The COVID-19 pandemic has had an impact on all of our lives and many businesses over the past year but the hospitality industry has been hit particularly hard. Withers have been assisting clients throughout the pandemic with advice on a range of issues relating to hotel development, from advising developers on contractor defaults (agreeing settlement terms and renegotiating existing construction contracts where required) to advising lenders on developer defaults and the renegotiation of facility agreements in response to requests for additional funding.
This note shares our thoughts on some of the issues we've encountered so far on current projects and suggests how some of the complications caused by the pandemic may be resolved now and managed or reduced in future projects.
Challenges for Developers
Renegotiation and variation of live contracts
Many of the schemes that we work on are hospitality led, but they are frequently tightly programmed together with residential and/or commercial elements, with residential purchasers or commercial tenants being additional stakeholders. Over the past year we have seen more developers being forced to return to the drawing board to renegotiate existing contracts or revisit their procurement arrangements to enable them to deliver projects in accordance with milestones or completion dates in their project documentation agreed with funders, purchasers and tenants before the pandemic. Alternatively they have actively engaged with these parties to renegotiate and vary their contracts to reflect achievable post-pandemic timelines. It is hoped that these parties will be open to renegotiation and variation of their contracts. If not, developers should take advice on the contractual consequences if they fail to meet their project delivery commitments.
Termination where renegotiation is either unsuccessful or unviable, or in the event of contractor insolvency
If developers are unable to renegotiate contracts, they may choose to terminate the existing contracts so that they can engage a new contractor on more advantageous terms to meet existing commitments to funders and other stakeholders. Developers may also need to terminate where their contractor has run into financial difficulty and is either insolvent or represents a clear insolvency risk. The terms of the relevant contracts should be reviewed carefully and advice sought before any termination action is taken to ensure that the contractual mechanisms for termination are adhered to exactly. Failure to properly comply with the termination procedure set out in the construction contract may itself be a breach of contract. Similarly termination may be a default event under a facility agreement or agreement for lease, so should not be contemplated without stakeholder consultation.
Potential implications for management agreements
Where a hotel management agreement is in place with a third party manager care should be taken to check whether there are any construction milestone dates in the management agreement or technical service agreement. If so it may be that there is a risk that one of these could be missed which would entitle the manager to terminate. It is unlikely that the manager would enforce such a right and quite possible that an owner/developer might be able to rely on a force majeure carve out. However it would be prudent to check and potentially secure a waiver from the manager for certainty, preferably well ahead of the milestone date.
Any proposed delay in the anticipated opening date should be discussed and potentially agreed with the management company as far in advance as possible. From a practical perspective this may mean that the hiring process for the senior management can be postponed.
A tighter insurance market
Developers are facing an ever-hardening insurance market in the wake of the Grenfell tragedy, the pandemic and Brexit. Developers are likely to find that project teams may not be able to maintain professional indemnity and other project insurances at the levels and on the terms they have committed to in the project documentation. We have certainly seen insurance premiums rise and more significant exclusions and limitations be contained in the cover offered at the start of new projects or on annual renewals of existing policies. Depending on the terms of the contracts in place, it may be open to developers to liaise with the project team to contribute towards the relevant members' premiums to enable cover to be maintained at the higher levels, should the developer (or their lender) require this or to work to agree to continue with a wider level of exclusions. A collaborative approach will make such market obstacles easier to navigate.
Less affordable performance security
Due to the risks associated with the pandemic and Brexit, performance security such as bonds and guarantees may be more expensive to obtain. Performance bonds are treated as project costs, which contractors are likely to price accordingly in a tighter market. Despite the market limitations, developers may nevertheless find that lenders are more risk averse and so insist on performance security being provided. This will leave some developers with no option but to meet the contractor's increased costs for the provision of such security. Certain lenders may be willing to agree alternative security arrangements, so again, seeking advice is recommended.
Contractors' reactions to the issues caused by the pandemic and Brexit
Contractors are now more frequently requesting specific additional drafting for their contracts setting out how the risk of the pandemic is to be shared between the developer and the contractor. It will be important for developers and contractors to agree before negotiations become too advanced how additional time and money claims associated with COVID-19 should be managed contractually. Such provisions will also need to be approved by the key stakeholders including lenders and future purchasers.
