This is when you intend to complete the property development project primarily as-is, but you need to sweeten the deal to get the project to a suitable state to continue, or simply to increase the financial return. Essentially, you attempt to embrace what positives remain and renegotiate out of any negatives. That means renegotiating contracts and re-setting relationships.
Circumstances limit what you can renegotiate. How you approach negotiations also depends on what level of project commitment you are in. If you now own the project, you will be trying to both protect your current investment as well as obtain better terms. You may be restrained from using the walk away option. If you are negotiating before you have ‘brought’ then you can be more aggressive. The negotiation trifecta is to increase revenue, decrease costs, and reduce risk. Targets for renegotiation include:
- Construction contracts
- Fee agreements
- Sale and purchase or lease agreements
- Loan agreements
Construction Contracts
You will be in a strong position when renegotiating construction contracts if builders are owed money and your involvement may be the only way they can recoup that loss. Even if you have no obligation to pay the contractor for work already done, it might be advantageous to do so. This is to help reach favorable terms to move the project forward. There is only so far you can go. There is little point cornering the builder into a position where they will lose more money on the project and go bankrupt before it is complete. That situation typically does not translate financially well for the developer either.
You can afford to take a stronger stance if the construction market has deteriorated to the extent that the contractor simply cannot afford to ditch this project, walk away and find work elsewhere.
But your position will be weaker if costs have risen significantly since a fixed price contract was signed. Not a lot will be achieved from trying to renegotiate a price where all the contractors, subcontractors and suppliers have no room to reduce price.
If you are a developer-builder, then you might have a strong walk away position from existing contracts by simply completing construction yourself.
Assuming there is a potential advantage to renegotiating the construction contract (and you still want to progress with the current builder), then consider these elements:
- Can the price be reduced? Can the main contractor contact each of its suppliers and subcontractors and renegotiate their prices, to bring down the overall price they are charging for this project? One way is to set a target for the contractor to achieve. If they fail, then you will have to (or threaten to) walk away and procure a new builder. You could bring on a new materials supplier who wants to undercut the existing one to increase market share. What leverage can you get over subcontractors to better their prices? Are you willing to sacrifice some for others that are keener for the work? Are the contractor’s profit margin and preliminaries and general excessive?
- Can the price be fixed? If you are not inheriting fixed prices, then reduce your risk moving forward by having them fixed. Similarly replace provisional sums with fixed prices. For example, kitchens may have a provisional sum allowed based on concept. But that leaves the final price up in the air and open to escalation. Either improve documentation to allow a fixed price or put a design-build cap on the cost. It might be desirable (from a budget risk point of view) to have a new price that is higher and fixed rather than lower and open to escalation. Alternatively, if you are already in receipt of a fixed price, is it fixed at a rate that compensates the contractor more than the additional risk deserves? Savings could be available if you take on some additional escalation risk and unfix prices.
- Can cashflow be improved? A dollar today is worth more than a dollar tomorrow, so the saying goes. Contemplate deferring payments thereby reducing finance costs and improving near term cashflow. Can you extend payment terms from say weekly to monthly? Only pay for materials once they are onsite? Deduct higher retentions? Or stage larger payments later?
- Can the contract be separated? Take the example where a main contractor on a house and land subdivision runs both civil infrastructure works and house building. They are mainly a house builder but subcontract to a specialist civil contractor and in the process make a margin on that subcontractor’s price. You could split that contract into two and remove one margin. Or you could separate out discrete areas like landscaping or fencing. Of course, how far you go needs to be weighed up against the additional management and coordination required as well as who is best placed to take on the risk.
- Can the program be improved? There may be an opportunity to re-program works to speed up delivery with more tasks running concurrently. Better payment terms (for example, bi-monthly rather than monthly) or a completion bonus could be just the incentive.
- Can works be staged? Is it better to stage the works rather than try and complete everything at once? For instance, take an apartment project comprising two buildings. The original developer had started construction on both but only had sales to sell out one. You could suspend construction on the second building with the intention of moving any purchasers to the first.
- Can the builder take on more risk? The existing contract may be a fixed price contract based on the documentation supplied. You may consider it better given your project circumstances to have the contractor take on design risk and run the consulting team themselves. Or as described above, are you better placed to take on more risk and reduce the builder’s role?
- Can you make the contract terms developer-friendly? Who knows what motivation and pressure the original developer was influenced by when they signed up the construction contract. This may have been the only builder the developer could find to work with them and the contract may reflect that. Do liquidated damages exist at a suitable level of penalty? Has the contractor provided a bank or performance bond? Is quality carefully defined? Are there processes to minimize variation claims and extensions of time?
Fee Agreements
Your ability to renegotiate fees with existing consultants will depend on the current resource demand in the market place and if they have any outstanding debt owed by the previous developer. Do they have something better to get on with and cut their losses on this project? Or is there an incentive to claw back fees now you are in charge? Ascertain just how crucial this consultant is for the project moving forward. You don’t want to get over aggressive, have the consultant leave but find out later you still need their design statements or other certification to complete your project. When renegotiating, look at reducing the price, speeding up the program of deliverables, having more senior staff involved at the same price, having more delivered for the same price, securing higher professional indemnity and liability insurances and securing better rights to intellectual property.
