Getting a handle on volatile material costs - best practices for construction lenders
In the complex world of construction lending, unpredictability often comes in the form of fluctuating material costs. Steel, lumber, and everything in between–their prices can swing wildly thanks to market demand, global political issues, and even environmental policies. These price swings can knock the financial stability of a project off balance, so as a construction lender, it's vital to handle these fluctuations with a careful hand and eye toward risk mitigation. This guide will arm you with practical strategies on steering through the high seas of volatile material costs, so you can ensure your investments are safe, sound, and profitable.
Get Comfy With Your Contracts: Know Who Carries The Risk
Mitigating risks that come with fluctuating material costs starts with really getting to know your borrower's contracts. They're not just legal jargon – they're your blueprint to understanding responsibilities, liabilities, and risk-sharing mechanisms between parties. Brush up on these essential documents to figure out who would carry the financial burden if material costs take a sudden hike. Sometimes, the contractor might be the one stuck with the bill, while other times, the risk might be shared or even fully transferred to you as the lender or the project owner.
A solid builder acknowledgement form can be a particularly important for documenting that all parties are on the same page when the project kicks off. Also. look for price adjustment clauses, material escalation clauses, or force majeure clauses that become relevant in case of extreme (or modest) price changes. Nailing down these terms from the get-go can save you from unexpected surprises down the road.
Keep a Hawk-Eye on Change Orders:
Change orders are a given in nearly any construction project, usually born out of unexpected challenges or alterations in project scope. However, when material costs are being temperamental, change orders can also be the result of needing to tweak budgets to fit into price shifts. It's crucial for your processing team to scrutinize these change orders keenly, ensuring that cost increases are justified and align with the current market prices.
This process demands more than a passing glance – it involves diving deep into the basis of the change order, the newly suggested materials or methods, and their cost implications for the project as a whole. It also requires staying in the loop about present material costs and trends, so your team can push-back orders that look out of sync with how the market is faring. By keeping a stringent review process, you can dodge unnecessary cost escalations and ensure changes are essential and the the project retains enough funds for completion.
Trust But Verify with On-Site Inspections:
On-site inspections can be a construction lender's best friend. They not only provide a reality check of the project's progress and quality, but also in the context of volatile material costs, they validate whether the paid-for materials are actually present and being used as intended. This is particularly key when lenders release funds based on work progress, including the builder's procurement of materials.
During these inspections, seek out signs of delivered materials that are either already used in the project or safely stored on-site for future use. This not only verifies the project's progress but also prevents potential fraud or misallocation of funds. Catch any discrepancies? Address them promptly with the contractor to keep the project on track and within budget. Exercise caution when disbursing for materials on-site - unscrupulous builders have been known to move materials between sites in an effort to get paid early.
Reassess Your Contingency Reserve Requirements
Contingency funds are your financial safety net, set up to cover unpredicted costs and overruns. With unstable material costs, it may be wise to adjust your contingency reserves to mirror the increased risk of price swings. That doesn't necessarily mean pumping a drastic increase, but rather tailoring based on the specific materials, their market volatility, and the project's risk profile and timeline.
Finding the balance in adjusting contingency reserves is key. Reserve too much, and you become non-competitive, too little, and you're susceptible to unexpected price swings. The secret sauce? Using historical data, market analysis, and risk assessment techniques to make informed decisions, adjusting reserves as necessary to protect both you and the project's financial health.
Tackling Volatility Head-on
Unpredictable material costs are a fact of life in the construction industry, posing both hurdles and opportunities for construction lenders. By following these strategies — attentive contract review, intense scrutiny of change orders, hands-on site inspections, and smart adjustment of contingency reserves — you can safe guard your investments and support project success.
Remember, navigating this turbulent sea requires not just financial savvy and construction knowledge but also a flexible, informed approach to risk management. Being informed about market trends, forming solid relationships with third party monitoring firms, and utilizing flexible technology for project management can all feed into a stronger, more adaptable strategy for handling material cost volatility.
Reach out to our team at Trinity to discover how our tried-and-true services can help you operate with confidence in an uncertain world.
