IRD pressure on the Construction Industry

It is important to keep proper books and records and ensure you meet your tax obligations. IRD say “declare it all or risk everything” in a recent announcement.

Late payments and bad debts are the main triggers of insolvency in construction companies. The payment of taxes however contributes to cash flow problems.

IRD’s recent release is heavily focussed on enforcement. Winding up applications by the Revenue are also on the rise generally.

For more information on the Revenue’s latest release relating to “cashies” read here.

 
Dealing with IRD

We recommend communicating early and negotiating a time payment arrangement if your company falls into arrears but generally your business is viable. The IRD will likely require you to complete an IR591 (12 month cashflow forecast) to support any plan.  The IRD provide the following advice for managing tax and for gaining financial relief for companies, partnerships and trusts <read here>

If the financial position of the company is dire then contact a Licensed Insolvency Practitioner to discuss the options. The IRD may consider financial relief or an instalment plan.

There is a high risk of financial penalties for failing to take action. By making a full voluntary disclosure, IRD say you may have your penalties reduced by up to 100%, you may avoid prosecution and you may retain your good business reputation. By communicating early on, your business has more chance of survival. By taking action early as a director you are less likely to be breaching your duties under the Companies Act 1993 and to be held personally liable.

New Zealand's construction sector, has a string of serious issues that bedevil the industry.

These problems are not just confined to the major construction companies themselves. They are having a seriously detrimental impact on the fabric of trade suppliers and sub-contractors that bind the industry together.

Underpinned by Auckland and Canterbury’s buoyant growth builders should be comfortable. So, why are increasing numbers of construction companies collapsing and going into receivership, declaring insolvency or being faced with the prospect of liquidation?

A Grim Roll Call

While some firms continue to struggle dealing with leaky building and council compliance regimes, much of this problem can also be sheeted home to New Zealand construction firm’s apparent willingness to take on too much risk despite operating on wafer-thin profit margins. This often places their very survival in the balance.

Just look at the unenviable roll call of deceased construction firms from last year, when over 100 construction-related firms have failed in Christchurch since the February 2011 quakes. Collectively, these failures have squandered $35 million.

Ebert Construction went into receivership, Mainzeal collapsed, Orange-H Group entered receivership, Tribeca, and Valiant homes are no more, while Fletchers suffered $800m in losses on 16 large construction projects.

Auckland liquidation notices make for grim reading these days.

Much of this turbulence comes from the industry’s desperate desire to outsource the risk associated with major construction projects, leaving New Zealand’s commercial construction firms balancing large amounts of risk.

This is a game of pass the parcel, where no one wants to be left holding the parcel when the music stops.

Risky Business

A significant amount of this commercial carnage stems from the companies own shortsighted behaviour. Some firms tender in the hope they will get away with screwing their price down to win the work. They submit a bid and simply cross their fingers they will be able to progress the project without incurring any cost escalations either in materials or labour or timing.

At its heart, the New Zealand construction industry as a whole needs a fundamental change in its approach to bidding and operating. If the head contractor incurs a price rise, they simply pass it down the chain, amplifying the impact across a network of subcontractors and trade suppliers.

The industry trend has been toward a growing number of parties and levels in the construction chain and often each of the parties in the chain working on a fixed price. The lead contractor is often not building, but is relying on subbies and outsiders to do the work. In that structure the higher you up the chain the more likely you are to be managing/administering and not building.

And for each level or party in the chain there are additional costs to be covered and also a margin that they charge, (which those further up the chain sometimes also charge a margin on), and that ultimately means a total build cost that is higher than it would be if, for example, a lead contractor was also the single builder achieving its margin.

Plus while that provides some cost certainty for those further up the chain it leaves everyone exposed to the impact and costs of time delays, and unbudgeted events, such as consenting events and finance constraints.

Many of these subcontractors are insufficiently capitalised to cope with cost blowouts. The ripple effect is enormous. Trade suppliers and labourers bear a huge risk.

How risk is allocated on a project is creating a very real a problem not just for a project team but for the wider construction industry as a whole. It’s an industry-wide issue that is yet to be successfully dealt with.

Busy Work Syndrome

Construction firms often find winning work straightforward. What is substantially trickier is to make project work for them financially.

Winning is simple. You cut your (or others) margin to the bone. But once they have a project they have to make it pay. Some construction companies are believed to run certain projects on 0 per cent projected profit margins.

Four to five per cent is a prevailing industry norm when 7 or 8 per cent is the target margin for firms to enjoy long-term viability.

