Alternative Lending in the Construction Industry
Generally, when people think of construction lending, they think of the obvious: Banks.
After all, in pretty much every sector of the economy, banks provide the flagship product: The traditional line of credit.
There’s no denying that the bank LOC has some definite advantages–namely, price.
While alternative lending varies with regards to fees and interest rates, virtually every product on the market is going to be more expensive than a conventional credit line from the local bank.
However, for contractors, these low rates are both a blessing and a curse: On one hand, a bank loan is cheap. On the other hand, bank loans are cheap for a reason…with their strict underwriting requirements, banks generally can only lend on the very cleanest, most secure deals. For someone who’s been in business 20 years, has significant assets, great credit, and a variety of solid account debtors, that may not be a problem, but for everyone else, it can present a real hurdle.
On top of that, in order to guarantee their security, banks often over-collateralize–it’s not uncommon for a $400k line of credit to be secured by $700k in assets, plus $400k in receivables. This requires not only significant assets, but creates the risk to a business owner of significant loss in the event of default.
It’s due to these drawbacks that some businesses turn to alternative lending sources.
While alternative lenders are more expensive, they’re able to offer flexibility that banks cannot. Additionally, depending on the type of product, some alternative lenders offer a level of value that is comparable to a bank line of credit. Below is a brief overview of the types of alternative lenders that exist in the construction sector, as well their benefits and drawbacks:
- Mobilization Funding
Starting a project takes money. Just getting to that first draw on a job can mean several weeks, if not months of payroll, as well as liability insurance, materials, and the costs of getting everything to the jobsite. Companies that specialize in mobilization funding aim to solve this problem by advancing contractors the money they need upfront to begin the job.
Benefits–Gets the client the money they need to start the job. Generally cheaper than a Merchant Cash Advance (MCA).
Drawbacks–High interest rates.
Particularly in commercial construction, getting to the first draw on a job is only half the battle–once an invoice has been submitted, the property owner has to wait for the bank to release payment in order to pay the general contractor, and the general contractor then has to wait until they’ve received the money in order to pay their subcontractors. For a subcontractor, this means payment can often take up to 90 days after the submission of that initial invoice….which, in turn, means another 90 days of floating the cost of payroll, materials, insurance, and overhead. Factoring works by advancing the contractor a percentage of their open pay app, giving them money which can then be used to keep things running while they wait to be paid by the owner.
Benefits–Aside from government backed SBA loans, this is generally one of the cheapest forms of alternative lending. Also, because so much of a factor’s security comes from the strength of the account debtors, a good factor will steer the client away from jobs that are unlikely to pay.
Drawbacks–Paperwork and red tape. Though getting funding through a factor is still faster than obtaining a bank LOC, there does tend to be a bit of underwriting and paperwork involved.
- SBA Loan
Recognizing that a conventional credit line may be unobtainable for many small businesses, even those with reasonable credit and assets, the government has stepped in and offered to back specialized loans intended to help small companies grow. SBA loans can go up to $5M, and offer rates comparable to that of a normal line of credit.
Drawbacks–Extensive underwriting. Lots of paperwork. Limited flexibility. Much like the traditional line of credit, these loans can be quite difficult to attain, particularly for borrowers with past credit issues.
- Merchant Cash Advance
A Merchant Cash Advance is generally the last resort for those in search of business financing. On one hand, these advances are easy to obtain, and the underwriting process is near-instantaneous, allowing applicants to get the money the same day they apply. On the other hand, the fees are exorbitant, often exceeding 200% APR. As such, these are essentially the PayDay Loans of commercial finance, complete with all of the problems normally associated with that industry.
Drawbacks–Extremely high fees
While none of these alternative sources of lending will ever replace the conventional line of credit, they do provide useful avenues for those times when a traditional credit line just isn’t a good fit. In addition, particularly with services such as factoring, it doesn’t have to be an either/or arrangement: A client may benefit from working with both a factor and a traditional bank, in order to get the flexibility needed without paying higher fees than necessary. Such arrangements can be beneficial for all, since such a partnership may also provide greater financial protection for both the bank and factor.