Preparing Your Company for Life after Recovery
Stites & Harbison Client Alert, October 7, 2010
“Be courageous. I have seen many depressions in business. Always America has emerged from these stronger and more prosperous. Be brave as your fathers before you. Have faith! Go forward!”
— Thomas A. Edison
This has been the longest, deepest and most difficult recession in the memory of anyone born since World War II. No one knows when or how, but the recession will end. The construction industry will rebound – and it will not resemble the industry we knew before. Many approaches to designing and building may no longer be effective – or possible. All of us want to rebound with the industry at the leading edge of the recovery – and not be left behind.
There are lessons to be learned from the recovery after the Depression of the 1930’s. Prior to the Depression both Kellogg’s Corn Flakes® and Post Toasties® held about the same share of the breakfast food market. When the Depression hit Post concentrated solely on survival. Kellogg anticipated a shift in America’s taste and prepared itself. When the Depression ended, Kellogg was positioned to take advantage of the new market; Post was not. It took Post decades to make up ground lost to Kellogg during those first few years of recovery.
Like Kellogg, we can foresee changes ahead. We know that the post-recession construction industry will operate under different regulations, financing policies, relationships, project delivery methods, technology, and construction contracts than the pre-recession industry. We also know that as it climbs out of the recession the industry will face several issues:
- Limited availability of private financing, labor and global resources;
- Governmental agencies increasingly involved as partners, in one way or another;
- A changing role for trade unions and merit/open shops;
- Aging baby-boomers; many with newly-minted risk-averse mindsets; and
- A Third World market that will serve as a competitor, a testing ground for new ideas and an opportunity for work and investment.
There will be new or expanded regulations governing how private projects can be financed and how all projects must be designed and built. These regulations will involve collateral requirements, qualifications for government guarantees, environmental compliance, mandatory sustainable design and construction; also more government paperwork in the day-to-day operation of your business.
- Investment resources for the private sector will be limited – equity requirements have increased and the government will continue to involve itself more deeply in the process. New credit requirements (or opportunities) facing the real estate investment community will tie credit (or favorable credit terms) to green or sustainable design, construction, and operation of buildings. For example, many of the construction loans which my firm has closed in the last year have been New Market Tax Credit (“NMTC”) transactions. Equity that would otherwise not be available is created by the sale of tax credits to an investor. The project must be in a qualified low-income area and is subject to many restrictions; but if a developer can tweak its project to fit the NMTC requirements AND can obtain a commitment of credits from a Community Development Entity AND can find an investor to purchase those credits (usually a financial institution), the benefits can be substantial (typically around 18% of total costs). These credits can also be combined with other incentive programs (e.g., grants and Historic Tax Credits) to increase the equity available for a qualified project. We can expect these sorts of government-supported credit facilities to continue for at least the first few years of recovery. These all involve relatively-short windows of opportunity and hard cost commitments at the front end. Traditional approaches to design and construction of large projects will not work in this environment.
- New credit requirements will also involve green or sustainable design, construction, and operation of buildings. In addition to the tangible tax credit advantage and long term operating advantage of sustainable building environments, there is significant intangible advantage in tenant and public perception of “sustainable” buildings. We can expect this perception to continue well into the recovery and beyond. Investors will increasingly evaluate a project’s “Sustainable Return on Investment” (“SRIO”) – assigning a dollar value to the environmental, social and economic life-cycle impact of sustainable design and construction. Irrespective of its tie to credit facilities and public perception, Green and sustainable construction is already mandatory on many projects in many states. It is inevitably winding its way into building codes across the country. A project’s sustainability evaluation doesn’t stop at the choice of a building material or mechanical system. It can flow through to a fabricator and erector’s business practices, both on-site and off-site. It can extend to whether the fabricator or erector has chosen to school its employees in the new green-ways of doing business and has chosen to place these new green-principles into practice in their own businesses. These will increasingly become factors in contractor, subcontractor, and supplier selection.
- Human resource paperwork is not going to decrease. For example, recent Executive Orders require employers accepting some government contracts to post notices of their employees’ right to organize and report the compensation of their top five executives.
Public, quasi-public, and institutional work will lead the recovery and remain strong. Industrial recovery will lead commercial recovery. It will remain difficult to attract investors to private commercial development, which, as it awakens again, must also absorb the considerable, vacant commercial inventory; and adaptive re-use of that inventory is highly attractive to proponents of the green/sustainable movement.
Examples of work we can expect to be available as the recovery broadens:
- Power generation and distribution, nuclear work, grid work, alternative energy work.
- Healthcare facilities
- Schools and university facilities
- Stadiums, arenas, and other public sports and recreational complexes
All of these categories of work will involve an increased level of public-private-partnership financing. Many projects will involve contract requirements that have not been seen before.
Increased efficiency and productivity.
The negative gap between the labor efficiency, cost efficiency and productivity of the construction industry compared to the remainder of the non-farm-based economy has been well documented. The economy as a whole will demand more efficiency and predictability from the construction industry.
We are in what will be a prolonged cycle of “hard cost” contracts coupled with accelerated delivery schedules. The teams that deliver these projects will increasingly be assembled and selected by means other than traditional low competitive bid coupled to a design-bid-build delivery system. This will give rise to opportunities for those who are prepared to explore new business relationships.
Strategies for the recovery.
- Understand what you are getting into on public work and publicly-assisted private work. Among other things, these involve “flow down clauses” – mandatory government regulations that impact how you run your business. Understand the paperwork requirements and be willing to follow them to the letter. Know that some business practices that are relatively-standard in private work may violate government regulations and carry civil and criminal penalties.
- Explore creative, collaborative alliances. Be prepared to share both risk and profit with former adversaries through use of non-traditional contract documents. BIM, IPD, Construction Management at Risk, competitive negotiation, and “best life-cycle value” procurement all lend themselves well to structural steel design, fabrication and erection. The risk averse among us will be frozen by concerns over legal exposure and insurance availability . Those on the leading wave of the recovery will choose their new partners well, develop means to mitigate risk, and fit insurance to the risk assumed.
- Differentiate your business from the competition. Innovation and collaboration are the keys. A record of price stability and cooperation will differentiate close competitors during formation of collaborative relationships. Entities making collaborative selections will look to industry and quasi-governmental certification programs that can differentiate one competitor from another. Be ready for “green” and “BIM” certification programs. They are as inevitable as the tides; some may already be here.
- And, as always, be ready for some hard work.
“The reason a lot of people do not recognize opportunity is because it usually goes around wearing overalls looking like hard work.”
— Thomas A. Edison
Considerable insight into these issues were provided by Angela Stephens, LEED AP Attorney in the Construction Service Groups of Stites & Harbison, PLLC, and Jamie Cox, a former Stites attorney who is also a LEED AP Attorney..