Construction lending is about to get hammered by trade war

Rising tariffs will put development projects and construction loans at risk. The Trump administration has begun renegotiating trade deals with many countries, while also increasing tariffs on imports such as steel and aluminum. These actions have led to what many are calling a trade war.

This has important implications for banks and other lenders working with construction projects because these projects traditionally operate on a thin margin of profitability and are likely to be negatively affected by rising costs.

Lenders should pay special attention to the current large material costs on their construction projects — a small rise in those costs could significantly jeopardize key vendor contracts. The rising costs from the trade war will adversely affect key parties involved in construction projects already underway. These vendors will struggle to meet obligations as the cost of materials rises abruptly.

Every construction loan has a budget that outlines the costs the developer expects to spend on each part, including for labor and materials. This budget is put together months, if not over a year, before the project begins. In normal years, an increase in materials cost would be accounted for, but no one predicted the sharp increase in goods now resulting from the trade war.

The prices of goods in the construction industry have already risen 9.6% in the last 12 months. These costs need to be absorbed for the project not to default. Traditionally, this problem falls on the shoulders of subcontractors. Agreements with subcontractors are often executed up to a year in advance, and it is common that the cost of materials is guaranteed by the subcontractor for 18 or 24 months.

For example, if the subcontractor agrees to provide drywall at $8/sheet and the cost of drywall rises to $12/sheet, the subcontractor is contractually obligated to pay the additional costs out of pocket. However, the subcontractor may only be making a 5% profit margin on the project — and thus a 10% increase in costs would result in the project being unprofitable. It becomes a better economic decision for the subcontractor to walk off the project.

When subcontractors are going underwater on a project, holding them responsible for the additional costs may cause them to go bankrupt, which will cause a significant problem for everyone involved. Construction lenders must work with their borrowers and contractors to cover the costs of the increased materials. This often means requiring the borrower to provide more equity to accommodate rising costs.

Lenders should review contracts with subcontractors that were executed months ago, as many of them are no longer profitable with the new tariffs. Preparing for the additional cost and looking for cheaper alternatives will help avoid some issues, but additional capital will be required in order to prevent a number of construction projects from coming to a complete standstill.