Five signs of a building company's health explained

For the sake of our own well-being, let’s not label the current state of the US building industry as an all-out terminal illness but rather a malaise – a serious one at that, but still with hope for recovery. Like any downturn in health, it’s important to recognize a patient’s symptoms in order to apply the best medicine.

Russ Stephens (pictured), co-founder of the Association of Professional Builders (APB), detailed five key warning signs that indicate a residential building company may be headed for trouble. According to the industry veteran, now is the optimal time for residential home builders to take stock of their business and cash flow – their financial health, if you will – to avoid facing a more dire prognosis on the horizon.

With a figurative stethoscope at the ready, Stephens sat down with Mortgage Professional America to detail those five stages of health – those aforementioned symptoms – and what builders can do to regain their strength. The five stages are:

• Potential loss on a contract: APB warns that this is stage zero, the first sign of trouble.  
• Actual loss on a contract: This stage is one where the building company, for whatever reason, has lost money on a project once their proportional fixed expenses were factored in.  
• Company lost money: If proportional fixed expenses were not factored in, the next stage of decline for a building company is an overall loss from all their activity during a financial or calendar year. 
• Negative equity: At this stage, building companies are extremely high risk and vulnerable because their liabilities exceed their assets.  
• Insolvency: Once a company reaches this stage and is no longer able to pay their invoices on time, they are classified as insolvent.  

To be sure, the last 12 months have been especially tough on builders, Stephens said, what with an uncertain economy fueled by inflation and showing signs of a recession. Add to that the challenges of securing building materials as a result of supply chain backlogs along with soaring property values, and it’s no wonder the industry is under the weather.

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Things have gotten so bad that around 80% of builders are using their own funds in order to complete clients’ homes, Stephens said. Some US companies are struggling to implement cost-escalation clauses which has led to a myriad of issues, he added. If those losses continue unchecked, he warned, builders eventually will find themselves unable to pay their bills and will be forced to call the liquidators in, he added.

But it’s not too late. Many builders – and consumers as well – can still save themselves, he said.

“Building companies can trade even while losing money and having negative equity,” Stephens began. “And that’s all because new construction is cash flow positive, and that masks a multitude of sins, effectively. That whole situation is what presents such a high risk for consumers, which is why it’s so important for them to be aware of these five stages of decline. Once they understand what could be going on under the surface, they can become more alert to the potential danger.”

Mind you, this applies strictly to new construction, he emphasized. Conversely, remodeling is not generally cash-flow positive. While the same stages could apply, they cannot mask underlying problems as with new construction, he explained.

“What that effectively means is that in new construction – and we see this all the time, even in good times – building companies doing new construction can continue signing new contracts effectively below cost and that can go on for years. But it’s like a cancer, really, because it’s eating away at the health, the strength, of the building company which is their reserves, their equity. If left unchecked, that building company will topple over and die at some point.”

But let’s start at the early stages of malaise, maybe a scenario starting with a figurative cold perhaps accompanied by low-grade fever. “To put this all into perspective,” Stephens said, “when we look at stage zero – which is the potential for a loss on a contract – this affected virtually every building company in the world with what’s happened with COVID. As a result, construction inflation virtually put every fixed-price contract underwater potentially.”

A brief timeframe opened up to be proactive on this, but forces emerged too fast: “The opportunity at that point was to renegotiate the contracts before they started,” Stephens said. “But this situation came in so fast, most building companies didn’t really have this opportunity. They started contracts that then turned negative quite quickly afterward, so this is why a lot of building companies ended up on stage one loss on a building contract.”

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This resulted in a scenario where builders dug into their own pockets to honor those contracts.

While consumers should be aware of this, it’s not necessarily a red flag given that it was a shared experience among virtually every builder, Stephens noted.

But then we start to get into the second stage when things begin to get a little more troublesome: “As we go into the next stage, this is where it starts to get really serious because around 50% of building companies lost money overall,” he said. “This is where they simply aren’t reacting quickly enough to a fast-changing situation. Although virtually every building company did get called out to at least one job, a lot of these guys reacted quickly, which is why we only saw 50% lose money overall.”

The danger when builders miss the warning signs comes at a time when consumers already are being hit hard by inflation and interest rates rises – not in a position to cover the increase in the cost of construction materials.

Ironically, it’s the work ethic of builders that can get them in trouble, Stephens observed:

“They’re always trying to do the right thing by consumers, and that means delivering on a promise they made a year or two years ago which, as a business person, is simply not viable anymore. I’m not suggesting they should be juicing contracts halfway through the build, but they should be at least renegotiating before construction starts and giving consumers a chance to pull out.”

Once builders start pulling out their equity to finish projects is when all kinds of red flags fly and consumers should start to take note. This could potentially be the beginning of the end for an already-ailing building firm, Stephens said.

“If they continue trading in that manner, they’re now going into negative equity,” he said. “However, what will happen – and this is why it’s now serious for consumers – it’s almost like a Ponzi scheme because a Ponzi scheme will work in good times but when the stock market crashes and investments slow down, there’s no money to rob Peter to pay Paul, and that’s how a lot of these building companies are operating. As we’re seeing the market go down, that’s when we’re going to see the tide go out. And, like Warren Buffet said, that’s when we get to see who’s been swimming naked. So that’s now the big risk.”

Know the signs, consumers!