August 1, 2008

Salvaging Unfinished Projects in the Current Credit Market


By John Baker and Doug Cushing

Summer 2008

What happens when a development project runs out of money before the work is done? Today's tight credit and uncertain market prospects put a shadow of risk over once-promising projects. As the expectation of profitability dwindles, even the smallest delay or unanticipated expense can upset a precarious balance — and the work can grind to a halt.

Each party, whether a tapped-out developer or under-secured lenders or unpaid contractors and consultants, has a stake in the project, the value of which diminishes as the parties dispute the issues. Each party can protect and even enhance its stake by cooperating with the others to maximize the property's value and to minimize avoidable dispute costs. What follows are the steps that must occur to achieve the best outcome possible.

  1. First determine the total value actually at risk. This doesn't mean the simple calculation of what percentage of the loan has been disbursed and how many dollars remain; those numbers establish the first floor only. The typical project under review in this situation is not finished, is probably late, and will require more money to finish than either the lender or the developer/owner expected to contribute. Given those factors, the parties need to realistically determine what the present value of the unfinished project may be versus the currently projected value if finished. Whether or not that latter projection is equal to the original pro forma appraisal isn't the issue — the critical consideration is what its completion will contribute to the value. The model here is triage for loss avoidance, not loss distribution.
  2. Each party must then conduct a coldhearted bottom-line analysis of its options. The lender may face the burden of injecting more funds into the project than its loan agreements' loan-to-value ratios authorize. The owner/developer may have to liquidate other assets. Contractors may have to consider discounting work or extending payment terms. These analyses must be balanced against the cost of delay and litigation, not to mention the impact on the cost of deferring completion for an even longer time. The "parties' paper rights," under contracts and loan documents, to recover delay costs, attorney fees, appraisal costs, etc., may not outweigh the consequence of losing tenants or buyers because the project was not finished and put on the market. A judgment that cannot be collected does not contribute to anyone's bottom line.
  3. Assembling the information should facilitate each party's determining the cost-benefit analysis it can adopt. Not every party will necessarily be able to participate on a true pro rata basis in a solution. The owner/developer may have no other assets to liquidate or contribute. The contractor may face unpaid tax claims or other liens from vendors that overwhelm its cash flow and threaten its ability to remain in operation. But within the range of financial adjustments or contributions that each can accommodate, overlapping zones can be found in which a solution lies.

A bank may have the right and power to refuse to advance funds, but if doing so converts a 90 percent product into a delayed project worth 70 percent of what was invested, exercising that right will put the bank further behind. Similarly, the contractor or owner may have to forgo some or all of its profit to finish, but by doing so it may recover its costs and keep its subcontractor relationships. All parties can enhance their returns by avoiding litigation costs.

How can this actually play out? Here is a recent case history.

The project was 90 percent complete, but the expected cost to finish would substantially exceed the original budgets. The owner's resources were depleted, credit limits were maxed out, and the contractor was owed a substantial sum. The lender suspended funding, the owner stopped work, and the contractor filed its lien. But the contractor chose not to immediately exercise its right to terminate the contract and foreclose its lien, leaving room for all parties to maneuver.

After multiparty, multiangle discussions, the ultimate resolution was a change order to the contract that ultimately led to completion. The contractor received more than 90 percent of its lien claim but agreed to an absolute maximum fixed cost to finish the work. The lender agreed to fund the final work, given the limit, and received an additional supplemental guarantee for payment from the investors and the owner. A short-term completion schedule was agreed to by all parties. At the end of the day every party gave up something, but no party was forced to bear the total burden or expense of the problem, and the project was then completed. That is obviously the ultimate goal of any construction project and should remain the goal even when problems develop.

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