As Brexit fears abound, the general consensus seems to be that the UK property market has peaked and is showing signs of cooling down. Some blame the spectre of a “leave” vote in the forthcoming referendum but predict a return to “business as usual” if the UK votes to remain. Others, with a focus on London, fear that the new Mayor and his views on housing and infrastructure could be an exacerbating factor. The glass half-empty crowd, and I count myself in this number, fear that Brexit may be a mere fig leaf masking the cyclical nature of the market and the ultimate inevitability of a downward cycle at some point in the not too distant future.
Despite all of this, at the time of writing, the market is still pretty hot. Good contractors remain in high demand and because of this they can still afford to be risk averse in their approach to selecting jobs and negotiating contracts. Many clients, but particularly those that are new to the UK market, are still struggling to attract good contractors to their projects. The more ambitious the project, the greater the challenge. However, if the commentators are right and the market has peaked, it should not be too long before good contractors are competing for work again, which should lead to them being less risk averse and pricing jobs more keenly through necessity.
Against that backdrop, this post considers two key questions:
- Given the prevailing market conditions, what can clients do to make their projects more attractive to the contractor market?
- As we teeter on the crest of the current property cycle, is this the time for clients to review their procurement strategies and consider how they might capitalise on the next downward cycle?
Early contractor involvement
In my experience, early contractor involvement is one of the most effective ways to attract contractors to projects in an overheated market. Under a typical two-stage arrangement, the contractor can perform a range of pre-construction services before submitting its final price and entering into the building contract. This benefits the client and allows the contractor to interrogate key project risks so that they and their supply chain can price them more intelligently.
Key advantages of this approach for a contractor include the ability to:
- Review project designs as they are developed and, in doing so, advise on buildability and value engineering to help reduce risk and drive cost-savings. This can also help clients to achieve their desired apportionment of design responsibility and avoid any suggestion that they have “designed and dumped” the project on their chosen contractor.
- Carry out their own surveys and validate the data and information which has been provided to them by the client. This can help to unlock negotiations in relation to key risk areas such as site conditions, retained structures and third party interfaces.
From the client’s perspective, early contractor involvement enables it to:
- Secure capacity with preferred contractors, whose overheads and profit can be competitively tendered and fixed at the start of the first contract stage. In addition, sub-contract packages can be priced on a transparent “open book” basis.
- Fast-track construction. Rather than having to wait until its project is fully designed before going out to tender, the client can tender each package as and when the design for it is sufficiently complete.
However, two-stage contracting is not without its disadvantages:
- Clients inevitably lose the competitive tension that exists where multiple contractors are bidding for the same project.
- Any pre-construction services agreement is likely to amount to a non-binding “agreement to agree” in relation to the building contract. If a client fails to agree a final price with its preferred contractor, it will be forced to go back out to the market.
- Clients will be fixing their contractors’ overheads and profit at the peak of the market. On large projects with long pre-construction periods this may be a bitter pill to swallow.
Another (obvious) way in which clients can make their projects more appealing to prospective contractors is to adopt a contractor-friendly approach in their contract negotiations. Clearly, this will need to be balanced with the client’s own commercial interests and the bankability of its project. Ways of doing this include:
- Retaining or sharing some of the risks that contractors are known to be resisting in the current market, such as those relating to adverse weather, statutory undertakers and unforeseen ground conditions, particularly if there is a low likelihood of such risks arising on a given project.
- Agreeing sensible limitations on contractors’ liability, for example, capping a contractor’s design liability to the level of its professional indemnity insurance (clause 2.17.3 of the JCT Design and Build Contract).
- Agreeing payment terms that ensure a healthy cash flow for the contractor for the duration of the project.
Shortening the contractual payment cycle may well go some way to alleviating contractor concerns at being asked to contract with a brand new SPV, or an overseas client. If a client is able to offer additional payment security, for example a parent company guarantee or an advance payment, that may alleviate those concerns entirely and make the project all the more appealing.
The billion dollar question: how to capitalise on a falling market?
Most clients will want to see a return on their equity as soon as possible and would prefer to get cracking rather than wait and see if the market moves in their favour. However, this does not mean that they cannot still take advantage of a falling market. There are a few ways in which they can do this without unduly delaying their projects, including:
- Procuring the early packages separately and then transferring the contracts for these packages to a single main contractor later on. Early packages may include demolition, site clearance, piling, basement slab and other “site preparation” works. This will allow the client to wait until later in its programme before tendering the main contract. Also, completing the packages in the ground will help to de-risk the project and make it more attractive to prospective contractors.
- If the client has full confidence in its market predictions, it could go even further than this and procure just the low risk elements to begin with, for example, shell and core, and wait until the market has cooled before tendering the riskier elements of the project, such as internal fit out.
This can still be done under a single contract to preserve the contractor’s single point responsibility. The contractor would be required to carry out the low risk elements on a lump sum basis and price the remaining elements on an “open book” basis at the appropriate time. It would then be within the client’s gift to accept the contractor’s final price or, if a better offer comes along, to change horses. However, clients should bear in mind that some funders may not be willing to lend against a project which is being procured in chunks that do not have sufficient independent value or saleability. This may mean that, in order to capitalise on the falling market, clients have to fund projects out of equity to begin with and re-finance later on, if third party finance is needed.
Benjamin Franklin famously declared:
“In this world nothing can be said to be certain, except death and taxes.”
I think the cyclical nature of the property market could sensibly be added to this list. If the naysayers are right and the next downward cycle is just around the corner, now is the time for clients to consider whether the deals they are doing today will stand up to commercial scrutiny this time next year. Interesting times may be on the way but the ability to attract contractors to projects without the need for prostration will be a welcome silver lining for most clients that I know.
This blog post has first appeared on PLC Construction Blog, 15 June 2016.