All in Agreement: Trail of Crumbs
Some states allow hunters and fishermen to lure their prey using bait or scent that can't be resisted. Some owners will bait a GC into building projects for an owner who can't afford it or who is highly leveraged. A highly leveraged owner is someone who can't really afford to have a project built and has very little of his or her own money in the deal. However, through persuasion and maybe a little Enron accounting, the leveraged owner gets a GC and a bank to bite.
The condominium market is a good example of owners who may be leveraged to the point of financial collapse. The following situation, as well as the owner and general contractor's names, has been changed to protect the innocent.
Big T Contracting entered into a contract with Small P Condominium developer to build a 25-story condo tower in a state where Big T normally builds buildings. This is Small P's first attempt at developing a condo tower outside of its area. Big T gives the developer a price to build the tower and the developer goes to the bank and starts the financing process. Small P convinces the bank that there is a demand for condos in the area. Small P condo developer also tells the bank that it already has buyers for 50 of the 120 units.
The bank looks at the price Big T proposed, knowing that Big T is a very reputable long-standing general contractor in the area and then considers the owner's limited financial resources. Although the bank knows that the owner of Small P has very little collateral and will be highly leveraged, the bank decides to go ahead with the deal because the condo market is very hot in this city and Big T is a reputable contractor. After all, buyers are lining up to buy the units that aren't even built yet. Also, the bank knows that if it forecloses, the subcontractors' liens will be null and void. In other words, the bank could end up owning the building without paying off the subcontractors.
Forget the ownerThe bank looks at Small P condo developer as simply a company to loan money to. Although Small P is not the ideal developer a bank wants to loan money to, the bank is in control from start to finish. The owner is simply a conduit in this case to loan money on a project the bank feels is in high demand. A leveraged owner pays a hefty fee to the bank for being highly leveraged and the bank gets its fee up front once the loan is made. The bank also charges a highly leveraged owner a higher interest rate. As you can see, the bank is in control and is highly compensated on a calculated risk.
The bank's biggest risk is the condo units not selling. It's interesting to note how simple the math is. If you multiply 120 units by 20 percent less than the appraised value, you end up with a sell-out price of $43,200,000. The total construction costs estimated by the very reputable Big T general contractor was $34,000,000 and the bank's estimated interest carry, marketing and sales commission costs, added another $6,000,000 for a grand total cost of $40,000,000, leaving the owner a profit of roughly $3,000,000 or more earned over a 24-month time frame.
The baitBig T general contractor knows that the owner Small P is leveraged and relying on the bank's money. Big T knows it's in the company's best interest not to self perform the work, so it hires subcontractors to do it all. The GC, by not performing any work, is spreading the majority of the risk on the subcontractors. The GC is willing to take a small risk with a highly leveraged owner in hopes of collecting a full fee, as well as adding one more successful project to its portfolio.
The bait the GC uses is its reputation in the marketplace. A highly leveraged owner needs a reputable GC to gain the confidence of the bank and community. The GC, in this case, is not looking out for the interest of the subcontracting community. Before the GC prepares an estimate, it has a rough idea of what the owner's resources are like and by the time it signs a contract with the owner, the general contractor will know everything about the owner's financial condition, as well as the financing.
In most cases it goes unsaid but the bank, owner and GC know from the beginning that the subcontractors will take the biggest financial hit if the project fails. The question is whether or not subcontractors realize they stand to lose the most.
SafeguardsBefore bidding or entering into a contract, find out all you can about the owner. Ask your banker to run a credit report on the owner. Find out the owner's name and Google it. You would be surprised what you might learn. I did an Internet search of a company name and found a Web site dedicated to telling the public how irresponsible this owner was.
Ask the GC if it plans to do any of the work. Ask for a copy of the contract between the owner and GC. Ask the GC who is financing the project and make a phone call to the lending institution. Once you form an opinion as to the owner's ability to pay you, then negotiate your subcontract.
You may want to negotiate a stop-work contract condition in the event of non-payment past 30 days with a high-interest rate tied to it, as well as a condition that would not allow the owner and GC to hire anyone to complete the work until you are paid in full. Negotiate the least amount of retention you can and negotiate a retention payment date. Maybe negotiate that retention be paid 90 days after your work is complete or paid as your work progresses.
The trick is to arm yourself with as much information as you need to make a wise business decision. Don't think for a minute that the bank and GC are looking out for your best interest in these situations. The condo market is becoming more and more risky, as highly leveraged owners get in to make a fast buck with minimal risk. Most owners create a separate LLC for each condo they develop. If one venture goes bad, that LLC fails and the owner starts a new one. As long as banks and builders are willing to lend money to highly leveraged owners, subcontractors are at risk unless they do their homework.
Bread crumbsLaying a trail of breadcrumbs behind you as you walk into the condo construction market won't help you find your way back to the markets you were doing well in before. The condo market may be the riskiest business in construction these days. Not only are there highly leveraged owners, greedy bankers and risk-shifting general contractors, there is also an enormous potential for a construction defect claim that could result in losing your ability to insure your company competitively.
Ah, but the potential for a subcontractor to make money while working for a reputable GC is too much to resist. Being lured into the condo market is something you have to do with your eyes wide open while knowing you have more to lose than the GC, owner or bank.
For years, people had been making money in the stock market, especially with high-tech stocks, when suddenly the market started dropping like a rock. As it dropped, people thought it was a great time to buy more. As you know, it didn't stop dropping. The drop was significant enough to affect the stock market as a whole and people lost a lot of money. High-tech stockholders were hurt the most, as well as blue chip holders.
It's interesting to consider that the condo market has attracted at-risk developers that may be highly leveraged. In other words, highly leveraged developers have little to lose and all to gain. These developers could destroy an average subcontractor if a project fails. Many people thought the stock market would continue to make them money, as do many subcontractors think the condo market will make them money.
Approach the condo market carefully and fully armed with the information you need to make a good business decision.
Remember: Teamwork begins with a fair contract.
If you read this article, please circle number 180.