In real estate development everything comes down to managing an (un)holy trinity of risks; namely cost, time, and quality.
Take a building contract between a developer and a contractor: if the developer wants a high quality building delivered quickly, it will pay the contractor a higher price. If, say, a longer programme is permitted, the sides of the triangle adjust again. And so on.
Unsurprisingly, these risks are also important to tenants, purchasers and funders taking an interest in development projects. When will the building be completed and to what standard? If it's late, what is the remedy? If I'm funding project costs, how much are these?
Sometimes developer and third party interests closely align. Both a developer and its funder will have a keen eye on cost certainty. But often there is genuine tension. A tenant taking a lease of (say) an office for its headquarters will focus on timely delivery and quality. So will the developer, but the emphasis may be more on triggering lease grant and commencing rent payments.
1. Different formulas to balance the equation?
One way for a developer to manage its risk to third parties is to offer them nothing more than can be passed down to the contractor. This is a textbook formula from which some are loath to depart. They may build in additional flex for good measure: for example, allowing more time to complete the works if the contractor becomes insolvent. This reduces the level of "retained" developer risk to a minimum.
Other developers – perhaps fewer than before – may put more on the line. They take pride in badging a project a "building by X", presenting themselves as well able to manage development risk. If so, they may bear the risk of some potential mismatch in promises given to (let's assume) a tenant and what can be passed down to the supply chain.
2. No one correct answer
There is no one answer to the development risk equation. Much depends on a developer's business model, which will inform its risk appetite. Bargaining strength is also key: a prospective anchor tenant in a major retail development will have more leverage than my sandwich-selling start-up. Experience shows that certain third parties – hotel operators and registered housing providers spring to mind – are among the more demanding (or cautious) of counterparties. They are less likely to be receptive to the risk averse pleas of some developers. A third party forward funding the development of its global headquarters may be even less susceptible to a developer's pass-through risk mantra.
If one throws into the calculus decreasing contractor appetite for taking on unmanageable risk, solving the developer-third party equation (or closing the negotiations) becomes that bit harder still.
3. From theory to practice
Even if there is no single answer, the elements to plug into the equation are readily spotted. Here are some ones we frequently see in negotiations:
Some developers will try to limit their exposure to claims from tenants and others for defective design. They may say they can't give an absolute guarantee that the design will be fit for purpose. It's certainly true that consultants and many contractors will insist on their design liability being similarly caveated. So a developer may have a point if it says it cannot pass all design risk to its supply chain. But it's going too far to disclaim all liability for design, especially given that the designers have been selected and engaged by the developer.
The solutions are various. But often developers will accept fairly unvarnished liability for design. That may be because they have negotiated robust building contracts. But it may also depend on the liability being for a relatively short period. It's common for developers to be released from liability to tenants and forward funders on expiry of the defects liability period under the building contract or a short(ish) period thereafter.
Developers like to be left to get on and deliver. They'd prefer not to have to go cap-in-hand to a tenant to ask for permission for "minor" departures from the agreed specification. Equally, a tenant may be nervous (or suspicious) of allowing too much discretion to a developer which would benefit from building to a cheaper specification. After all, it wants its new office to look like that in the plans.
If the parties have divergent views, we can expect detailed negotiations around what are permissible or immaterial variations (which do not require tenant consent) and those genuinely impacting a tenant's interest (which do).
There is also the question of tenant-driven changes. Developers are often reluctant to allow a tenant any scope to initiate change. Context and bargaining power matter here. If the developer is only delivering a shell and core unit, tenant variations may be unnecessary. But the position will be different if the deal is for a turnkey project (like for some hotels), or if it is recognised that a tenant's needs may evolve.
Where a tenant or other third party is given the right to request changes, negotiations will focus on how the cost and time risk is ascertained and allocated between the parties. There may also be cut-off dates for requesting changes and tests for ruling out some kinds as too disruptive to the developer. One final word of wording, VAT. Where a tenant is VAT exempt or partially exempt extreme care should be taken to avoid the owner's VAT option being disapplied.
Delay in delivery
This can be one of the most keenly negotiated areas. A developer will wish to be relieved from liability opposite a tenant or forward funder for late completion of the building. Equally, the counterparty will want a clear commitment that the building will be completed by a certain date. So the parties may negotiate the grounds for extending target dates in great detail.
What happens if the building is delivered late? Should a tenant be entitled to receive damages? Anyway, exactly what kinds of loss will it suffer? Some developers try to exclude liability for any kind of purely financial loss (like loss of profit). And when – if ever – should one or other party have the right to walk away from the deal due to a failure to complete the building?
Often the answers are outlined in initial heads of terms, but with the detail left to subsequent negotiations.
This is perhaps the area with the most entrenched opposing views. A developer will say that practical completion under the agreement for lease/development agreement must mean PC under the building contract. Otherwise, it may be caught between a building contractor which believes it has done its job and a tenant (or other party) maintaining that the works are clearly incomplete. Being piggy-in-the-middle is never much fun.
But the counterparty will often be warily unsympathetic: it may not trust the developer (or its professional team) to administer the building contract impartially. It will argue there should be a freestanding test of practical completion under the agreement between the parties.
Often developers win this particular negotiation and the market seems certainly to have moved this way. But the minimum price for that will be giving the tenant or other party rights to inspect the works and make representations prior to PC, plus providing a warranty from the person administering the building contract.
Similar concerns arise around the developer's obligation to make good defects appearing after practical completion. Which defects and for how long? Only those which are classified as defects under the building contract? Is the period within which they must be notified 12 months after PC? Or longer? What are the defects response times? Some counterparties – particularly those investing in social or build to rent projects – will have stringent timescales for "emergency" defects. Can these be mirrored in the building contract?
And who certifies that notified defects have been made good? A developer will prefer it to be the person administering the parallel defects liability provisions in the building contract. But the third party may again be suspicious, particularly if making good triggers an overall release of the developer's liability.
Naturally, one could expand on these points – and others – at length. But as there is no extension of time available here, we would be delighted if you contacted any of our real estate team to discuss any points of interest.