Q&A: How Is COVID-19 Affecting the Construction Industry?

April 8, 2020

Colliers’ Greg Main-Baillie and Levine Kellogg Lehman Schneider + Grossman’s Jason Kellogg provide perspective on what schedule complications will mean for the real estate industry.

Greg Main-Baillie, Executive Managing Director with Colliers International. Image courtesy of Colliers International

The coronavirus outbreak has taken a toll on the economy and all the facets of the real estate business, including the construction industry. In an attempt to help stop the virus from spreading, construction sites are being shut down across the country and many projects are being put on hold and reassessed.

In the interview below, Greg Main-Baillie, executive managing director for the Florida Development Services Group at Colliers International discusses how the industry is going to be affected by a slowdown in deliveries. Jason Kellogg, partner at Levine Kellogg Lehman Schneider + Grossman, touches on the legal aspects of the story and some of the measures businesses can take to protect themselves.

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An estimated 30 percent of all U.S. construction materials are imported from China. Supply shortages are already affecting the industry. How will this impact construction costs in the near future and the long term?

Main-Baillie: As developers are increasingly choosing to put their construction projects on hold and municipalities begin closing departments to protect their workers, the construction industry is likely to hit pause. Concurrently, as we have heard, China is turning back on. I expect this to allow for the restocking of commodities and we shouldn’t necessarily see supply shortages, but rather the availability of materials.

Boston was the first city in the U.S. to shut down its construction sites to help stop the virus from spreading, and other cities are following suit. How can stakeholders involved in projects at various stages of completion cope with closures?

Main-Baillie: The closures are inevitable. Stakeholders are going to have to find creative ways of financing and/or deferment to keep employees and cover costs. Likewise, general contractors typically hold pay-when-paid clauses with their subcontractors and/or the right to hold payment for 90 days or more. If the market halts, overleveraged stakeholders will have a tough time bringing projects to completion.

What effects do you expect to see in Florida’s development scene?

Main-Baillie: Right now, there is a wait-and-see mentality. Many are making sure they have cash on hand and are waiting for stabilization in the market before making commitments. There is a lot of money on the sidelines, and this situation will present a host of opportunities. South Florida has been climbing to the top of the market and many have paid a premium for real estate. Unfortunately for some, that will mean buying opportunities for opportunistic buyers as this stretches on. Many people will make the tough decision of selling to try to recoup their investment, especially those who recently closed on a purchase. At the end of the day, construction is a primary kick-starter for the economy.

On another note, we may see more people turn to infrastructure projects, which are a good driver of business. The U.S. Department of Transportation’s projects are a great way to get people back to work.

Which real estate sector will be most affected by a slowdown in deliveries?

Main-Baillie: The entire market will be affected. It mainly depends on how the industry is positioning for a rebound. Right now, the industrial market is experiencing a boom, as e-commerce gains traction. Everything is moving to a shipping/delivery basis, and there has to be a place to supply, store and distribute these goods. It remains to be seen if that will bolster the industry on the other side of this.

The other question is how will this crisis impact the demand for Class A and Class B office space? Many people will realize they can work from home and analyze how many of their staff actually need to be sitting at a desk that has to be paid for. We could see this continue to shift the office market into smaller footprints, with a focus on coworking spaces.

Each sector will experience some effects from the slowdown in deliveries, but only time will tell what those will be.

How will this crisis impact the construction financing landscape? What are lenders’ biggest concerns?

Main-Baillie: In the immediate term, it will impact the ability of the borrower to be able to make payments. Most people won’t be seeking ways to spend money right now given the level of uncertainty. Developers and lenders are looking at both sides to see if there is a justifiable return on investment to cover loans.

Since the last downturn, the regulatory environment around financing is more stringent. If anything, this crisis is seeing a loosening of federal regulations to encourage spending and encourage businesses to stay in the economy. Everyone is feeling fear and trepidation. It’s not so much about requiring more stringent standards as it is about qualifying the justifications behind a deal. It’s in the developer’s best interest to do that, as well as the lending institution. Developers and lenders are on the same boat. They are both trying to assess risk at a time when everything is changing by the week.

How has the coronavirus outbreak interrupted the entire real estate market?

Jason Kellogg, Partner at Levine Kellogg Lehman Schneider + Grossman. Image courtesy of Levine Kellogg Lehman Schneider + Grossman

Kellogg: In many ways—for example, commercial leases. Tenants whose sales dry up will not be able to pay rent. Landlords will look to enforce their leases—but as the saying goes, you can’t get blood from a stone. This is already causing negotiations about workouts and extensions that, if unsuccessful, could lead to extensive litigation. For the construction world, this means commercial buildouts and enhancements will likely be put on hold. Landlords won’t want to pay for new tenant buildouts without assurances that the tenant will be around to inhabit the space, and tenants will be nervous to pay for enhancements.

This will also impact commercial sales and construction. No doubt thousands of commercial real estate contracts were in the pre-closing phase when the epidemic hit. Buyers are nervous, particularly if their intention was to improve the property. With experts predicting a recession, parties are analyzing whether it may be more efficient to breach the sales contract and forfeit deposits. There are attempted renegotiations occurring.

For those contractors who signed up to build the improvements, it’s a tense waiting game. Standard contracts give contractors the ability to extend the contract time but may not necessarily protect them from the increased cost of materials and labor that many predict will occur by the disruption in supply.

Are insurance policies beneficial for those affected by construction delays or site shutdowns?

Kellogg: Possibly not. Builder’s risk policies generally cover only losses caused by direct physical loss or damage to the work. This physical loss limitation likely does not extend to epidemics. Business interruption insurance typically contains a similar physical damage limitation. Some business interruption policies include a rider for losses caused by civil authority actions. Such a rider may apply in areas with “shelter-in-place” orders. But they may also require physical damage.

Despite its general ability to deny coverage from a legal standpoint, the insurance industry is already anticipating a public-relations issue. It has approached Congress about working with the government to recognize some business interruption claims. This is similar to what happened after 9/11. Rather than enforce Act of War exclusions for those who suffered losses from the terrorist attacks, the industry worked with the government to pay out. Owners and contractors should monitor this situation, particularly the laws that are coming out of Washington during the pandemic.

How can all parties involved in a construction project legally protect themselves during these challenging times?

Kellogg: Owners and contractors should review their contracts and look for provisions, including force majeure and unforeseen conditions provisions, that may impact their rights. Consult a lawyer if there is any uncertainty. Owners and contractors should then provide any notices required by the contract. Owners may consider suspending or terminating the project if the contract allows. Contractors should carefully track all impacts to the schedule and the project’s cost. Contractors should also review subcontracts and provide subcontractors and suppliers with any notices required under those contracts.

What advice would you give to construction companies facing the disruption caused by COVID-19?

Kellogg: Talk to their lawyer and ask the lawyer to review all relevant contracts. In addition to contractual remedies or strategies, a lawyer may be able to find common-law legal remedies to bolster contractors’ leverage with owners. These include legal concepts like “frustration of purpose,” which may apply if the contract was entered into before the coronavirus’ emergence.

What are your mid- to long-term expectations regarding the legal effects of the pandemic?

Kellogg: I expect long-term and far-ranging effects. The industry has seen labor shortages. It has seen shortages of steel and lumber. It has seen recessions. It has seen acts of God, from hurricanes in Florida to tornadoes in Kansas to snowstorms in New York City. But I don’t think it has seen this all at one time and for an extended period that, as of now, no one can predict an end date for. As a result, the legal industry expects a run of construction-related workouts and litigation in the coming years.