Negotiating your construction contract for a development is a crucial part to ensuring the success of your project. We often see borrowers who have agreed terms with a builder, only to have to go back to the contractor as their lender has changes they require to the contract.
Below we address Liquidated Damages, Retentions and Performance Bonds which are three items a lender will place some focus on when reviewing a construction contract. They are important levers within a construction contract that provide the developer and by proxy the lender protection. However, they also can place further risk on the project which we also discuss below. Firstly lets talk about what each of these items are and why they are important.
Liquidated Damages (LD’s)
Firstly we will discuss Liquidated Damages. This is a mechanism within a construction contract that is designed to ensure a project is completed on time. It normally comprises a daily cost to the builder for any delays to the target completion date. This daily cost will vary and is normally representative of the finance cost of there being a delay in completion.
Within the contract a target completion date will be set and if that is missed then the contractor may need to pay Liquidated Damages. Throughout construction the builder can make Extension of Time requests for items that are outside of their control to extend the targeted completion date and give them time to meet it. These need to be accepted by the developer.
Liquidated damages are a handy tool to have within the contract as in simple terms, money is a motivator. If a contractor is aware that there is a true financial cost to them not completing a project on time they will be incentivized to apply further resources and attention to completing your project and catching up on their program as required. This is important as finance can be costly and delays can result in significant financial outlays for the developer. It may also put pre-sales and other commitments at risk so being able to trigger liquidated damages is useful in motivating a contractor.
Performance Bond
A performance bond is an amount of capital set aside or committed by the contractor as a form of insurance against their performance. Often this will form a guarantee from the contractors bank that they will pay out the bonded amount in the event that the contractor defaults on their obligations, however, we have also seen these take the format of funds held on trust or the guarantee provided from an insurer.
The performance bond normally comprises 5% of the total contract value (i.e. $150,000.00 for a $3,000,000.00 contract). It is important as in the event the contractor defaults on their obligations, most commonly resulting in them being fired from the project, the developer will need to find another contractor to complete the works on site which often costs time and money. The performance bond will ease the burden of this releasing the funds to manage these costs.
A lender will often require this within the civil and construction contracts and then likely take an assignment over these as part of their security pool. They want to ensure if things go wrong on the project they can control the flow of funds to ensure the project moves forward as seamlessly as possible and any losses are mitigated.
Retentions
Retentions are a small amount of funds that are held back from each payment against performance of the contract. They are effectively held as security by the client until specific conditions within the construction contract are met.
These funds are normally released once all defects are rectified and any outstanding payment disputes (see Liquidated Damages) are resolved.
The contract will stipulate a retention rate which is normally somewhere between 5 and 10%. Each payment under the contract will then have that percentage of the payment withheld until the conditions within the contract are satisfied.
Retentions are important as, similar to liquidated damages, they provide security and incentive to ensure the development is completed to a requisite quality and on time. This is the reason that a lender would seek to include a retention within a construction contract.
It is necessary to understand the framework of the contract and how release of these retentions is applied. Misunderstanding these may negate the leverage held and result in the release of the funds without obtaining the desired benefit.
So, the above surmises these three important contemplations within a construction contract. While these are important and can provide surety and some protection to a developer or lender, they also can increase the risk for the contractor. Retentions and the performance bond in particular can create pressure for a builder's cash flow.
A performance bond provided from a bank for a contractor is typically fully secured by way of a lien hold on cash. This means that the contractor is required to put 5% of the contract's value on deposit prior to getting underway with the project.
Retentions, as mentioned above, can be up to 10% of the contract's value. This means a further 10% of the contract's value is withheld from the contractor.
Given, particularly in a competitive market, contractors will price aggressively to win business margins on development projects can be as little as 10 – 15%. With that in mind, the profit or margin from a development project for the contractor can be entirely tied up through past the completion date. If there are cost overruns, issues within the contractor's business (or on other contracts) or other unforeseen cash flow issues for the contractor they can quickly come under pressure.
Because of this we and lenders often do some diligence on what other projects the contractor may have underway to get an understanding of any collateral risk. We will also often lobby to have some dilution bought into a construction contract to perhaps remove or limit retentions or liquidated damages. This is to remove some of this cash flow risk, however, it is not often possible to completely do away with this particularly on larger contracts.
Overall, it is important to understand all contracts you enter and what their nuances mean for all parties involved. A development goes best when all parties are successful and therefore ensuring all are critical. Your quantity surveyor will normally be in a good position to provide advice and help to negotiate these contracts and it is always worth consulting with professionals when preparing and reviewing key contracts.
If you have any questions, please don't hesitate to reach out!
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