Lowballs lead to strikeouts

As construction suffers, many worry inexpensive contractors will create stalled projects
By Yaffi Spodek | December 10, 2010 02:36AM

Construction firms have long had a habit of bidding below cost to beat out the competition and snare jobs. But as the backlog of construction jobs that had existed is petering out, the underbidding is happening even more — and it’s becoming even riskier.

As companies bid low, observers fear a spate of stalled projects down the line, when the firms run out of funds midconstruction.

“We’re in a very dangerous spiral,” said Louis Coletti, president of the Building Trades Employers’ Association. “I’m already starting to hear stories about subcontractors, and some general contractors, who aren’t able to finish their jobs because they don’t have any cash flow and they’re bankrupt. … There will come a point when they may be at risk of going out of business.”

In the past six months, Coletti said he’s observed increased concern surrounding this issue. For one, underbidding is becoming more prevalent.

“There’s a limited amount of business opportunities, and contractors are [setting] their prices as low as they can,” he said. “It’s a terrible trend for the construction industry when their bids are unrealistically low, and not at least breaking even.”

According to Barry LePatner, of the corporate construction law firm LePatner & Associates, construction-industry unemployment is particularly high — 20 to 25 percent, well above the national jobless rate. That slump has only increased competition.

LePatner, who has written a white paper on the subject, entitled “LePatner’s C3 Model: Construction, Cost, Certainty,” said that while construction firms have lowballed for decades, the repercussions of the practice are just beginning to be felt. The reason for this is that traditionally, underbidders have made profits by creating cost overruns.

According to Richard Wood, president of Plaza Construction, some companies have always “lowballed bids,” though he noted that his own company does not. “With construction purchased before completion of design, the opportunity exists for construction companies to recover some of the money that they perceive was left on the table,” he said.

One tactic of a company may be to bid on a set of drawings, knowing that they are missing components, Wood explained. These incomplete documents can provide an opportunity for a “change order strategy” to make a profit in the end.

Though Wood acknowledged every company is entitled to conduct business any way it chooses, he said, “an extremely low price should concern a client, and the validity of that bid should be put into question,” with the client understanding that they may be exposed to extra costs.

In boom markets, when the margin was made back through cost overruns, LePatner estimated that cost overruns by the construction industry nationwide exceeded their estimates by $1.2 trillion. However, with the credit crunch, the money to finance overruns no longer exists. Unlimited construction financing is gone. And mezzanine loans — which financed most cost overruns — are also relics.

Coletti pointed out that existing construction loans have the highest level of nonperformance compared to other types of loans, making banks even more reluctant to finance construction projects. He fears a repeat of the financial struggles of the 1990s, when the industry lost 20 to 25 percent of its capacity because a number of contractors filed for bankruptcy.

Of course, often there is no way to know if a low bid is simply a cost-efficient one or a risky one. One solution may be to change the bidding procedure.

As The Real Deal reported last month, LePatner is advocating for the widespread adoption of “fixed-price” contracts, as opposed to the current method of using Guaranteed Maximum Price contracts, which he referred to as “baloney.” Despite a name that suggests otherwise, a GMP contract is based on incomplete design documents, invariably leading to significant cost overruns, LePatner said.

“It’s been happening for years, and I’m trying once and for all to end this fraudulent nature of fast-track projects, so the country will be better off,” he added.