Consultants might be convinced to take an ownership stake in lieu of fees. If you are taking over an office development, why not offer the architect space for their business at a discounted lease term in lieu of not paying any further fees? At a minimum you save leasing commission and you fill up part of the building.
Sale and Purchase or Lease Agreements
What rights do you have to renegotiate existing agreements to buy or lease? There may be a force-majeure clause or other condition that you can call upon as a valid reason to negotiate. If you have the right to quit contracts (such as in a liquidation) are you assured of making more money by securing new contracts? Or is it better to continue with existing ones?
Your negotiating position is stronger when the market has improved since the agreement was signed and you have the right to terminate the existing deal. Of course, you don’t have to terminate, you could simply go back to buyers and ask for a price increase. Only if they refuse do you terminate. Even if the right to terminate is not black and white, you might get purchasers to agree to a price increase if you plead your case. This is more likely for the more emotive residential home purchaser[1] than for an investor and definitely not for a commercial lease (where they are much more likely to simply lawyer up and fight for their position). Consider this example:
You are taking over a 100-unit apartment project where the average sale price was $1,000,000 and 90 sales have been made. You have the legal option to terminate contracts. At that price there is zero profit in the project because of delays and budget overruns. You need 20% more income to make the project work. The real estate market for apartments has appreciated by 25% since these contracts were signed with buoyant (but not rampant) demand. Canceling all contracts and reselling for an average of $1,250,000 is an appealing option as that now puts the project into a fundable position (you can secure a bank loan to complete construction). However, securing another 90 contracts will take time and marketing expense. Plus, the risk is the market turns south. Rather than cancel contracts, you determine the best option is to ask existing purchasers for a 20% increase — they are still buying under market value and you can get the project to work. Through a lot of face to face meetings and difficult conversations[2] you get 50 buyers to agree to this increase, have to terminate 30 and agree to a smaller 10% increase for the remaining 10 buyers. You then sell the originally available 10 units plus the terminated 30 for a higher than expected average of $1,300,000. These sales though do take some time and the market appears to be flattening out with the final few sales as low as $1,200,000. That achieves an average sale price of $1,230,000 — just enough to convince funders and continue the project. Whilst some money may have been left on the table, the risk of selling the entire 90 units was too great.
When asking for more money, understand the implications from a public relations and marketing perspective. Asking buyers for more money, contrary to their original contracts, is not the best look. As I have experienced, you can find yourself as the developer villain in a local news article. Framing the increase as the only way the project will proceed may get a more sympathetic reaction — providing your assertion is justified and buyers remain in profit.
There are other items that can be negotiated with buyers and lessees. Sunset dates and other deadlines, which because of the current delayed state of the project, cannot be met and will need to be extended. Additional works that the purchaser has requested may no longer be feasible. Warranties and guarantees may need to change. Design changes may be required, contrary to what the purchaser has originally signed up to. Whether you need to make concessions to obtain agreement or can take a firm line will depend on who holds the contractual negotiating power. That will be you if you can walk away and they have signed up at a below market rate (that presumably they want to keep at least some of that windfall).
Finance Agreements
Are you coming in with your own equity and debt financing or are you looking to take over existing financial obligations? If you are looking to take over existing financial obligations, then what you can negotiate will depend on where those financiers currently stand in relation to their security and how much you need their money. Once again, who knows what predicament the original developer was faced with when they sourced financing. They could have agreed to exorbitant fees and interest rates because no one else would fund them. If you are the financier’s best hope of recouping their investment (let alone the interest) then they may be very motivated to work with you. To help them out of this project, you might be able to secure a very low interest rate moving forward. The existing situation could be so poor that you can get them to write off some of the principal and reset interest on a smaller balance. Or if you have secured funding from other sources at better rates and more favorable terms, you might be able to buy existing financiers debt out (at a discount of course!).
Financiers might entertain swapping debt for equity. This transfers a debt obligation where the developer must pay interest and return principal to the lender irrespective of how the project goes, to an equity stake where the financier only gets their money back once the project is complete and there is sufficient profit to pay for it.
Alternatively, there may be existing equity holders whose original investment is now severely depleted. To regain some of that back you could negotiate their shareholding down. Or convert their equity with expensive preferred returns and profit share into debt. Contemplate offering (or forcing) financiers and investors ownership into the final product. For example, in a housing development rather than the project having to pay an interest rate it can’t afford, an investor’s loan repayment is restructured into receiving a completed home. This also helps you sell down the project.
With complicated projects can come complicated existing financial arrangements. For such projects in trouble, navigating the existing financial arrangements can be like opening Pandora’s box. However, whilst securing a project where all previous financial interests have been eradicated is cleaner, you can lose unique opportunities to maximise value.
Throughout any renegotiation,
ensure that you still maintain a good working relationship with all those involved
as there is a long way to go!
[1] Note, some jurisdictions have legislation in favor of home buyers that prevents this.
[2] I won’t get into the details, but I have had to endure this less than enjoyable task a number of times — in lawyer’s offices, places of work with burly workmates present, cafes with professional negotiators attending and even people’s living rooms surrounded by an entourage of extended family. My approach: lay all the facts on the table, don’t hide anything and try and turn it from an emotive issue to being purely financial.
Andrew Crosby
+64 21 982 444
andrew@xpectproperty.com
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