important part of knowing your member, the types of risks associated with commercial loans tend to be more varied and wider in scope. This article is one in a series to help credit unions more clearly understand some of the unique risks of business lending.
Lending to contractors can present some unique challenges. Contractors are often desirable members that carry large-balance deposits and loans, are a critical catalyst for community revitalization, and can be a good source of referrals. Additionally, the residential and commercial construction industries have rebounded strongly from the late 2000s recession. However as borrowers, contractors come burdened with certain risks, and it pays to be sure you understand these risks prior to getting in too deep.
For the purposes of this discussion, we refer primarily to general contractors that do major projects, as opposed to trade contractors. Generally speaking, you can analyze trade contractors such as plumbers and drywall installers just like regular operating companies. However, contractors that use progress billings, account for their work on a percentage of completion method, and employ a bonding company, present much different risks.
Progress billings, whereby a contractor’s customer agrees to pay in installments as the work is completed, are common in the industry. However, be aware that such billings do not count as receivables on the balance sheet. Nor are they legally enforceable under a security agreement and UCC filing. From a practical standpoint, progress billings may not be collectible either, because if the job isn’t completed or is done incorrectly, the contractor won’t be paid.
The percentage of completion method of accounting is useful in estimating the borrower’s income, and a detailed work in process schedule should be obtained from any contractor you lend to, along with other standard financial information. The calculation of income is typically based on an amount of costs spent versus costs incurred ratio. For instance, if the contractor has spent 90% of the cost of a project, it is considered 90% complete, and you can recognize 90% of the anticipated income. But note that this doesn’t consider retentions that may not be paid for months, or at all, cost overruns, or other variances in income. Tracking the percentage of completion is valuable in understanding your member’s current financial condition, but an in-depth knowledge of the borrower and of the projects they are involved in is fundamental to understanding the risk. For example, who is providing the funding for your member’s construction project? It is not unheard of for a general contractor to begin a project, issue progress billings, and then not get paid because the customer didn’t have their financing in place. This is also a good reason not to provide lines of credit to a contractor. If they build for someone with construction financing, they shouldn’t require use of a working capital line. On the flip side, if the contractor offers financing to her customers, as the lender you should only finance one project at a time, giving yourself the opportunity to review each project on its merits.
Bonding presents its own issues. If your member can’t complete a project, the bonding company steps into their shoes. While the bonding company is generally in a subordinated lien position to your credit union, the practical effect is that the bonding company controls the process and determines who will get paid and when. You can be sure they won’t pay you before they reimburse themselves.
One of the more formidable risks common to all contractors is how much of their success relies on the individuals in their operation that are responsible for the bidding process. Most contractors are fairly adept at estimating project costs. But it only takes one missed estimate on a bid to potentially create a huge cost overrun. This may be the single most likely area for a contractor to create a big problem, and there is little you can do to prevent it. The best way to deal with this is to be sure your borrower has a significant amount of equity in the business to help them weather any single adverse event, and to discourage them from taking on projects with which they don’t have much experience.