Here Comes The Sun
Posted: 7th October 2014 09:32Against the backdrop of Dubai’s success with Expo 2020 and the emergence of green shoots of recovery, the prospects of resurgence in the property market look very promising. Is the time ripe for replacing the negative sideshow of dispute resolution with the positive endeavour of delivering quality projects, on time and on budget? If so, have the banks recovered their appetite for development finance? For the answers to these questions, and many more, please read on.
Are we ready for an Era of Enlightenment?
As the inset shows, the statistics are impressive. With all of these projects in the offing, the question should not only be how are these projects going to be procured, but also whether there will be enthusiasm for a more enlightened approach to procurement. In other words, can we do away with the “nail to the wall” approach of imposing onerous terms and allocating risk unnecessarily on contractors, in favour of a more collaborative, partnering approach?
Expo 2020 and beyond
- Extra US$ 23bn of GDP in next seven years
- 25m visitors, 70% from outside UAE
- 300,000 new job opportunities
- 840,000 sq. metres gross lettable retail space by 2016
- 6,000 new hotel rooms by next year – total 65,000
- 80,000 hotel rooms by 2020
- AED 2bn to build a canal through Downtown by 2017
Procurement and Risk Allocation
Procurement essentially boils down to three issues, namely time, quality and money. Put another way, what an employer wants is the right building, at the right price, on time. When considering the allocation of risk at the procurement stage (and throughout the currency of the project) the golden rule should be to allocate risk to the party best able to deal with it. Ideally, the parties should create a risk register for use throughout the project and seek to avoid, reduce or mitigate the risks for the benefit of all.
Regrettably, there has been a tendency for employers, particularly in harsh economic climates, to impose unrealistically onerous conditions on contractors who have little option but to capitulate if they want the work. Needless to say, this creates a contentious environment from the outset and heightens the prospects of confrontation and disputes. Contractors may feel driven to cut corners, quality suffers, relationships deteriorate and disputes “blossom”.
The position had become so bad in the United Kingdom in the 1990s that the construction industry was regarded as the most contentious of sectors. The publication of the Latham Report in 1994 recommending more collaborative approaches was the precursor to the Housing Grants, Construction and Regeneration Act, 1996 that sought to address some of the more contentious issues in the construction industry and foster a more collaborative, less confrontational environment on site. This approach has been embraced in a modern form of procurement that seeks to simplify the language of the contracts and promote partnering and collaboration. This is discussed further in the procurement section below.
If the promotion of collaboration improves the prospects of successful delivery of the asset, which form of procurement reflects this ethos most effectively?
Modes of Procurement
The “traditional” mode of procurement, whereby the contractor builds the design produced by the architect and engineer, is popular in this region, most commonly in the FIDIC “Red Book”, but a crucial weakness is the expectation that the designer, paid by the employer, can be expected to discharge the contract administration role impartially. There is also the tendency for lawyers for the employer to amend the standard form to impose more onerous terms on the contractor.
Design and build procurement (in this region the FIDIC “Yellow” Book) provides for a single source of responsibility on the part of the contractor in respect of design and construction. There is, however, the weakness of expecting the Engineer/Employer’s Agent, often an employee of the Employer, to be impartial in the discharge of the contract administration function.
Management contracting, be it by the management contractor or construction management route, is not so visible in the region and its “fast track” ethos has led to unattractive results in the past. So is there a better way?
The New Engineering Contract (“NEC”)
If we consider the success of the procurement of the infrastructure for the 2012 London Olympics, there may be a pointer to the way ahead. All of the major infrastructure for 2012 was procured by way of the New Engineering Contract Third Edition (“NEC3”). NEC has been increasingly the contract of choice of many institutional employers in the United Kingdom such as the British Airports Authority. NEC3 is a markedly different form of contract. Its language, albeit unusual, is straightforward and its structure affords a range of options for different projects. It can be used in any jurisdiction and can be adapted to address specific legislative approaches (such as the prohibition of “pay when paid” clauses in the United Kingdom).
The key feature of NEC3 is the promotion of partnering and collaboration by way of incentivisation and key performance indicators (“KPIs”). If the contract provides for a bonus to the contractor for early completion, is this incentive not more likely to lead to successful delivery as opposed to the “stick” of liquidated damages? Originally liquidated damages were intended as a “carrot” to secure timeous completion by the contractor, the common understanding being that they would not be levied. That intention has been replaced by almost an expectation on the part of employers that liquidated damages will flow to the bottom line.
Other incentives could be sharing of savings by the employer and the contractor where the project comes in under target cost or incentive payments to the contractor where KPIs are achieved, such as employer satisfaction criteria being exceeded or the asset being cheaper to operate and maintain than expected.
There is, therefore, a strong argument that the partnering/collaboration approach has to be the way ahead. If so, how should we finance these projects in this new golden age?
With liquidity indicators suggesting that development finance debt is becoming more available in the Dubai market, what will be the attitude of lenders when faced with this new form of procurement? It is in every party’s interests that real estate developments are completed on time and on budget. Lenders who finance developments are interested parties, with usually more money at stake than any other party involved, and the new enlightened approach of NEC3 is likely to be approved by lenders if they are educated of its benefits and buy into this new way of thinking.
The NEC3 procurement method will not make any difference to the finance and security structure that a lender will typically adopt for a real estate development financing but there may need to be amounts made available in a construction tranche of any bank facility to meet incentivisation payments if the contractor manages to satisfy certain KPIs. Equally, lenders may use the KPIs as methods to keep track of the development and potentially call an event of default if they are not met, albeit that this would be a deviation from the ethos of NEC3.
Lenders will continue to take security over the property and the building contract with step-in rights as well as collateral warranties or direct agreements from contractor and the key members of the professional team. On the face of it, a more collaborative approach to procurement may appear to weaken the lender’s position as it does not pile all of the construction risk on contractors as was historically the case. However, the main reasons why developments go wrong, from a lender’s perspective, are when they are not delivered on time and on budget invariably as a result of deterioration in relationships. A form of procurement that is more likely to improve relationships and deliver quality should be welcomed with open arms by the real estate development finance industry.