The Current State of Affairs of Contract Language
By Nushin Huq
12 min read
A Q&A with John Moran, Chief Executive Officer of Moran Construction Consultants and Glendon Steady, Chief Operations Officer
Baton Rouge, LA-based Moran Construction Consultants is a construction consulting firm with clients across the country. The company’s clients include lenders, investors, developers, government entities and appraisers. Moran Construction Consultants specializes in construction loan monitoring, document and cost reviews, property condition assessments, construction cost consulting, completion guarantees, SBA funds control and owner’s representation. Tax Credit Advisor interviewed John Moran, chief executive officer, and Glendon Steady, chief operations officer, about the pandemic’s effect on supply chains and project costs and the current state of affairs of contract language. The following Q&A was edited for clarity and length.
How has language evolved over the pandemic?
John Moran: What we’re seeing is that there’s such volatility in the market right now, and it’s been primarily material pricing to date. We are seeing a lot more issues with labor pricing recently that will be addressed with contract language upcoming, but for now we’re focused on material issues.
So really the project teams have been trying to figure out how to equitably share risk given the current state of affairs and the extreme volatility in the market.
We’re seeing contract language become more specific in defining when a cost or time change is appropriate. A lot of the AIA and similar document language addresses these issues, but just not specific to current market conditions – extreme volatility that we’re experiencing right now from a number of different sources.
Can you unpack that further – give an example of a particular provision or two?
Moran: Sure. Right now, the goal is equitable sharing of risk. We’re seeing different clauses defining the decision makers and the processes for decision making specific to cost and time impacts. We’re seeing articles that define COVID-related delays and COVID-related impacts on cost. We’re seeing articles be very specific about what is COVID related. We’re seeing quite a variance in that in itself – what’s an actual COVID impact and what’s not.
From there, we’re seeing articles become more specific towards how the cost and time impact is shared. There are minimum thresholds established that the contractor will be responsible for a certain percentage of additional costs after which the owner would be responsible for a change order.
What would be an example of something that would be COVID-related versus non-COVID-related?
Glendon Steady: COVID-related, currently, is really speaking to supply chain disruptions, the inability to get material or the inability to get material at the same cost that you went to contract with.
That is really a COVID impact to a project. In the big scheme of things, the easiest way to put it is that COVID-related impacts are now being isolated to supply chain disruptions. Whereas once upon a time, we also had to consider, ‘The city isn’t going to inspect our property, so we can’t move it forward any further,’ or ‘We’ve had a COVID case on our site and now everybody has to go home for 14 days.’ We’ve moved beyond that piece of it, and it’s being isolated again to supply chain disruption on material.
What does this mean for you?
Steady: It means more expensive projects that take longer, that cost more. What’s taking longer is trying to figure out—after you’ve closed a project, development or deal, and it moves into construction—once we deviate from our original budget or our original plan of execution, we’re chasing our tail wasting time trying to get it back on the rails. So, we’re building and all of a sudden, we have a problem with steel costs. We have to figure that out. So, we’re having to push pause till we figure this out instead of just moving forward in the natural progression of a project. It’s creating challenges and hurdles in the market because every day it costs more. So, while we have to push pause to move it forward – while we’re paused, it costs more every day.
Moran: It’s really creating difficulties getting projects off the ground to begin with because they’re coming in higher than they have previously. It’s causing budget issues, and whenever a developer experiences a budget issue, he’s going to immediately try to figure it out. You go through the value engineering process that takes a minimum of weeks. After which, you figure out that we saved X dollars going through this two-week process, but during those two weeks costs have increased Y dollars and you’re back at square one – you’re still over budget. So right now, the volatility is just making it difficult to come up with actual budget numbers that work for a period of time that gives the project the ability to procure the materials and lock in prices.
Steady: Then a parallel exercise that’s run along with increasing hard costs. When the hard costs increase that line item within the developer’s proforma increases, and there is a point of no return. If costs are increasing and rents aren’t increasing at a proportional rate for that developer or that market, the deal may or may not even make sense. You’re closed on a budget, costs rise a few million dollars, that proforma may not work. So, the developers are stuck in a conundrum of do we just move forward and lose a little bit of money on a hard cost or do we try to wait this out and take the risk of our proforma not balancing out. It’s a very difficult situation not only for contractors trying to mitigate costs from downstream—from the subs and the vendors—but also for the developers trying to mitigate costs from their general contractor and making sure that still works in their overall proforma.
What kind of cost increases are you seeing?
Moran: As far as cost, over the past couple of years, we’ve seen roughly a 30 percent increase in material costs, which equates to roughly a 15 percent increase in overall job cost/hard cost. On the labor side, it’s been a pretty steady increase of three percent annually up until last year when we saw a little higher than a three percent increase in labor rates. But in 2022, we’re seeing that rate really start to rise at a much higher rate. We don’t have the numbers as of now, but we have been working with contractors to gather information and see what kind of a trajectory it’s going to take in 2022. We do expect it to be significantly higher than that three percent average.
