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Despite Unprecedented Construction Slump, Contractors Remain Cautiously Optimistic
While the residential sector of the construction industry is currently in a depression and it is difficult to see any other way to go but up, there will likely be more bad news on the horizon for the commercial sector because most commercial contractors came into this year with a significant backlog. Additionally, there continues to be a credit crunch as well as a government financing slowdown so that projects are still stopping in the middle of construction either because the owners are unable to obtain continuing financing, lenders are refusing to continue to fund, or government funds are frozen, particularly in California with its budget woes. From the retail perspective, there will be smaller projects but there is likely to be renovation, improvement and redemise of commercial space. Such projects can keep those commercial contractors that specialize in retail construction busy even though there is less of it and competition is higher. Although the current picture is grim, it can be weathered with look-ahead optimism.
Subcontractors
Where this recession in the construction industry has seemingly hit the hardest is with subcontractors. General contractors are dealing with subcontractor problems in several ways. They are agreeing to pay them on a biweekly basis rather than once a month. They are paying via joint checks to assure that suppliers and sub-subcontractors receive payment. They have also increased their scrutiny in the prequalification process, looking more closely at their subcontractors’ financial statements and cash reserves. Their bonding companies are also closely scrutinizing their subcontractors and getting more involved in the contractors’ dealing with their subcontractors. And, of course, it is getting tougher for the subcontractors themselves to obtain surety creditor.
Contractors are seeing subcontractors chase opportunities “to the bottom,” that is, coming in at extremely low prices in order to get the work. Contractors have also seen subcontractor failures where the contractors needed to take over the work, either by virtue of a subcontractor’s default or the subcontractor’s acknowledgment that it needed to walk away from the project and allow the general contractor to bring in a substitute subcontractor so as not to delay the project. General contractors are concerned for the future because they have exposure for the failure of their subcontractors to pay withholding taxes, prevailing wages and employee benefits, and sub-subcontractor and supplier invoices by virtue of the general contractors’ payment bonds and their indemnity obligations to their bonding companies.
Bonding
As to the contractors’ own bonding relationships, so far contractors who have had long-term relationships with their bonding companies have not seen a significant change in the way the surety industry is handling their accounts and requests for surety credit. Contractors have noticed that sureties are busier as the bonding company accounts are asking for more bid bonds because of the increased number in the industry bidding on projects. In that regard, where there once were three to five bidders on any one project, people now are seeing 20 to 25 bidders.
New Business Strategies
Contractors are responding to the significant increase in bidders in several ways. Many contractors, seeing that many potential bidders at a pre-bid job walk, are simply staying away. Others remain hopeful and are chasing the projects by sharpening their pencils to assure that they can successfully complete the project with a slim margin for profit.
There are other business strategies as well, both good and bad, that contractors are using to address the current financial crisis. Those contractors that were previously in the private sector are attempting to move into the public sector where there are more projects. However, public sector construction is filled with pitfalls, such as increased reporting and notice requirements as well as regulatory compliance obligations not included on private projects. These pitfalls may trip up an inexperienced contractor. The fallout from the foray of private contractors to public work is yet to occur but many predict a heyday for the legal community. The same scenario is predicted to occur for those contractors venturing out to new geographic areas and/or new types of construction in order to obtain work. Some contractors are reaching out to potential joint venture partners as a way to move into new markets—potentially slightly safer than doing it on their own. Some contractors, who have both a construction side and a service side, are focusing on their service side during this recession.
If able, some contractors are simply running off their backlog, letting go of their employees as they finish up projects, and going into hibernation to await the turnaround in the market, which they are convinced will occur.
Owner Procurement
On the flip side, contractors are witnessing substantial changes in the way owners are procuring construction services. For example, contractors in the private sector are seeing an increased use of requests for proposal and requests for quotation where previously the owners would negotiate contracts with their favored contractor. However, the owners are not going to the open market but are approaching four or five preferred contractors and requesting pricing from them. On public works projects, the situation is almost insane. There was one public works project where 74 potential bidders showed up a pre-bid job walk!
Future Predictions
It is predicted that public works is the sector of the construction industry that will recover first – including infrastructure, military and energy (which is both public and private). Contractors are likely to follow the government money for the next couple of years. The more difficult question, however, is what happens with the private sector. There arguably is a vast amount of equity sitting on the sidelines. For example, there is a lot of cash in hospitality. It is possible that hotel owners will use their cash to renovate existing properties and, then, when the credit crunch is over, finance in order to obtain operating cash on a going-forward basis.
Getting back to the optimism noted at the beginning of this article, many contractors see significant opportunities from this economy for the construction industry—the potential to make lemonade out of lemons. Recessions can be good for the construction industry to allow the players to focus on their key market, key relationships and core values. This economy also provides an opportunity for construction companies to invest in their people—to decide who they want to keep in the business and invest in, who they should give opportunities to, and who will demonstrate their loyalty. It also becomes a buyer’s market for picking up talent. It might also become an opportunity for growth allowing companies to purchase entire operations, not just individuals. This business slowdown also gives contractors a chance to evaluate their own performance, institute new processes and install new systems, something that is difficult to do when everyone is busy. Downturns highlight weaknesses and reduce competition.
It is well known for those in the construction law business that the industry is made up of tremendous optimists. So, even in this very troubling time, it is good to see that some contractors, although sensitive to the concerns of many companies and individuals, also see this time as an opportunity in all its many facets.
This article, written by Sedgwick partner, Marilyn Klinger, Los Angeles, is based on a panel presentation given at a May 1, 2009 construction industry conference in Seattle, Washington. Panelists included Richard Walker of Howard S. Wright, Andrew Beyer of Walsh Construction, and Scott Olson of S.D. Deacon, all West Coast commercial general contractors.
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