Real estate is usually the most straightforward asset to finance. We know the collateral is in a fixed place and where to find it. We know there is an established real estate market to evaluate the property and dispose of the property. We expect that rent will usually be the source of cash flow that will repay the debt. Most real estate loans are repaid over several years, usually through regular payments that will include principal and interest.
Financing a service provider is an entirely different animal. A doctor, lawyer, engineer, architect, general contractor, etc. has different financing needs outside the realm of real estate. Service providers (or contractors for short) perform a service and then bill for that service. When the service is billed, the contractor records an account receivable as an asset on their balance sheet. If a contractor has a need for cash before they can collect on the account receivable, they may need a line of credit so they can access working capital. Once cash for the receivable is collected, they will use the proceeds to repay the outstanding balance on the line of credit.
It’s interesting how some real estate fundamentals can help us understand underwriting for contractors as well. For example, an ideal real estate project has a tenant identified before the loan is funded. This is so a future source of cash flow for repayment is secured. Ideally, we would like to see a similar situation for the contractor before making a line of credit available. Much like a real estate project needs a tenant with a lease, we would like to see a contractor with a signed contract for a customer. This way, we know the contractor has secured future cash flow. Good practice dictates the underwriter ask for a list of contracts to see how much work is left to be completed, which is an indication of future cash flow for the contractor.
Another useful feature of a real estate lease has to do with determining the price of rent. The lease will state what the required rent is each year as a fixed price. A contractor’s contracts should be evaluated for pricing too. Some contracts are “cost plus,” meaning the customer agrees up front to pay a certain percentage of profit based on the cost of materials. Other contracts are “hard bid” or “fixed cost,” meaning they will only receive a set amount of money, regardless of the cost to complete the service. Fixed cost contracts have more risk, and require the contractor use great judgment in estimation and cost control to ensure a profit can be earned.
The issue of collateral is generally more difficult when dealing with a contractor’s line of credit. In real estate, cash flow from rent collection is the primary source of repayment, and the sale of the real estate asset is the secondary source of repayment. With contracting, the accounts receivable should regulate the size of the line of credit as if they are collateral, but they are truly the primary source of cash flow for the repayment once cash is collected. If accounts receivable are the primary source of repayment, a secondary source of repayment will need to be identified.
And lastly, with an accounts receivable being a primary source of repayment, it is necessary for a lender to consider the counter party risk of those receivables. The lender should identify any concentrations of receivables, and know the credit risk of those concentrations. A contractor with a high concentration of work done for one customer will be in dire straits, if that customer fails to pay or fails to renew a contract in the future. This is just like in real estate when a project is dependent on a single tenant. The underwriter must assess that tenant’s ability to pay as part of financing the real estate.
To summarize, when evaluating a contractor’s creditworthiness, it is ideal that a contractor has existing contracts. The underwriter should review those contracts to evaluate to determine future cash flow. The underwriter should determine if the contracts are “cost plus” or “fixed cost,” and if they are fixed cost, understand the bidding and estimation process is very important. The receivables for work performed on contracts should regulate the size of borrowings, but shouldn’t be confused as a secondary source of repayment. And, it is necessary to understand the underlying credit risk of those receivables, if the contractor is highly dependent on a particular customer or contract.