What’s achievable in the market?
Steady: There are two things that play here. One school of thought says, ‘You just keep bidding this project out until we find the right contractor to do it at this price.’ When you do that, you’re wasting time, and again, time is money. So, any contractor you pick is going to be above that original budget at this point. That’s one school of thought to make it happen. That sometimes works and it sometimes doesn’t. The other school of thought is what I first mentioned, and that’s the collaborative effort, where you’re working, you’re designing and pricing the project in real time until the design is complete. At such a time, you have a real number at that particular snapshot in time. And the goal is to then close the deal, right then.
So, you have design and pricing working parallel. You get to the finish line at the same time, you have a good hard number that’s got an expiration date on it that is after closing. We get the deal closed, and then from that point forward, the proactive approach is asking the right questions and making sure the processes are in place for a speedy and efficient project buyout or a project procurement.
Why do people bring you in?
Moran: We’re engaged by lenders and investors nationally to manage their risk related primarily to construction costs, construction time and quality and conformance of the completed work. We are adding value to their program in that their lenders and investors’ expertise is not in construction, and so we are their eyes, ears, expertise in construction.
Steady: Furthermore, we’re gathering from our volume of work. We gather real time data nationally, as well as regionally, and locally for specific regions, specific product types, and have a pulse on industry best practices.
Moran: We’re in a unique position in that we handle 400-plus projects annually. The project types range broadly. We handle any type of project that’s considered commercial construction, and we keep all of the information that we gather in a database. We’re able to compare costs on a local level, nationally. We’re able to consider contractor performance nationally, developer performance, design team performance. We’re able to compare the starting cost with final cost to get the Delta for change orders. We’re able to compare your starting duration with your actual duration at completion to see how long these projects are actually taking. We’re able to drill it down from a national to a local level, given our volume, nationally.
So, your projects are all over the country?
Steady: They are, approximately 50 percent of our business—that 400-project volume, plus or minus 200 of those—are affordable housing deals that utilize the Low Income Housing Tax Credit.
How are you providing value to your clients?
Steady: We not only go to the project monthly and report back as the eyes and ears on the ground that John alluded to – that’s the second piece of our business. The first piece is an upfront due diligence review where the value that we’re providing there is basically a sounding board. Is this contract language adequate? Is it in line with current industry standards? Does it protect and/or mitigate our risk related to time and cost in particular? Those things influence quality by default. We’re adding a tremendous amount of value on the front end before the deal is closed by reviewing due diligence on a granular level. Again, they’re banking and investing experts. We are construction and real estate experts. They lean on our expertise and our recommendations. Again, utilizing what we’re seeing happening all around us and all around them, and kind of bring these ideas to their team and offer them as solutions. We’re not just pointing out problems. We’re really trying to provide sound best practices in the industry that have worked elsewhere that may align with the objective of this particular project.
When the project runs into a problem, hurdle or challenge, we’re offering our expertise, as well as what we’re seeing nationally on a real-time basis. We’re able to provide input and insert ourselves into the project team as a participating and contributing member and not just a voice that raises our hand and says, you’re doing it wrong.
Moran: At a basic level, we identify issues, offer potential solutions and assist in steering the project teams towards a desired outcome; contributing to a successful project completion.
What are some provisions that you might want to include in your contracts?
Steady: What we would like to see in the contract language, between the contractor and developer, is a clear delineation of when cost escalation will be paid by the developer. We would like to see that threshold in the language, whether that’s on a percentage basis or a dollar amount. That’s up to discretion, and up to everybody’s risk tolerance, but we want to see a specific threshold called out.
We’d like to see when we reach that threshold, what is the equitable share, who gets what percentage and who’s responsible for what percentage. We’re also starting to see successful teams, prior to closing, lay out exactly who is going to make this decision, and the process by which this decision will be made.
In the olden days, it used to call out who was the initial decision maker, but that was an initial decision maker for any disagreement. These are specifically related to cost escalation, as John started the conversation, it’s very specific to time and cost changes where this language revolves around. Then, how do we use contingency to cover some or all of that cost? How is that contingency to be used? When is it to be used, and who is going to use that money?
Moran: We’re seeing this language being expanded on in the change order sections of the typical AIA, or similar type of agreement. We’re seeing it addressed in force majeure language, where they are further defining government mandates and pandemics as force majeure items. We’re seeing force majeure language also deal with who’s going to be responsible if you must fall back on the force majeure terms. That’s the critical piece of force majeure. If you do have to fall back on it, who’s responsible for what? If you don’t define it within the contract, you’re setting yourself up for a dispute.
Steady: That leads to dispute resolution. The dispute resolution terms are being expanded around these items that we’re discussing. Lastly, a termination clause. If your project is not going to work based on budget issues, you need to have an out. It’s always best to define it within the contract agreement.
