By David Taylor
Marvin Gaye’s classic 1971 record “What’s Going On” turns 50 this year, and interestingly, as many of us look around the 2021 housing industry, we can’t help but reflect on how relevant those three words continue to be.
Since the beginning of the Covid-19 Pandemic, demand for single-family homes have soared, acting as one of the bright spots in the economy. It’s clear many Americans fled large, city centers in favor of the suburbs while mortgage interest rates fell to historic lows.
Recently, however, the Commerce Department announced single-family home starts declined from March 2021 to April 2021 by 13.4 percent and overall construction starts down 9.5 percent.
Wait, what?!?
Yes, it appears several underlying factors have rippled through the housing market, potentially causing a major concern for lenders for the foreseeable future.
According to Business Insider , lumber prices rose by more than 250 percent over the last year. In fact, the National Association of Home Builders estimate these increases may add more than $24,000 to the price of the average single-family home. While some might assume this price surge is due to a lack of raw material shortage, a number of factors are in play. Actually, these lumber shortages are a result of a combination of mill closures and slow production due to infection concerns along with the unexpected increase of Do-It-Yourself (DIY) aficionados on lockdown, creating a “Perfect Storm”, otherwise known as “insufficient domestic production.”
The result -- high demand plus low supply equals high prices. This dilemma is eerily similar to the 2007 steel situation, when fabricators wouldn’t protect a quoted price for more than 24 hours due to a raw material shortage. Officially termed “backwardation,” this situation occurs when current prices of an underlying asset are higher than prices trading in the futures market. In other words, backwardation is when the forward price of the commodity is less than its current market price. While the steel market in 2007 was relatively short lived, experts predict lumber may not stabilize until late 2022.
“Force Majeure,” presents a further complication to this market driven situation. Defined as a “unforeseeable circumstances that prevent someone from fulfilling a contract,” Force Majeure is a term that has been included in construction contracts for decades.
When the pandemic began in the first quarter of 2020, the textbook definition of “Force Majeure” became more uncertain for lenders. Because some party must be responsible for covering costs for the substantial material price increase, many lenders’ solution was to ensure the project’s funds were available if necessary, to advance the project to completion – whatever the situation.
As we navigate the new norm, how do lenders maneuver through this market volatility? We see two options:
1) Watch the Commerce Department’s May numbers to understand if a temporary dip occurred --
Given applications for building permits rose .3 percent, loan applications are sure to continue, and the feasibility process must go on. So, proceed like everything is “normal.”
2) Be Prepared – Use data analysis in the underwriting process
For example, a Project Review offers a line-by-line analysis of a project budget in relation to the prepared documents. If a project completed currently in 2021 offers less than $35/square foot pricing for framing, caution is strongly advised. Likewise, if framing is below $35/square foot coupled with a 2.5 percent overall project contingency, another red flag should be raised. Using this process allows for checks and balances on pricing for various components and supplies.
One of the most crucial ways to successfully complete a project in this current industry climate is to include a robust project contingency within the funding requests to ensure requirements are achieved for each funded project. A project’s budgeted contingency should reflect and provide enough cushion for fluctuating industry “board prices,” which is what one would pay if a stick of lumber was purchased right off the shelf.
In the end, the key is to be prepared and informed.
Only time will tell if this market volatility continues and if rising inflation exacerbates an already difficult decision. Whatever happens, lenders must over prepare for these unexpected influxes to ensure they stay on top of “What’s Going On,” and remain relevant and solvent in the potentially bumpy days to come.
At Trinity, we’re glad to assist lenders overprepare in this uncertain construction lending marketplace. Please reach out to us with any needs, and we’ll be glad to help.