Lending to Architecture Firms
Fraker, Greg, The RMA Journal
Because it is largely influenced by the amount of construction spending in the economy, the architecture industry is cyclical in nature. Construction spending, and thus architecture activity, usually outpaces the overall economy during periods of economic growth and declines when the economy weakens. The data in the RMA Annual Statement Studies[R] confirms this: During the recent recession, annual sales growth for the typical architecture firm declined from 13.5% in 2007 to -19.1% in 2010.
Regardless of the economic environment, you should consider several key factors before lending to an architecture firm. Among them are 1) the qualitative characteristics that influence a firm's success, 2) the quantitative measures that indicate if it's financially healthy, and 3) the quality of collateral and guarantees available. This article will discuss these three factors in greater detail.
Analyzing an Architecture Firm's Qualitative Factors
Although many qualitative factors influence an architecture firm's success, among the most important are its specific market niche, the expertise and experience of its architects and staff, and the quality of its risk management practices.
Because most architects prefer professional autonomy, their firms are usually small. Approximately 79% of architecture firms owned by AIA members have fewer than 10 employees. (1) Also, many architects have an affinity for and specialized expertise in a particular type of project. So before lending to an architecture firm, you should understand the types of projects the firm designs and which factors may influence the demand for them.
According to the 2009 American Institute of Architects Firm Survey, (2) institutional projects--for education, health care, transportation, religious, cultural, and recreational facilities--have historically accounted for about 50% of all U.S. architecture industry revenue. Commercial projects (office, retail, and industrial facilities) account for 30% of industry revenue, and residential projects (single- and multifamily housing) make up about 10%. "Other construction" and "nonconstruction" activities represent the remaining 10%.
Institutional projects are typically funded by government agencies (usually local and state governments) or by nonprofit organizations. Government funding for institutional projects is often determined by public-sector budgets. As David Johnson notes in his article "Municipal Distress: What to Consider When Working with Local Governments," public-sector budgets are often constrained by underfunded pension and health care liabilities, increasing debt service obligations, inadequate revenue sources, and practical and political limitations. (3) Nonprofit organizations, meanwhile, are typically funded through fees for their services, contributions from private donors, and government grants.
For commercial projects, demand is often influenced by real estate and economic factors, including the supply of existing commercial properties, interest rates, access to credit, and business and consumer sentiment. Architecture firms with a niche in commercial projects may be more adversely affected by economic cycles, as business investment in new or updated facilities often lags the beginning of an economic recovery, accelerates rapidly once a recovery is under way, and then declines steeply during an economic downturn. (4) The factors that influence an architecture firm's market niche should be analyzed within the context of the geographic area in which the firm operates. Traditionally, architecture firms have focused on projects within their own geographic market. However, owing partly to technology and also to a lack of local opportunities since the recession, some firms have sought projects outside their own market, including projects in other countries. (5)
Professional Expertise of Architects and Staff
Like other professional services, an architecture firm is often hired because of the reputation, expertise, and experience of its architects and other professional staff. …