Contractors increasingly pushing into development works
Author: Jamie Collum
Over the past fifteen to twenty years, many contractors have decided that the housing development industry, given its adjacent nature to construction and the significant growth and profits in the industry, is a great area to expand their operations. While certainly a worthwhile and profitable industry, contractors need to be aware of some of the pitfalls here and how it can present new risks and impact existing relationships tied to the construction entity.
Construction is a risky business, that is why the life blood of any construction company is its ability to generate short term liquidity. A hung receivable, profit fade and growth all require access to cash. This means a healthy balance sheet for a contractor is one with a foundation in cash and short-term receivables. This working capital then supports the contractor’s active backlog and if sufficient will ensure the contractor can overcome any cash flow challenges that arise (delayed payments, profit fade, etc.).
Development entities on the other hand are often light on short term liquidity. The general nature of a development company leads to a balance sheet with considerable investments in property but very little cash flow. There is typically a high amount of mortgage debt as well connected to the property holdings. New developments are generally financed up to 80-85% of the cost of the development (hard and soft costs) with equity investments of 15-20% (including land equity) only being required by most lenders.
As such, the very nature of the two businesses are at odds with each other. A contractor must always be generating cash flow to support its backlog while a development company is looking to invest all of its free liquidity into current and future projects. Holding cash really defeats the purpose (cash is not king in this industry).
As a result, contractors who enter the development space need to put some considerable thought into how to structure the new venture to ensure it does not impact their day to day construction operations. A first step to consider is to incorporate a separate legal entity that is walled off from the construction firm. This way the balance sheet and liquidity profile of the construction entity is protected. Furthermore, doing this will ensure that any operational issues that arise in either entity are less likely to spread to the other. The last thing a contractor wants is for a poor performing development project to impact or poison the construction entity. The same logic is true for the opposite.
The second area contractors need to consider is who will do the construction work for the development entity. This question often seems basic given there is a friendly construction firm already in the picture and risks that an owner would argue can be better controlled by self-performing the work. The logic is often true but going back to our original point on cash flow, it becomes critical that the construction entity is not used as a bank by financing construction via slow payments from the development entity. If you decide to use your construction entity to build the development, ensure that you sign formal contracts and pay on trade terms. We have seen many a contractor run into issues with their bonding because slow moving receivables show up on their balance sheet from a non-arms-length development company.
Remember, the foundation of a construction bond or surety bond facility for your construction company is an indemnity agreement. An indemnity agreement is an agreement between the contractor, its owners (personally) and the bond company, that protects the bond company in the event of any surety losses as a result of bonds issued on behalf of the contractor. It is essentially a hold harmless agreement and all contractors with an active facility will have one in place with their respective bond company. Generally, when you incorporate a new venture your surety company will want to add that new company to their indemnity agreement. However, if you incorporate separate entities, wall off the operations from each other and have trade contracts and payment terms for any building arrangement, this gives you a much stronger argument to have your development entity stay off any indemnity agreement.
Many contractors have seen a great deal of success entering the development space. It is important to make sure with any new venture you are structuring it to minimize risk and maximize profit. To ensure that is the case, make sure you are discussing any new ventures with your construction bond broker, accountant, banker and lawyer. These are the experts that will help ensure you are set up for success.