Understanding Construction Risks

OP CIVILBy Kristopher Stahle

The performance of the construction sector relies on a complicated web of internal and external factors the level of risk varies wildly from country to country, region to region and even city to city. The construction industry, for example, behaves a lot differently in New York City than it does in Madison, Wis.

To successfully and thoroughly gauge risk, businesses need to understand factors that impact construction on both a macro and micro level. The big-picture economic outlook could look positive, but the behavior of individual companies or within individual locations might not match up.

But on the whole, construction remains more risk-prone than other sectors. According to an industry report by Atradius, a trade credit insurer, the past few years have brought only mild growth. Widespread issues include high competition, slim profit margins, the tendency of public buyers to pay late and a high proportion of business failures compared to other industries. Recent major political events have also introduced another layer of uncertainty into the global construction sector, including China's rising inflation, the polarizing U.S. election, Brexit and tanking oil prices.

There are also new opportunities ahead. Technology continues to rapidly transform the industry, particularly augmented reality, drones, 3-D printing, autonomous equipment and advanced building materials. The global trend toward urbanization is another positive. As more of the population chooses to live in large urban centers, the demand for housing, social transportation and utility infrastructure also rises.

Evaluating Macro Risks

When evaluating risk on a macro level, one factor that wields a heavy influence on the construction sector is a country's economic health. In Germany for instance, high employment rates, low interest rates and the recent influx of refugees and asylum seekers are increasing housing demand and accelerating construction growth. In the United States, the sector's healthy growth over the last few years has been aided by a burst of non-residential construction. Growth is expected to continue expanding if the Trump administration makes good on promises to invest heavily in infrastructure improvements. However, political gridlock and shifting priorities mean this might not come to fruition.

Two countries with poorly performing construction sectors due to poor economic health are Italy and Saudi Arabia. Italy's barely existent GDP growth – only 0.8 percent in 2016 and even less predicted for 2017 – has caused the construction sector to contract. Investments in the sector are expected to decrease 1.2 percent by the end of this year, with new housing investments down 3 percent and public works investments down 3.5 percent. In Saudi Arabia, tanking oil prices have deteriorated the larger economy. Because the Saudi government is the largest sponsor of construction activities, the construction sector has keenly felt the squeeze.

Payment practices and the rate of insolvencies offer another way to gauge the health of a particular area's construction sector. Slow payment is a common issue in construction worldwide, putting a strain on suppliers' liquidity. In Italy, for instance, payment can take as long as 5.5 months, the problem exacerbated by tight lending conditions and habitual late payments from public entities. Saudi Arabia doesn't fare any better by this measure here, average payment duration is 120 to 180 days, and non-payment notification and insolvencies have recently been on the rise.

Even Germany, which has one of the most stable construction sectors globally, isn't immune to these risks. Average payment time is as high as 45 to 50 days, putting pressure on smaller firms. Although insolvencies have decreased in recent years, the proportion is higher than in other German trade sectors, accounting for about 16 percent of all business failures.

Evaluating Micro Risks

To evaluate risk on a granular level, payment practices and length of time in business should be scrutinized. In terms of the former, trading experiences of at least a year can provide valuable insight, as can the payment experiences of peers. End buyers can also reveal a lot about a company's payment practices. Just one poor end buyer can have a trickle-up effect, negatively impacting the entire supply chain. And while newer companies don't automatically pose a high risk, businesses should put extra precautions in place before trading with them. These precautions can include requiring financial insight and supplier-friendly terms and obtaining bank or parent company guarantees.

The size of the firm can matter, too. In general, larger companies tend to be more stable than small- and medium-sized businesses. Larger businesses tend to pass price pressures on to the next level. They also benefit from high margins in private-public projects and are more able to look for business opportunities abroad. Small construction companies, on the other hand, traditionally have weak equity ratios and limited financial scope, and are especially vulnerable to payment delays and defaults.

Trade credit insurers can protect businesses against payment risks, but they also can provide analysis and guidance on the front-end of any new business venture and alert companies of any uptick in instability on both a micro and macro level.

Kristopher Stahle is a risk underwriter analyzing the construction/construction materials sector for Atradius' Risk Services-Americas division. He can be reached at Kris.Stahle@atradius.com.

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