The business model of large developers has traditionally run something like this:
- Secure a development site and gain necessary planning permission for a multi-storey office/hotel/apartment/multi-use building.
- Start pre-sales from potential owners and accept deposits at pre-construction prices. (At this stage the developer holds the risk and if pre-sales are slow then projects are deferred or even cancelled.)
Once the minimum number of pre-sales have been made, the developer will put the project out to tender and accept the lowest bidder’s price. Then the real negotiations start with the successful builder required to reduce overall project costs.
As a developer your profits are now locked in at the difference between your sales revenue and the costs submitted by the builder. The project risk has now been transferred to the builder. The builder’s margin is now between two and three percent of project cost.
Large building companies traditionally own no construction assets, as they then sublet all the components of the build to a further team of subcontractors. The builder’s profit is then the difference between the contracted price and the total costs submitted by the subcontractors.
Again, in a competitive marketplace, lowest price will ‘win the day’. Subcontractors have fixed assets they need to finance and key skilled staff they need to retain, so continuity of work is an important objective for them. They may bid low to get the work and hope to recover the margin through charges for contract variations.
More recently, in this model, construction commences and suddenly the impact of Covid on supply chain and availability of workforce causes both massive delays and increased costs. The builder’s margin is quickly absorbed and the only recourse they have is to swallow their pride and approach the developer to ask for assistance.
The developer from the comfort of a firm contract refuses to assist. The builder continues to work to ensure cash flows and delays payments to subcontractors. Work slows down even more, and the downward spiral can only be prevented by the builder tipping in more cash from capital or lenders.
The cash eventually is not forthcoming and the builder files for protection and goes into administration. Their narrow capital base has been eliminated and the administrators try to sell the uncompleted order book as a ‘going concern’ to other builders.
It is important as negotiators that we understand that no profit is made on the signing of a contract, rather the profit flows from the execution of the contract. The allocation of all project risk to one party of the contract, will either result in an expensive initial price commensurate with the risk, or a failed project.