This strategy is designed to maintain each firm’s internal capacity. They understandably want to ensure they have a continual flow of work flowing through their pipeline so they can keep their staff employed.

However, they aren’t sure when these projects are going to come on-stream. If a firm wins too much work then human and financial resources become critically stretched. When work comes on stream site managers become overloaded, more administratively focused and less functional.

We have seen instances where key staff like project managers have had 10 to 15 sites to manage when in the past they may have one or two. Quality, efficiency and cost control suffers. Losses arise.

The passing of risk and responsibility down to sub-contractors and below means that site managers have less control, are less effective as the subcontractor possibly takes short cuts, quality suffers, and where these acts are picked up everyone faces rework delays which are uneconomic and unproductive.

This puts tremendous strain on everyone. That can’t be good for the industry.

Short-Term Cost Focus

Studies identified the top three issues confronting construction companies during the current procurement phase were:

1. Clients focus on lowest price (81 per cent)
2. Cut-price bidding by contractors (76 per cent), and
3. Lack of visibility around the potential pipeline of future work (75 per cent).

With a recent Government Policy Statement on Land Transport promising record levels of proposed infrastructure public investment, a greater focus on whole-of-life value for projects is required to deliver a sustainable construction industry and overcome its cultural malaise.

A fragmented multi-layer structure, stretched administrative and project management, declining quality and thin margins result in substantially greater risk for both the public and the construction sector. Obsessively cutting costs inevitably leads to poorer-quality infrastructure.

Moreover, if contractors are continually subjected to a series of bidding wars centred on cost rather than quality outcomes, this will destabilise the broader New Zealand construction industry, which is already operating on chronically scant margins.

Government infrastructure programs are conceived to deliver value for successive generations of New Zealanders. Adopting a lowest-cost provider strategy for these projects simply leads to higher maintenance and remediation costs downstream.

Greater Government Transparency Required

With the construction industry generating 7 per cent of New Zealand’s GDP in 2017, it is little wonder Prime Minister Jacinda Ardern’s government is looking to mitigate some of the issues plaguing the industry.

The current problems affecting the construction industry are not unique to New Zealand. A lack of transparency around the scale and timing of central and local government development plans, a chronic skills shortage, poor-quality builds and an epidemic of construction company collapses are all concerning.

The Prime Minister Jacinda Ardern, together with Peter Reidy, Fletcher's Construction chief executive ,and other notable industry players unveiled their Construction Sector Accord a new joint strategy designed to combat these structural issues.

According to Ardern the Construction Sector Accord will improve the construction sector's culture and reputation, bolster its workforce and deliver safer, more durable and affordable infrastructure buildings and homes.

The Construction Sector Accord acknowledges that past construction industry clients and Government decision-making behaviours have spawned systemic problems that negatively impacted the New Zealand economy and the wellbeing of New Zealanders.

Final Observation

Construction company failures do nothing to enhance the industry or the economy. In a construction boom, it's hard to recruit subcontractors and taking on too much work can produce a flow-on effect, which can quickly snowball.

Taking on risk is fine provided it is priced into your final bid. Failing to price risks correctly is foolish and exposes the firm and the wider industry to greater volatility and that is bad news for the industry as a whole, for employees, subcontractors and ultimately clients and the broader public. Everyone loses.

Stage 1 of the The Construction Sector Accord is a welcome development as it recognises much of the above. Stage 2 is tasked with how those goals will be delivered. In the meantime we have observed that sometimes it is better to be less busy but be paid, rather than be very busy and not end up paid. So we encourage all participants to do their due diligence on the human and financial capabilities of the people and organisations they are considering doing business with, so they are making informed decisions based on where the risks lie.

With Auckland’s housing shortage and home renovation activity, you would be excused for thinking building companies should be surfing a building boom and reaping the rewards.
However, many continue to fall over despite promising industry conditions, leaving customers, contractors, suppliers and even the taxman in the red.

Building is a complex task

Building involves multiple parties from designers and architects to surveyors and councils, to suppliers and to customers. There are few companies that have the ability to perform the entire build process.

There are external specialist suppliers. Whether it’s the architect or the excavator and/or foundation company or the window supplier or the plumbers/sparkies and tilers and painters these trades (and many more) are usually separate from the builder. There are a lot of relationships and expectations for a builder to manage and at each stage the plan can go wrong. As margins in the industry are slim, any error or delay is costly, time consuming and potentially business ending. Defective work has a double impact in delay and cost.

