Posted: 26th February
What are the pitfalls to avoid when acquiring a distressed construction project?
The perfect storm
There is an expectancy within the community of insolvency practitioners that we will see a significant rise in distressed projects in the market later this year. Building on this picture, Barclays have very recently reported that they have made a provision of £4.8 billion for loan defaults due to the pandemic and other major lenders are expected to follow suit in the coming weeks. Distressed projects can be created by many different factors, but when several compound, they could create the perfect storm for developers, potentially placing them into administration or receivership.
There is no doubt that government support and political pressure on banks have succeeded in holding back the tide to date. Insolvencies in 2020 were 40% lower than the previous year and the lowest since 1989, but that looks likely to dramatically change this year.
Other factors that will create this perfect storm and push insolvency on businesses include changes made to accountancy regulations by the introduction of IFRS 9. This relatively new standard moves from an ‘incurred’ loss to ‘expected’ loss model, meaning that expected credit losses for the duration of the loan period must be fully recognised by lenders in the financial year relating to any loan default. This will force banks and funders to deal with the issues they have on their balance sheets in the corresponding financial year, rather than allowing the can to be kicked down the road, which was the case in previous recessions.
Additionally, the restoration of Crown preference will be a factor that will influence banks to act quicker with their plans for those businesses that are in troubled waters. Since December 2020, HMRC has once again become a preferential creditor, which puts them ahead of banks and funders with floating charges in the event of an insolvency. This puts banks in a more vulnerable position as their ability to recover losses from insolvent companies is now somewhat diluted in some scenarios.
So, what is this all likely mean?
Banks and funders will certainly be undertaking their internal reviews and decisions will be required on what they do with the sites that they take over through the insolvency process. They will be faced with a variety of predicaments on these assets – from sites with or without planning and partially or nearly completed construction sites, through to finished buildings which are unsold or not leased.
If, as expected, most of the banks do not have an appetite to continue with the developments, many will look to move them on. This is where opportunity may lie for those developers who wish to speculate in this type of market. On the face of it, because these developments are defined as distressed acquisitions, there is an assumption that they will be purchased below market value, thus making appraisals and potential yields look attractive. This may be the case, but any developer considering this prospect should be fully aware of some of the pitfalls they may face and factor these into their viability appraisals.
Acquisition pitfalls to avoid
If no construction work has commenced, then apart from legal due diligence on the site in terms of outstanding charges etc, it will be planning, planning conditions, allocated community infrastructure levy and section 106 obligations that are the main issues developers should be aware of. Also, any specific arrangements with statutory authorities should be borne in mind.
Developers looking to acquire, at this stage, should also consider design work completed to date and willingness of the existing design team to continue (on the basis that they may/may not have been paid). If a new team is appointed, it is important to agree who will pick up liability for work undertaken to date. Also, at this stage it will be crucial to understand the cost to complete and to have the ability to value engineer a design, especially if planning has been approved. The majority of this should however be standard process for most experienced developers.
If the construction project has been partially completed, the situation becomes a lot more complex and developers looking to acquire must know exactly what they are taking on in terms of the challenges, risks, and opportunities:
Firstly, an assessment should be undertaken of site safety and security. This is based on assumption the construction has stopped and the site is vacant. At the time the site is passed from bank to new developer, the liability for this immediately shifts over.
As part of the due diligence, an estimate must be carried out on the cost to complete. One of the fundamental reasons for this exercise is to get an understanding of remedial works that are necessary to rectify substandard work. This unfortunately will be common on sites of this nature as Contractors and Sub-Contractors are likely to have been working, often unpaid, in a situation of some conflict. Cutting corners on the work and even deliberate destruction can often be found. Developers should carefully include a contingency to cover this in any appraisal before contemplating purchase, or else make sure their pre-acquisition surveys are very robust.
Giving due consideration to the design team for a partially completed project is also important and can often require a more granular review than for projects at the planning stage. Also linked is the type of procurement and how much liability an existing or new contractor would take on should a Design and Build Contract be preferred. Using an existing design team obviously has its benefits and provided agreement can be obtained in picking up full design liability, this certainly is the preferred option. If, as is often the case, an existing design team member has had a soured experience and no longer wishes to continue, several variables must be considered. These will include, looking at collateral warranties for design to date, particularly their validity and whether they can be transferred to the acquiring developer. Similarly, any new designer may not be receptive to taking on liability for previous design work, but it may be necessary to validate the design work required for the project to complete. On distressed projects, design responsibility and transfer can be a myriad of complexity. It is important not just for the actual project but also for exit, that liability is clear and there are no grey areas which could severely impact the outcome development value if a potential acquirer identifies a risk.
Contractor procurement is another major decision in the process. On most projects, it makes sense to consider utilising the Contractor who was employed by the previous Developer, and whose contract should be terminated at point of receivership or administration. Unfortunately, this is not always the best solution, as often the Contractor will have gone through some financial difficulties on the project and may have variations and loss and expense claims unpaid that they may seek to recover, in part or whole, from the acquiring Developer.
Another fundamental part of this decision process is associated with the type of contract they engaged on previously. If it was Design and Build or a standard contract with a design portion, (Design by Subcontractor such as cladding, for example) the importance of having a clear transfer of liability is as important as mentioned above in connection with the design team. In fact, with a Contractor, it can be even more complicated, as numerous sub-contractors, supply chain members and the professional design team, can all have design responsibility, or levels of it.
Completely changing the form of procurement is an option worth considering especially on larger projects. An example of this may well be using managing contracting or construction management, whereby you can look to potentially utilise an existing supply chain. Also, on projects nearing completion, a similar model could be utilised, albeit with a much smaller CM or MC arrangement in place.
Developers looking at designs by others normally have confidence that they can improve what is there by putting their own stamp on it and value engineering the specification. All of this is of course possible so long as the impact of time is considered.
Some opportunities may arise where a building’s usage could be re-purposed. This could apply whether it’s at pre-planning stage through to a finished asset. A lot of discussion is taking place in the market just now about the potential for retail schemes to be re-purposed as residential and the office and retail space in mixed-use being converted to residential. The logic behind both being that residential has held it value far greater than the other sectors in the economy. On the face of it this is a sensible solution, but a lot of feasibility work must be undertaken to ensure that change is viable as it only will work in certain locations.
There are many risk factors that must be considered should opportunities present themselves through insolvency. The Developers who will win in this arena are the ones who carry out the proper due diligence, are aware of the pitfalls and plan the project to deal with them.
Whilst this paper has focused on potential pitfalls a Developer will have to consider before buying a distressed site they are equally relevant to an Insolvency Practitioner or LPA Receiver charged with completing a development on behalf of a bank.
Managing Partner, Robinson Low Francis
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