Construction projects are crumbling because of payments friction
The leverage of payments goes both ways on a construction site. For example, a plumber hired to complete a project may withhold performing work as a result of nonpayment, while a general contractor may withhold payment until a couple remaining faucets are installed.
Streamlining the invoice approval process and providing transparency in the payment flow for construction sites enables projects to reduce risk, obtain better loan terms, secure better contractors, and deliver projects faster. Slow money results in slow projects and critical to that flow is not only improved payment rails but also better document workflow systems.
As payment is the primary form of leverage, it becomes critical to the relationships and the success of a development. Projects can suffer significant setbacks due to slow payments. The delays not only cause increased management and interest costs to a developer but can also delay turnover when the developer begins to lease up the building and generate revenue.
When a contractor working on a massive commercial project, say a new mixed-use development, submits an invoice, it is often aggregated with other invoices. The invoices are sent up a long string of approvals and payment is sent back down that long string before they are ultimately paid. That’s because most contractors in the U.S. are subcontractors, meaning they are working underneath other contractors, often called general contractors. And these general contractors are working for developers that are taking out loans from banks to pay for the construction.
Because of these layers and layers of contracts, it can take months to pay an invoice, as the payment will flow through several bank accounts before ever reaching the account of the company that performed the work. Each bank account that the payment flows through is another opportunity for the cash to be used to pay for something other than its intended purpose.
The threat of mismanagement is why the Office of the Comptroller of Currency recommends that lenders pay subcontractors directly because a direct payment can prevent the diversion of funds for other purposes that expose the lender to additional risk.
The risk centers around lien laws in each state that will allow a contractor to place a lien against a property for nonpayment. That’s right, a plumber who’s had to wait too many months for payment can file a mechanic's lien and derail an entire multimillion-dollar development. These liens can sometimes supersede a lender’s first lien to a property and are the primary risk for commercial construction lenders. Thus, ensuring the invoices the lender pays are paid is critical.
Direct payments and transparent tracking of them equates to reduced risks for lenders. Typically, a lender will disburse a payment by funding a local account at their institution. The bank has no way of tracking what happens to the funds once they've been withdrawn. With today’s improved technology and smartphone adoption, lenders are now disbursing payments to an account similar to an escrow account where developers and contractors can then initiate payments to the approved recipients. This level of control maintains the contractor’s payment leverage while preventing diversion of funds.
The entire process is transparent and visible to all stakeholders, which provides an audit trail of who’s getting paid and when. This logic can be analogous to an automatic payment on a student loan. When a lender knows the account will be auto-debited each month, the risk of default is mitigated, and they can offer reduced interest rates. In construction lending, an analogous tracking of payment data can minimize the risk of subcontractors not receiving payment leading them to file a lien. Access to this data mitigates this risk and leads to lien-free completion of projects.