UK: Protecting Your Investment - Having Proper Construction Contracts can Actually Save You Money

Last Updated: 26 March 2010
Article by Ian McCann

Introduction

When times are hard, as they have been for the last few years, we find that every penny counts. Unnecessary luxuries are ditched and what limited money we have is spent on essentials. The principles that govern our personal lives also extend to our business deals and unfortunately in the last few years one of the items that has often deemed a 'luxury' when dealing with developments has been a formal construction package.

What I mean by this is a package containing a building contract, consultants' appointments, collateral warranties, bonds and guarantees all of which have been completed and executed by the parties. In recent years these have taken second place behind getting 'the deal' done but now investors are more insistent upon proper risk allocation and protection for any risk that they are taking on board. If investors are being asked to take on construction risk then they are expecting to be provided with a full and proper construction package that allows them to recover any losses they incur from the people who designed and built the development.

If they can't get that from the building team they will look to the original developer to provide them with that comfort – either through exclusions of liabilities, indemnities, project specific insurance, a reduction in price, or all of these.

Unfortunately what we are seeing more and more is that this area was neglected when putting the deal together and the packages being offered now do not provide the level of comfort investors expect in return for the risks they are being asked to adopt.

This is having a negative impact – reducing sale prices, putting exclusions for latent and inherent defects in leases or making the projects unfundable. Saving money in the short term is costing considerably more when you come to realise your investment.

The point behind entering into formal contracts is to provide certainty, all parties will know what they are expected to do: when, how and why. The contracts set clear contractual obligations on all the parties to them, thereby avoiding ambiguity and the need for third party clarification (and the extra cost and time this will incur).

Due Diligence and Future Marketability of a Development

Construction contracts will contain certain, basic pieces of information that are fundamental requirements for any future due diligence process.

Any purchaser, funder or tenant of a commercial property will need to see: -

  1. A copy of the Completed Building Contract;
  2. Copies of the professional team appointments; and
  3. Copies of the draft contractor, sub-contractor and professional

In the case of a purchaser or tenant, these parties will be directly in the firing line if things go wrong further down the line, particularly for a tenant who has taken a full repairing and insuring lease. They will need to be sure that if they suffer any kind of loss as a result of a defect in the design and/or construction of the development then they can pass it down the line to the contractor and/or the professionals through the collateral warranties.

Banks also take a keen interest in the documents as they will typically be investing a large amount of money in them. They will want to be sure that they are taking on minimum exposure. They will also need to be comfortable with the underlying contracts in case they have to "step in" to the shoes of the Employer at any time.

Risk

Formal contracts provide a record of risk allocation. It will not only will be clear who is taking what on board but it will also allow the parties to price more accurately for the risk that they are being asked to take on board.

Costs can be clearly stated and there will be certainty and control of the overall budget.

They will also specify the quality of finish that is required. There will be certainty about what the client wants and how that is to be provided.
Programming can be clearly stated, such as when the contractor will start, when he is are to finish and the circumstances in which this can be amended are clearly defined.

Collateral Warranties

In a normal commercial transaction, the building contracts and appointments are entered into between the developer and the professional team. In doing so the developer has a direct contractual link with the team. The developer will then usually sell or lease the completed project but as the purchaser and/or tenant are not signatories to the original contracts they have no direct contractual link with the team. This will make it more difficult for them to recover any loss from the team or to ensure that they make good any defects.

The way to get round this is to obtain a collateral warranty from each member of the team to the third party. What this does is establish a direct contractual link that will allow the third party to pursue the granter of the warranty directly.

It is collateral to the main contract so it is imperative that the underlying contract is acceptable and does not contain any exclusions or limitations on liability. These will apply to the collateral warranty EVEN if they are not specifically stated in the warranty.

Standard Forms?

These are available but it is not sufficient to simply pick up the standard forms of building contracts, appointments and collateral warranties "off the shelf" and sign up to these. You must bear in mind that these documents have been drafted up by the professional's own industry and are there to protect their members.

The standard forms do not fully address current market needs and still fall short of what the market expects. The use of these in their unamended form continues to have a detrimental effect when it comes to maximising the potential value of your investment due to the number of exclusions and limitations on liability contained in them.

Most funders will generally not accept unamended standard forms as they present the funder with an unacceptable risk profile.

Making Money

It may seem daunting, boring and time consuming to have to deal with the contracts and I appreciate that it is in no way as sexy as looking at plans and designs, but nonetheless it is every bit as important as a means to making sure you get maximum benefit (i.e. profit) from any development.

Let's put it this way – you've worked all your life, you've scrimped, saved and borrowed as much money as you can and you've gone out to buy a top of the range Maserati.

It's shining, gleaming, fast and the envy of everyone. It's what you've always wanted and people are clamouring up to look at it and buy it. You don't then decide to save a few quid at the last minute by popping down to Joe Bloggs Tyres to put some knock-off Pirellis on.

Sure they look like tyres, they're black and round, they may even have tread on them, but you can be very sure that at some time you'll be speeding down the motorway and they'll burst and you'll end up with a gleaming wreck. Then you'll really end up putting your hand in your pocket all for the sake of saving a bit of money at the start.

What you need to do is look at the broader picture, think beyond simply getting things up and running and think also about what will be needed further down the line.

Spend a bit of time, and yes money, at the start of the project getting the construction package right and in doing so you will save yourself time and money and protect your long-term profit in the end.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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