Constructing Opportunity for Asset Based Lenders
Assessing the opportunities and risks for asset-based lenders serving the construction and building materials industry.
Date July 2018
Written by Neal Weekes, Director, Gordon Brothers.
The past ten years have seen overall growth in the UK construction industry. However, that growth story consists of winners and losers across sectors and asset types. Construction loans currently represent only 6.5% of asset-based lending activity, as cited by the Asset Based Finance Association (ABFA). This disconnect between industry performance, the asset intensiveness of construction, and the small penetration of asset-based lending to the industry represents untapped value for investors. But capitalising on that opportunity requires careful consideration of the sources of value, positive and negative.
Understanding the optimal timing for liquidation, the costs required to do so, and other factors that impact performance and recovery values will ensure lenders can succeed. Major drivers of construction asset values include overall market activity; trends within subsectors supported by construction; seasonality; asset specificity; equipment manufacturer preferences; commodity cost exposure; liquidation costs, and the viability of other soft assets that complement hard assets, such as rental streams.
The Office of National Statistics reported that construction output continued its recent decline in May this year, falling by 1.7% and the overall construction industry is forecast to contract throughout 2019 (Glenigan, 2018). That said, growth is expected in particular sectors like education, health and civil engineering and although the outlook for London and the South East is poor, the Midlands and the North of England are forecast to be strong performing regions, set to outperform the UK as a whole.
The UK construction market consists of both the public and the private sector. The public sector, in addition to usual government spending projects, relies heavily on special projects such as the 2012 Summer Olympics and Crossrail, the 118-kilometre railway line currently under development. As the Crossrail project is nearing its end, HS2, a high-speed railway linking London to Birmingham, the East Midlands, Leeds and Manchester, is the next major project the industry is preparing for.
The whole HS2 project is expected to run for 15 years with construction commencing on the first phase in 2019. Total budget for the project has been revised to approx. £55 billion, up from its initial projection of £33 billion, although some experts expect the final cost to be somewhat higher. Whatever the cost, there is no doubt this project of building new stations, tunnels, bridges, embankments and viaducts will require significant investment in new plant and equipment, with optimal operation and at speeds that ensure timescales are met. More than half the 230-kilometre route between London and Birmingham, Phase 1, will be in cuttings or tunnels and the project has already attracted a lot of ecological attention.
Notwithstanding the above, over 90% of the UK construction sector turnover is generated in the private sector, with 43.5% of that turnover generated by SMEs with 249 employees or less (Office for National Statistics, 2018). Whilst the public sector work has dropped off marginally, growth in the private sector continues and the need still remains for good quality new and used equipment.
Lenders also need to have a good understanding of the key drivers of their clients’ activity and what sector exposure they might have. There can be areas of strength and weakness based on sector variations, regardless of how the overall market is performing. Private Housing is forecast to decline by 13% in 2018 and 8% in 2019, with weak new house sales set to restrict the sector, although Build to Rent is anticipated to rapidly grow (Glenigan, 2018). Not surprising the retail sector will continue its decline as investment in new retail developments falter and the growth of on-line retailing continues. It remains to be seen however, what affect refurbishment or change of use to existing retail developments and buildings will have on the industry.
An increase in university and secondary school building projects is set to drive Education sector growth in 2018. Heath and Civil Engineering sectors are also forecasted for strong growth as NHS funding is still a political priority.
As in any asset-based loan, understanding collateral dynamics is critical. Unsurprisingly, building products and construction is a very seasonal business; April through October is typically the high selling period during which time as much as 70 to 80 percent of sales may occur. However, variations in weather can shift this timeframe from year to year, which is why a high-low analysis is always recommended as part of the appraisal scope. Depending on the asset type, values can swing by as much as 5 to 15 points between seasons.
Lenders need to consider how easily their collateral can be repurposed if needed. While some equipment is multipurpose and can be redeployed to other uses, some is job-specific. Recovery values on job-specific or customised assets can be impacted by industry downturns as demand for those assets shrinks.
For equipment that has many uses, it’s still important to consider variations within the category. For example, mobile cranes have wheels and can drive on the road, which makes remarketing the assets easier as the equipment can be readily relocated or grouped with similar assets to attract a larger pool of buyers. Tower and crawler cranes on the other hand need to be trucked. Costs to tear down and trailer the cranes increase recovery expenses. Additionally, a crane's age, capacity, and accessories are all major value drivers. Lenders should expect appraisers to list these detailed specifications and auxiliary equipment as these specifications affect the asset’s marketability.
In a small number of cases, highly specialised equipment may recover better because the asset is of strategic importance to a competitor. For this reason, it’s important to work with appraisers that understand the nuances of different equipment types and the forces affecting the industry.
EQUIPMENT MANUFACTURER PREFERENCE
Lenders should also be cautious of the recovery implications of different original equipment manufacturer ("OEM") brands and their acceptability in the marketplace. While the assets may be of high quality and condition, appraisers and liquidators also consider the brand loyalties of prospective buyers. For many, the OEM brand can be a benefit if their employees are pre-trained and experienced in using that equipment. It can also be a significant drawback and lead to reduced recoveries if re-training requirements exist for the buyer. Other softer factors, such as preference and manufacturing origin may also affect recoveries of various equipment. This consideration applies most heavily to equipment leasing borrowers.
COMMODITY COST EXPOSURE
Another area of consideration lenders should assess is whether borrowers may be exposed to fluctuations in commodity values. Building materials distributors, equipment manufacturers and civil or commercial contractors may be vulnerable as they require commodity inputs or maintain commodity inventories. The prices of commodities fluctuate based on market conditions, which are in turn affected by regulatory and geo-economic changes.
While individual asset recoveries may be strong within certain segments of the construction industry, the costs to undertake a liquidation can be quite high. For instance, transportation and ongoing storage costs for heavy equipment assets can be significant if relocation is required.
Lenders should also be aware that equipment could be on sites controlled by main contractors and access may not be immediately forthcoming. On the plus side, whilst on such sites the equipment should be secure.
In addition to lending against hard assets, lenders should examine the possibility of evaluating contracts for equipment rental companies, which are often overlooked. Contracts range in duration from one to six months for short-term contracts, to one to four years for long-term contracts. Long-term contracts can have significant unexpired terms as of a liquidation or valuation date, which can produce substantial cash flow. Lenders to equipment rental companies should consider including the value of those rental streams. It's important to partner with appraisers that have experience valuing contracts to conduct this type of analysis.
While construction holds significant opportunity for asset-based lenders, it’s important to partner with professionals that understand the industry and can help identify risks and additional sources of value. There’s a wealth of collateral across the industry, but the assets can behave very differently in liquidation based on the factors detailed above, and more.