October 2010

Surety Bonds & The State of Construction

Glenn Ricciardelli, CPA, CVA, CFE, CFF, Partner, Matson Driscoll & Damico

Imagine this: real estate agents are so busy they can barely see straight. Prospective home and commercial property buyers are falling over themselves to outbid each other on the next great piece of real estate. Banks are lending, lending, lending. It seems as though the party will never stop.

And then it does.

The scenario described above takes place in 2007. It was only three short years ago, but seemingly a lifetime away for the people caught in the thick of the property crunch.

Statistics for new home sales, which are carefully monitored because they signal the health of the construction industry and impact economic growthⁱ , tell a much different story:

• In its August 18th report, the Commerce Department noted "new homes plunged to a 40-year low of 276,000, down 12 percent from the previous month and 32 percent from that level in July 2009."ⁱⁱ The Washington Post noted that this was "the lowest level since 1963 and far worse than what analysts expected."ⁱⁱⁱ
• The average price of a new home dropped to $253,300, the lowest reading since early 2003. ^iv
• Homes are sitting on the market for approximately 11 months. In a healthy market the average sell time is around five months.^v
• Mortgage applications have decreased by 43 percent between late April, when the homebuyer's tax credit expired, and early July.^vi
• According to the US Bureau of Labor Statistics, construction unemployment was 21.8% in April 2010, well above the overall US unemployment rate of 9.9%.

As if the news about continuing depressed new home sales wasn't bad enough, a recent article in The Wall Street Journal reported, "some of the largest commercial property owners are defaulting on debts and surrendering buildings worth less than their loans." The article goes on to note, "these companies all have piles of cash to make the payments. They are simply opting to default because they believe it makes good business sense."^vii In the next few years, more landlords are expected to follow in these companies' footsteps.^viii

Given the state of the industry, it isn't hard to understand why the construction business is currently facing a variety of challenges that are expected to continue into 2012. These market conditions have set the stage for an increase in contractor failures, which in turn are expected to lead to an increase in surety losses.

When a surety bond is invoked, a forensic accountant's primary functions is to provide the surety with the information necessary to properly address the situation and make the decisions needed to get the project back on track and finished in a reasonable timeframe. As such, they are frequently brought in to assist in the following areas:

• Developing an accurate snapshot of the project's status
• Determining what has gone wrong on the construction site
  • Is the contractor behind schedule due to a lack of resources?
  • Did a subcontractor fail to deliver or complete a key element of the project at a critical time?
  • Making an evaluation as to the financial health of the general contractor and/or subcontractor
• Make an evaluation as to the financial health of the general contractor and/or subcontractor

In the event the surety elects to tender another contractor to cure a default and complete the project, a forensic accountant can assist in tracking the costs incurred to complete the project while segregating any acceleration or increases in the costs to complete. He or she can also assist the surety in recovering these costs from the original contractor in accordance with the terms of the surety bond.

The faster a surety can get an accurate understanding of the situation, the faster it can make the necessary decisions that help it decide how to best complete the project. After all, no one benefits from prolonged and needless disputes in the construction process. Avoiding default is almost always better and much less expensive than cleaning one up after the fact.

About the Author

Glenn Ricciardelli, CPA, CVA, CFE, CFF is a Partner in the Boston office of Matson Driscoll & Damico. You can reach him at gricciardelli@mdd.com or 617.426.1551.

ⁱThe Washington Post, "New-home sales hit a 40-year low", Dina ElBoghdady, August 25, 2010.
ⁱⁱNewsweek, "Home Prices: Don't Buy the Hype", The Street, Laruen Tara LaCapra, August 31, 2010 and the Department of Commerce, "Statement from Commerce Secretary Gary Locke on New Residential Construction in July 2010", August 17, 2010.
ⁱⁱⁱ Idem.
^iv Ibid.
^vPatrick Newport, Economist with HIS Global Insight. Ibid.
^viThe Washington Post, "New-home sales hit a 40-year low", Dina ElBoghdady, August 25, 2010.
^viiThe Wall Street Journal, "Commercial Property Owners Choose to Default", Kris Hudson and A.D. Pruitt, August 25, 2010.
^viii Ibid.