SURETY CORNER: Interest Rates and the Canadian Construction Industry
In a press release dated September 7th, 2022 the Bank of Canada announced they would be raising interest rates by 75 basis points. This hike came on the heels of a July 13th, 2022 release which similarly saw a 100 basis point increase, marking a significant effort to curb inflation. As written about by FCA Surety’s Andrew Cartwright in May’s edition of Surety Corner, “it is clear the inflationary environment has been more stubborn and persistent than many expected when it first arrived.”
The September Bank of Canada press release goes on to state: “Given the outlook for inflation, the Governing Council still judges that the policy interest rate will need to rise further… Council remains resolute in its commitment to price stability and will continue to take action as required to achieve the 2% inflation target.”
With this in mind, this article will address what the Canadian construction industry can do to prepare for a sustained high interest rate environment.
Who will be most impacted by rising interest rates?
Speaking generally, sub-trades will bear a more significant impact to their corporate balance sheet as a result of rising interest rates. The nature of the construction pyramid means they are further removed from project funds than a general contractor and as a result are more frequently relying on financing of some form to pay employees, suppliers and other project stakeholders.
In addition, sub-trades often rely on financing for their construction equipment. Particularly on work where the subcontractor may be locked into fixed price contracts for long term periods, it is important to factor in the increased cost of borrowing into future margin calculations.
General Contractors Making Use of Operating Credit
A true general contractor’s balance sheet should look materially different than that of a sub-trade. Firstly, they are closer to project funds and can drive billings to front load a contract in an attempt to remain cashflow positive. Additionally, given that the amount of work being self-performed should be materially lower than that of a sub-trade, they should have less costs to finance prior to receiving payment.
This is why it is particularly concerning to see habitual operating line of credit usage by a general contractor, especially in a high interest rate environment. General contractors may not have the same project costs to finance as frequently as sub-trades, but the margins they achieve typically reflect that. A reliance on operating debt to pay sub-trades in a high interest rate time period may erode the margins a general contractor expected to enjoy at the time of bidding a job.
With construction lending costs rising and an increasingly large number of projects being delayed due to supply chain challenges and buyer uncertainty, developers will most certainly feel the increased cost of borrowing. A symptom of this is likely to ripple through the surety industry as developers continue to lean harder onto their surety brokers to release deposit funds into the project through the use of a Tarion Bond and Excess Condominium Deposit Insurance. While interest rates rise, rates for deposit releases by a surety remain consistently cheaper on an ongoing basis.
When it comes to developers who are questioning how rising interest rates affect their surety relationship, Alastair Cartwright, Vice President at Tokio Marine Canada had the following insight:
“Over the last few years, the general rule for contingencies to be included in development proformas is approximately 5% of the project cost to complete. In an environment with rising interest rates, supply challenges, and construction cost escalation, this level of contingency may no longer be sufficient, especially on longer duration high-rise condominium projects.
When creating a development proforma in consultation with the project cost consultant, Developers should consider running sensitivity analysis to determine the cost impact of both increasing interest rates over the duration of the Project, and the associated interest cost impact of project delays, to ensure that there are sufficient contingencies built into project budget to handle these variances at the outset. Having done this analysis will also assist with an application for Tarion Bonds and ECDI as the surety will certainly consider the adequacy of the project contingency as part of their underwriting considerations.”
How can contractors manage a high interest rate environment?
FCA Surety took to the market to ask two surety professionals what their advice for contractors is during these inflation fighting efforts by the government, to which they had the following to say:
Mark Skanes, Vice President at Western Surety Company
“Everyone knows interest rates are going up, and this will be a trend for some time. As a result, contractors need to keep their lenders aware of any potential issues that will reflect problems on their balance sheet. A strong balance sheet gives lenders latitude when determining rates/terms, surprises have the opposite effect. In addition, added emphasis should be placed on collecting accounts receivable, to minimize operating line usage, and pending long term financing requirements should be finalized as soon as possible. Needless to say, being profitable and building up your company’s finances, is always the best way to hedge against inflation and rising interest rates.”
Michelle McCafferty, Manager at Tokio Marine Canada
“For contractors that currently have any variable interest debt of consequence, we would recommend taking the extra effort now to forecast the impact of future rate hikes on their cashflows and get a plan in place now for how they will manage it into the future. They should enlist the help of their accountant, if needed, and be having discussions with their bank as soon as possible to plan and manage their banking facilities. Both the banking and surety industry place a lot of value in clients who are proactive rather than reactive when it comes to managing their companies, and those who are actively planning for the downside, rather than waiting and hoping it will work out. Naturally, where possible, it would also be prudent to minimize taking on further debt until we come out the other side of what could be a fairly long and drawn-out financial weather system.”