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Image of a contractor with a hard hat and holding plans outside and walking towards a residental property

Business Lending to Contractors

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.

Value for Construction Put In Place, Source: U.S. Census Bureau

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.


Close-up of a dial showing high risk

Managing Risk After the Business Loan is Made

By Larry Middleman, President/CEO, CU Business Group, LLC

The business loan documents are signed and the funds distributed. That means your job is done, right?

Wrong. Due diligence and risk management are crucial steps after the business loan is made. Proper risk monitoring over the life of the loan is essential to identifying potential problems before they occur and early detection is the best way to fend off problems before they become big issues. 

Effective risk management practices also allow for frequent ‘touches’ of the loan in an efficient and cost-effective manner.  The days of simply doing an annual review on a business loan are long past.  As the late-2000s financial crisis amply demonstrated, conditions can change rapidly.

A Scaled Approach

In our work with credit unions across the country, we see many examples of excellent business lending risk management practices.  We also see credit unions where risk monitoring is non-existent.  In recent years, regulators have stepped up their oversight in this area, so be prepared for a rigorous review of your risk management practices in your next exam.

My view is that monitoring activities should scale depending on the general riskiness of the loan.  Important factors include the dollar amount of the loan, the type of loan, and the borrower’s industry.  Higher risk loans include lines of credit secured by accounts receivable or inventory.  Certain industries, such as retail and hospitality, often carry higher than average risk.

Many credit unions take an all-or-nothing approach to risk monitoring, e.g. “we only monitor loans over $250,000”.  While this attempts to balance monitoring efforts with the associated cost, in most cases a more thorough approach is warranted. 

I believe the right framework for credit unions is to adopt a risk management system for their business lending portfolio.  This holistic view encompasses all the key elements of risk monitoring, both on an individual loan basis and on the entire business loan portfolio.  Here are the fundamental steps in establishing a risk management system in business lending.

Tracking

Management must put a process or system in place for timely and effective follow-up.  A ‘tickler system’ is the best tool for setting key follow-up dates.  A typical follow-up activity would be sending a letter to the borrower requesting updated insurance records.  The trick is to re-set another tickler for two weeks later to ensure the insurance information has been received.  Simply sending the letter is not effective risk monitoring – actually receiving the information and analyzing it is true risk management.

Today, with the advent of cloud-based loan operation systems, tracking and follow-up is easier than ever. Automated tickler alerts can be set up that will email a notification to the loan officer, or even directly to the borrower.

Analyzing the Borrower’s Financial Condition

The fundamental activity in risk monitoring is reviewing the borrower’s financial situation. This will identify changes in condition as compared to the original underwriting and subsequent reviews of the loan, a key to identifying potential problems before they arise. You may notice that a borrower has had a decrease in sales or unusually high expenses, and that is the time to talk with your borrower. 

Global Cash Flow Analysis

It is critical to understand your borrower’s other obligations.  Other projects or commitments that go bad may drag down the performance of your good loan.  This takes expertise and resources, but again – early detection and fast action are the best methods of warding off loan losses.

Monitoring Industry and Market Conditions

When dealing with commercial real estate, look at the market conditions for the property. Are rents in the area rising or declining?  What are the occupancy trends of comparable buildings?

Consider the macro view of your member’s business. Will industry-related government regulations affect the company? Will potential state or federal taxes increase the price of the firm’s product or service?

Stress Testing

Stress testing is a tried-and-true method of identifying the key areas to watch for during the life of the loan.  At what point would the debt coverage be less than sufficient to support your loan payments?  How low can the lease income or occupancy rate go before there are potential problems with the cash flow of the property?

Multiple Touches

Automated risk monitoring solutions exist which allow for cost-effective loan monitoring between annual reviews.  We recommend at least two ‘touches’ of the loan in addition to the in-depth annual review.  These touches might identify certain situations, such as: Has the borrower’s or guarantor’s credit score recently decreased?  Are there any environmental issues with a property adjacent or near to your collateral?

Monitoring the Overall Portfolio

Credit unions must also step back and view the forest (the business loan portfolio) and not just the trees (the loans).  Does your portfolio have excessive concentrations in one loan type or industry?  What is the weighted-average risk rating of your portfolio?  What is your exposure relative to the credit union’s net worth?  Management must take the macro view to complement individual loan monitoring.

Reporting

I see it all the time…management believes the right things are being done, but they really don’t know – and sometimes they only find out when it is too late.  Proper management and board oversight is only accomplished with thorough and complete reporting from the business lending area of the credit union.  An effective risk management system includes a continuous feedback loop to keep everyone apprised of both the positive and negative aspects of the business loan portfolio.

As with individual loan tracking, systems exist today that take much of the manual effort out of portfolio monitoring and management reporting. Operational managers as well as senior executives and board members can have real-time access to detailed, easy-to-read dashboard reporting. Such reports can display information as varied as industry concentrations, portfolio profitability, and even average time-to-close.

I once heard a gem of wisdom that rings true: “The best way to make money in commercial lending is not to lose money.”  Implementing a risk management system will dramatically increase your odds of not losing money and being successful in business lending.

Larry Middleman is the President/CEO of CU Business Group, LLC, the largest business services CUSO in the industry, serving more than 580 credit unions in 47 states.  He can be reached at 866-484-2876 or lmiddleman@cubg.org.