Recent reports of difficulties besetting the construction industry have placed an increased focus on the types of funding that can keep struggling businesses afloat.
But what kind of financial assistance should your business be seeking?
Why would I need a loan?
Loans are useful for both principals and contractors to ensure cashflow for the duration of a construction project.
Consider a property developer working on a large, inner-city apartment complex. The initial upfront costs are high, there is limited (if any) cashflow on the project until completion when you can sell the apartments, and there are continuing obligations to contractors during the course of construction. A construction loan may help to ensure cashflow in light of all these challenges.
A contractor, on the other hand, may want to expand operations for a future project but have cashflow problems due to a slow paying principal on their current project. They could consider debt financing or a construction loan to assist in preparing for the upcoming project.
We will now look at some of the more common loans contractors may take out.
Capital equipment loans
Capital equipment loans are key in the construction industry to removing the large upfront cost of plant and equipment for projects.
There are a variety of options regarding the ownership of the equipment depending on your needs.
Types of capital equipment loans include:
- hire purchase
- equipment finance lease
- chattel mortgage
A hire purchase agreement can be for an initial deposit, followed by regular repayments which will eventually lead to you owning the equipment outright. If you can’t afford the equipment or no longer need it, a hire purchase agreement might allow you to return the equipment instead of continuing repayments.
However, the financier retains legal ownership of the equipment until the agreement is paid out, meaning that the equipment may be repossessed if you default on payments.
Equipment finance leases are similar to hire purchases because there are regular repayments and the financier retains legal ownership of the equipment. The core differences are:
- generally, there is no goal of owning the equipment – although in some circumstances, you can make a residual payment and take ownership of the equipment
- you can renew the lease on negotiated terms (lower repayments and/or interest rate due to decline in value of the equipment), or can opt to lease a new item instead
By contrast a chattel mortgage is a fixed interest loan that is secured by a mortgage over the equipment.
Unlike a hire purchase agreement or equipment finance lease, you own the equipment from the start. This means that the equipment shows up on the business books, both as an asset and as a liability, which may provide tax benefits in the form of interest deductions and depreciation.
Loan for construction
A loan directly for construction will allow a principal to get started on a project without worrying about cashflow that may be tied up in the success of the project itself.
To apply for a construction loan you will likely need:
- A site description, including zoning. You must mention if any zoning changes are in the works!
- An architectural drawing which will enable the financier to easily understand the nature of the project in comparison to wordy, technical documents. A picture is worth a thousand words.
- A feasibility study that demonstrates why your project makes sense, and importantly, how your project will generate a positive return on investment.
- Costing and timelines so that there is an easy-to-follow map of the milestones and expectations of the project.
- The CVs of the head contractor, subcontractors, and any consultants that you may work with. This shows the lender that the plan is thoroughly formulated and backed by seasoned professionals.
Construction loans are often secured against an asset, or perhaps in the provision of a personal guarantee, to reduce the risk for the lender.
If you are not offering any security you may find your borrowing limits are lower, your interest rate is higher, and/or the lender requires on-demand repayment provisions in the loan agreement.
Invoice or debt financing
In the construction context, invoice or debt financing can be used by a contractor to obtain funds using as security invoices which have not been paid by the principal. This helps maintain cashflow where a principal is slow to make payments on a project.
There are two main types of invoice or debt financing:
- invoice discounting
- invoice factoring
With invoice discounting the contractor controls the credit, so the principal will not be aware that the invoices are being financed.
With invoice factoring, on the other hand, the financier controls the credit, so the principal will know that the contractor is obtaining finance.
Some of the advantages of financing include the quick availability of funding compared to other forms of loans, and (in the case of factoring) getting rid of the time and stress of chasing your own invoices.
On the other hand, you usually end up paying a higher interest rate than other forms of funding and (again in the case of factoring) a principal and others in the industry may begin to consider you a financial risk as they are aware you are obtaining finance. Invoice financing will also not be useful if the principal is paying on time.