Challenges for lenders and other investors
Strategies to reduce the risk of developer borrower default
If you are a lender and funding a project which is in a position where borrower default is a concern the terms of your facility agreement should be your first point of reference. The facility agreement will contain lender controls and borrower reporting obligations for your benefit. Lenders should, however, be mindful that developer borrowers may require some lender flexibility to allow room to implement plans designed to limit project cost overruns and delays. Developers equally should be mindful that lenders will expect clear and open reporting if such flexibility is to be given.
If a new programme is agreed, a variation to the facility documentation may be necessary to adjust negotiated milestones. Lenders may also expect to see satisfactory evidence that the borrower has planned how it will still meet its obligations under third party documentation such as agreements for lease, or that the borrower has negotiated suitable concessions under such agreements.
In the event of developer default...
Where a developer has defaulted on its obligations under its facility agreement, or any of the construction contracts, or is likely to default to the detriment of the project's progress or value, a lender may wish to exercise its step-in rights.
These rights are typically granted under the collateral warranties or third party rights lenders receive as security. ‘Step-in rights' allow the lender or a nominee to take the place of the developer under the relevant contracts to ensure that the project can continue, despite the developer's default.
That said, in our experience, it is relatively unusual for step-in to be a lender's preferred option unless that lender has particular construction experience. It is likely that a lender would prefer to discuss the progress of the project with the borrower to better understand the measures that the borrower is putting in place to deal with the pressures of the pandemic. The most successful funded projects will use the facility agreement terms as the basis for constructive discussions between the parties, enabling them to protect their respective interests in a project.
Where hotel management and service agreements are in place which form part of a lender's security, a well advised lender is likely to expect to approve any substantive changes to those agreements necessary to address project delays.
How might projects in 2021 and beyond deal with pandemic uncertainty?
Where projects are ongoing or in advanced pre-construction stages, developers may be less willing or able to revisit their procurement arrangements. However, there may still be opportunities even within live projects to explore alternative arrangements which could benefit later phases or sections. Much will depend on the scope and complexity of the various elements of the proposed scheme and on fostering a collaborative approach within the team. At the start of a project, consideration might also be given to adopting a standard form contract which promotes collaborative working and risk sharing.
Construction management procurement
As hospitality projects often have tight timeframes, if embarking on a new project in 2021, construction management procurement may be an option offering the sector greater flexibility for project delivery. Adopting construction management procurement means that a number of different trade contractors are engaged by the developer, but managed by a construction manager. Construction management procurement can be used to encourage a collaborative project culture and accelerate the programme for the project by overlapping design and construction activities. This procurement option may also mean that it will be easier to make changes to the design as the project progresses.
Construction management procurement may not, however, be as attractive as a lump sum contract to certain lenders. This is because the overall outturn cost of the project can be less easy to assess albeit that cost certainty can be achieved for the individual trade contracts. With the pandemic and the difficulties it is posing for project delivery, lenders may now be more open to the flexibility of construction management.
Alternative construction methods may also be a feature of future hotel development projects. Modular construction allows the components of the building (or some parts of it) to be manufactured off site. This is likely to be beneficial where numbers of workers on sites is still restricted to reduce the risk of the coronavirus spreading. While of course not suitable for all hotel developments, some schemes may well benefit from using modular construction methods. However a modular approach may not be as appropriate for highly bespoke hotel projects where complex design and aesthetic quality are of greater importance.
Modular options are nevertheless evolving and can be used for a wider range of projects than previously. There are some very sustainable modular solutions of real quality, which not only have speed of delivery benefits but also have strong environmental credentials. Sustainable design and construction with a longer term vision of how spaces can be used, adapted and re-purposed are likely to be increasingly called for in the hospitality sector and beyond.
The ‘take away' point from the above is that parties involved in construction projects in 2021 should do all they can to ensure a transparent, collaborative project environment. All parties are likely to have been impacted by the pandemic and Brexit to some extent and so it is essential to work together and find suitable workarounds to relieve the pressures of the pandemic and allow projects to progress to completion successfully.
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.