Can you spot the yellow flags on your construction project?

Delays caused by the pandemic, limited supply of materials and labour, and the need for new safety protocols are escalating costs

The profit margin is being squeezed. Numerous milestone dates are under pressure. Projected expense forecasts are escalating. Contractual claims are on the rise.

These are all early warning signs of distress for construction projects. And as the fallout from the pandemic continues, there will be more warning signs among more projects across the country.

Developers need to know how to avoid falling into a distressed situation to protect the value of their assets. Lenders need to know when such a situation is developing to protect their interests in the project.

A bank or loan monitor can play a crucial role in assisting both parties. While the usual focus of project monitoring is on reporting, during periods of economic upheaval such as we are now experiencing, these professional cost monitors, also called quantity surveyors, serve an important role in identifying early signals that a project may be in trouble.

Should the financial situation deteriorate, they can also assist in pinpointing issues and providing information and documents that loans officers, receivers, managers and trustees may need to complete the project or to preserve as much of its value as possible.

As the impacts of COVID-19 accelerate, here’s how developers and lenders can protect valuable real estate assets with the right advice performed by the right professional.

Expect more construction projects to go into distress

Unprecedented fiscal stimulus led to a drop in insolvencies in 2020, but it is anticipated that there will be a significant increase in insolvency appointments for the remainder of 2021.

As government support measures are wound back, so-called Zombie companies and those teetering on the boundaries will find themselves in trouble. The real estate sector tends to lag other sectors because it takes time to transfer construction projects to loans officers who can manage complex, high-risk accounts. But we can expect COVID-related distressed situations to emerge.

Already, banks have increased bad debt provisions for failed loans anticipating increased levels of distress within the industry.

The role of loan monitors

On a typical construction project, when a lender requires loan monitoring, a loan monitor is appointed to assume responsibility for keeping an eye on the development budget, verifying that invoiced work was completed and identifying any budget or delivery issues. Their mandate is outlined within the loan agreement between the lender and the developer.

They help the developer keep track of whether the project is within budget, and if not, the reasons why. They also assist in identifying potential solutions to resolve budget problems and whether it may be necessary to tap into the contingency budget.

For the lender, the loan monitor compiles information and provides monthly reports detailing budget progress, if there are any cost variances or irregularities and if additional funding is needed.

But when a project begins experiencing serious financial issues, the goals and scope of this work can take a dramatic shift.

Identifying yellow flags

With profit margins on many construction projects already squeezed by planning and approval delays and more developers proceeding with slim margins, the financial risks are extreme. Loan monitors are often the first line of defense in alerting developers and lenders to the warning signs of financial distress.

Warning signs include:

• Repetitive schedule delays and missed milestones

• Lagging activity and numbers on-site, even when considering COVID safe measures

• Presentation of the workplace is poor

• Lagging trade payments; frequent complaints from subcontractors or suppliers about late payments

• Permits and approvals are not being submitted

• The developer is reluctant to approve an injection of cash for a schedule adjustment or minor budget overrun

• Contingencies are being depleted

• Requesting discounts for shorter payment terms

• Requesting payment for materials off-site and out of sequence

• Overbilling to catch up on delays and cash flow is being impacted

Why proactive project monitoring is critical right now

In recent years a large number of loan bankers with workout experience in distressed situations have retired. Concurrently, many bank relationship managers have never seen a distressed construction project. So, when these situations inevitably arise, they are likely to be challenging for banks to manage.

"This is why, more than ever before in recent history, loan monitors will be important allies in the months ahead."

Niall McSweeney

President, Cost and Project Management, Asia Pacific

Role of a loan monitor in a distressed situation

When a project begins experiencing financial distress, lenders and other secured creditors aim to quickly identify challenges, timelines, and the best go-forward plan to mitigate loss. They need a clear understanding of project risks, what it will cost to complete the project, and the immediate and long-term site and development activities required.

This is where an experienced loan monitor is crucial to achieving these goals. If a lender determines their investment in a construction project may be in jeopardy, they will often turn to a receiver administrator to minimise losses, maximise asset value, and mitigate liability.

A receiver administrator, trustee or monitor can be appointed by a secured creditor under the security agreement or by the Court on behalf of a secured creditor. If a project goes into receivership, the receiver may operate and manage the business until it is sold as a going concern or sell or liquidate the assets to repay the outstanding debt.

In a distressed situation, decisions aren’t made monthly; they’re made daily, often hourly. Dealing with intense time pressures, receivers require accurate, complete information from the loan monitor to help them determine whether to complete, reposition or divest the asset. Since a receiver may or may not have much construction experience, the loan monitor must be able to anticipate, review, analyse, prepare reports and deliver documentation to assist them in devising an appropriate go-forward plan.

This can involve the following responsibilities:

• Review receivership documents to anticipate what is needed

• Prepare a risk assessment of the project, and the project team

• Assess the value of work in place

• Conduct a cost-to-complete analysis of the project and the options for doing so

• Review costs incurred and payables, including holdbacks and liens

• Review trade contracts and government permits, approvals and compliance

• Conduct a risk and schedule assessment

• Perform lien reconciliations (retention of title)

• Carry out a detailed certification of materials stored off-site to reduce the risk of loss

• Determine the immediate and long-term site and development activities required

Ultimately, the lender and receiver will rely on the loan monitor to enable them to devise a remobilisation plan that reduces risk going forward.

Relevant monitoring expertise needs to be a top priority

Developers and lenders need to ensure that should the financial foundation of a project under construction begin to show cracks, there is a capable loan monitor in place who can recognise yellow flags and also assist in mitigating risks when a distressed situation takes hold.

The impending challenge during this unpredictable and volatile period of upheaval is that Australia has never before experienced this level of repeated economic shock in such a short period. Many loan monitors today were not active in this role during previous recessions and have little experience with distressed projects precipitated by macroeconomic factors. What experience and expertise should you look for in a loan monitor who can assist with a potential or current distress situation?

Here are some of the most important:

• The ability to respond quickly and produce accurate assessments and reports

• Finance, management and hands-on construction experience, including knowledge of project management and scheduling, and risks and issues that can arise

• Comprehensive understanding of the SOPA Act

• Ability to review and verify contracts and loans, insurance and Court documents

• Ability to accurately assess the total value of work in place; risk can escalate exponentially if trades are certified or signed off as complete when there is work outstanding or deficiencies to correct

• Experience protecting stalled projects and the ability to assist in mobilising a team to achieve results; this includes project managers, architects, mechanical engineers and specialist consultants such as those with expertise in contract solutions, performance analysis, exterior envelopes and mould abatement

Summary

Construction projects are inherently complex, dynamic and unpredictable. During this unprecedented pandemic period, developers and lenders should ensure the right loan monitors are in place for your projects and are conducting anticipatory project monitoring.

By alerting you to yellow flags and helping to mitigate the risks that can arise from myriad sources, vigilant monitoring can assist in achieving maximum recovery of loans and credit facilities and preserving the value of important real estate assets.