Normally, a loan agreement is only between a lender (say, a bank) and a borrower (say, a principal/developer). However, in a tripartite agreement the financier includes the contractor as a third party in the loan agreement with the principal.
The idea behind a tripartite agreement is that if the principal defaults on the loan, the lender can ‘step in’ and still work with the contractor to complete the work. This provides additional security to the lender by ensuring the work is completed regardless of the principal’s future financial status.
With more and more developers facing difficulties, contractors that are in a comparatively strong financial position may be tempted to provide support to a principal who is struggling to complete the project on which the contractor is working. Obviously it will be in the contractor’s best interest for the project to be completed so that the contractor is paid for their work.
There are clear risks in this approach from a financial perspective. The principal will no doubt have obtained primary and likely mezzanine financing, the former being secured over real property and the latter at a high rate of interest. A thorough financial analysis of the project costings, pre-sales and the superior lending arrangements will be vital to ensure that the contractor doesn’t end up robbing Peter to pay Paul – or worse, doubling their losses!
Key terms in a construction loan agreement
There are certain terms in a construction loan agreement that will be of high importance.
Interest and default interest
You should be intimately familiar with the interest provisions, including the amount of your rate, whether it is fixed or variable/floating, and whether a higher rate will apply in the event of default (discussed further below).
Repayment and prepayment
It is important to know how repayments must be made. Will they be regular fixed repayments? Will there be a balloon payment – a larger payment that reduces the amount of the regular monthly payments – at the end of the term? Or will there be a single bullet payment, where the entire amount of principal and interest is repaid on the repayment date (which may be the date of completion of sales for a construction project).
You should also know whether you have the right to pay back amounts early to reduce the amount of interest you pay. If this is possible under the terms of the loan, you should check if you have to pay the lender a fee for the privilege.
As touched on above, your lender will have certain requirements before they advance you money. The terms of any loan agreement will provide that there is no obligation for the lender to do this until these conditions are met.
Events of default
An event of default is pretty much exactly what it sounds like: an event that brings the borrower into default under the loan agreement. Some examples of common events of default found in loan agreements include non-payment of the agreed loan repayments, representations being found to be false, and insolvency of the borrower.
With regards to insolvency being an event of default giving rise to an automatic right of termination, it should be noted that the ipso facto law reform regime that came into effect in 2018 applies to specified insolvency or restructuring events for corporate entities.
In the context of a loan, this regime would provide a stay on a lender enforcing its contractual right of termination until the corporate borrower has had an opportunity to restructure or sell its business.
Consequences of default
The consequences of a default will be impacted by whether the loan has already been advanced or not. Where the loan has not been advanced, an event of default will mean that the lender is no longer obliged to lend the amount and may recover any out-of-pocket expenses.
If the loan has already been advanced, an event of default will usually mean that the lender makes the entire loan (including interest) immediately due for repayment.
It is common in loan agreements for the borrower’s default to trigger a higher rate of interest. Whether the rate is enforceable will depend on whether the rate is proportionate and reasonable under the circumstances as opposed to being unconscionable and out of all proportion to the legitimate interest of the lender. In the latter case, the default rate will be considered a penalty and will not be enforceable. This will always be a question of fact and circumstances, and these circumstances are analysed as at the time the agreement is entered into, rather than at the time of default.
Additionally, if there is security for the loan, then the lender will likely enforce the security to ensure repayment on the loan.
So, what should a principal or contractor do to mitigate the harsh consequences of a default?
Ideally, you should:
- negotiate (if possible) and closely review clauses that specify events of default
- ensure you have sufficient grace periods, both in the loan agreement and in arrangements with other parties such as subcontractors
- ensure that your actions do not trigger default
Obtaining finance helps you maintain cashflow for a project or get your hands on the right equipment for a big job.
However, financing can be risky when not approached with the requisite care and due diligence.
To reduce the risks, you should:
- ensure the type of financing suits the needs of your business
- seek professional financial and legal advice before signing any documentation
- be acutely aware of the key provisions of your financing agreement
Batch Mewing acknowledge the contributions of Josh Saunders to this article