Instability in the hospitality real estate construction market is having a far-reaching effect on developers and contractors. Cornelius Riordan, an attorney with Robbins DiMonte and an expert in the construction industry, answers six questions about the repercussions of construction delays and what hoteliers and construction companies can do to ameliorate the risk.
1. What are your insights on the current instability in the hotel industry regarding construction delays?
Three factors are the major causes of delays or not going forward with planned projects: inflated prices for construction materials coupled with supply-chain disruptions and labor shortages.
Many city-center hotel projects are delayed or stopped for now because of the uncertainty of the business traveler, though we’re seeing a little offset from leisure travel and resort development. Building in resort areas presents its own challenges with higher transportation and materials costs because of the expense to ship to more remote areas [and the lack of] a plentiful supply of labor. The scarcity of skilled labor is intensified by older workers retiring and younger workers not choosing a career in the trades.
In addition, hotel developers or contractors are faced with challenges in borrowing, with banks hesitating to lend to hotel projects because of COVID uncertainty. We’re seeing lower loan-to-value ratios and an increase in borrowing costs due to interest rate increases, and we don’t know if the Fed will continue to raise rates.
2. What are the repercussions for the future of a hotel entity under construction now?
It’s a combination of many issues. Supply-chain constraints continue to be a major concern for developers with hotels under construction. We’re seeing a lack of production in China due to COVID shutdowns, leading to uncertainty regarding when materials can be shipped and when they’ll arrive, plus delays at U.S. ports. If a contractor has available labor but no materials onsite, the workforce still needs to be paid. It’s not as simple as laying off or furloughing workers because contractors need to have a ready team when the project resumes. Developers who are working on multiple projects may have the flexibility to move workers between projects.
In addition, inflation is creating further instability because contracts are mostly fixed price and lenders have loan-to-value ratios so the loans have to stay in balance. Delays are also disrupting revenue streams—a six-month construction delay means six months of revenue the hotel operator will not obtain and six months of lease or rent payments that developer is deprived of.
3. Who shoulders the risk—the developer, the construction company?
Let’s define the risks first: Owners and developers are facing increasing costs because of delays, which result in additional loan servicing obligations and loss of revenues. The general contractor has to shoulder additional costs for material and labor being provided by the subcontractors, and what they call general conditions, which are their obligation to pay for general maintenance of the site.
If you have an ongoing project, your contracts are already signed and may or may not have standard provisions that address cost increases due to delays. Generally, those tend to be limited in the remedies that are available for a general contractor. In that case, the general contractor would shoulder risk through what they call flow-down provisions, which shifts the costs down to the subcontractors. If you’re just starting a new project, the best way to approach it is to write in provisions that spread any risk among all parties: owner, developer, general contractor and subcontractors.
4. What are examples of recent delays, price increases and shortages in construction projects?
One of my subcontractor clients was unable to obtain piping materials because the supplying plant in Korea had a fire. He was not able to get replacement material from any other source and there was a long delay in the project. We sat down with all the stakeholders—the public owner, general contractor, my client and the supplier—and worked out a resolution where everybody absorbed a percentage of the cost increase. It would have been impossible for my client to have survived that if he’d had to shoulder all the risk. We were fortunate in this case that everyone acted reasonably under the circumstances and did not want to get into litigation over the matter.
5. How can organizations mitigate risk and recover losses? Can contracts provide any protection?
Yes, there are various ways contract provisions help, classified by known events and unknown events. A typical force majeure clause allocates the risk of loss if performance is hindered, delayed, or prevented because of an unknown event that the parties could not have anticipated or controlled after the contract is signed, and the contractor would be entitled to time and or money as a result of the delay.
Now that COVID is a known event, the typical force majeure provision would not apply. When formulating contract provisions now, the issue must be specifically addressed: a delay or disruption or cost increase caused by COVID or other viruses. Those provisions allowing for price escalations can be capped and would likely state "an equitable adjustment up to and not exceeding x percent." You could also have more liberal change order provisions for dealing with COVID-related disruptions; or provisions that deal with the impossibility of performance due to COVID-related conditions and what they call frustration of purpose which is similar, but the standard to prove it is more onerous. Emergency provisions in contracts provide some relief but would probably not apply to COVID. These provisions relate to a declaration of an emergency by a government agency for things like wildfires, floods, etcetera.
Another avenue to mitigate risk is insurance. It’s been pretty well litigated and established that the typical business interruption insurance policy does not apply to COVID-related delays or loss of income, because those types of policies require there be physical damage to the property. But a builder's risk policy does provide some protection against disruptions on a construction project. Companies should look at the policy provisions closely to see if a specific insured peril such as COVID-related events are covered. There is a newer type of policy called business disruption and supply chain risk insurance that has been offered by some insurers in the last year or two that might also be worth investigating.
6. What do you see on the horizon for hotel construction/development for 2022?
COVID itself is still a risk, but not like a year ago. I think the big three risks for developers and contractors to manage are inflation, supply chain disruptions and labor shortages. I just don’t see how the supply chain and labor issues are going to dissipate significantly. Labor issues will impact costs as contractors will have to pay more to attract certain skill sets.
The cost of lending for a hotel development project will also be a challenge because we’re in a period of rising interests rate and high inflation. So, the overall debt service incurred will increase and that means the amount developers or contractors will be able to borrow will decrease. Some developers may choose to scale back on projects as a result, and build a four-star hotel rather than a five-star property.
In addition, I think demand for new development will continue to be strong in the leisure hotel sector due to pent-up demand and remain weak for business travel.
Cornelius Riordan is an attorney with Robbins DiMonte.