Delays mean you are exposed to price increases and often further delays as preferred suppliers have to juggle their production schedules to meet new expectations. The cost of standing still due to delays also mounts up. Staff and the fixed costs (premises, and the inevitable leased ute and the dog) continue even if the project is standing still.

Those slim margins are easily gone especially if your customer controls themselves and does not vary much as the build progresses. A lot of builders make their money from increased margins in the hope for customers variations. So the initial build price is priced at or just above cost to win the work.

What can go wrong? Examples based on real life

Architects and Designers

The architect/designer may have their own view as to what the customer wants. I have heard of one house renovation project where the architect has changed some basic room dimensions a dozen times. Specialist suppliers are sick of the changes. How the builder is supposed to cope with that while managing a project and a business is anyone’s guess.

Assuming that is all under control and agreed at the beginning, the customer is happy and everyone is friends. It’s all going to be great.

Customers

Once the build starts the customers expectations can change to expect the world’s best house at the very lowest price. The customers have become experts in building, (the customer may even have a helpful builder “mate” in the background stirring the pot). They can be unmoving on price increases even when they change things. Maybe there are delays with council issuing consents on the initial build or on the variations. Disputes arise with customers and payments are delayed. Banks, suppliers and staff start to become nervous. How do you manage? You have lots of customers, you are growing. It’s the third day of a new month and you don’t have any money in the bank but you will be alright.

You get grumpy, and decide the customer(s) needs to be ignored for a while. That will show them….WRONG.

The customer relationship is no longer constructive (sorry, another pun). Maybe the customer’s bank is also getting nervous and it is taking more and more of the builder’s time and resources at each project payment milestone for the bank to release funds to allow the customer to pay. Some customers will construct disputes to force the price down/or gain an advantage and a concession or discount.

In the end while this is false economy as it forces corners to be cut later or in the worst cases, the customer has to find a new builder with new delays and often a higher cost. But it happens.

And you still don’t have any money. The contract payment you have missed out on equates to the margins on maybe 4 or 5 normal builds. You are now way behind.

Some customers know that the costs of recovery through any disputes process may mean there is no cost benefit. As a small but growing builder you may not have the time or energy let alone the money to contest a non payment. Have the best contract terms you can get.

If you and/or the customer has any type of construction completion insurance make sure you understand what it means, what and how much it actually covers and on what basis the cover maybe withdrawn. Some associations operate under a relatively complex structure.

Pressure from prior project failures

Increased build activity increases the problems and the cash requirements. Companies thrive and others fail. Many of the failures we see arise from the pressure that has built up from years of below average trading activity because of persistent project failures. There are many that will have been slow payers for years, have maxed out or are well over their credit limits with suppliers, they have changed suppliers a few times, they are generally well behind with their commitments to IRD. Only the ute gets paid for on time every month. Like a gambler, they have no other avenue but to fail eventually. It only takes one creditor or dissatisfied customer to act decisively and the whole façade (sorry, pun) falls down. A bunch of waste and ruin is all that is left.

The people involved in these companies are in my opinion much better off financially and in all other aspects of life working for wages or salary. They may even have a company ute for you!

The impact of our completely risk adverse bureaucracy cannot be ignored. We have seen new parties entering the market with a viable business plan to operate on a larger scale where investors have lost millions of dollars in development and machine costs, but have run out of money (millions budgeted and spent) and folded without much being built due to council, compliance and government decision changes or delays. The bureaucrats keep their jobs, but it can hardly assist our productivity.

The bigger projects are so complex few can appreciate the risks that are being taken by all parties in those projects, and the foresight and work needed even before the build starts. Added to that the very small number of NZ (and possibly Australian) contractors with a balance sheet strong enough to undertake big projects comment those projects would be at best superficial and likely unfair. This article does not focus on those projects or contracting parties.

Why small to medium sized Building Companies Fail

I am pretty certain that very few builders assess what would happen if a project payment is delayed a month/or does not occur at all. Would they be able to survive financially? Some would be able to, no doubt.

Some small to medium building companies do well during a boom because they provide good quality product and attract good customers (realistic to price fluctuations and prepared to pay the price for a quality build). They have industry knowledge and know what is possible for the customer’s price expectations. They do not over commit, and they build some delay into project pricing. They may have relationships with the architect of designers. They know the world is not perfect.

Growth requires cash

You have to pay more people often weekly to operate and manage. Your customers don’t pay weekly, they may pay monthly or even every two months if there are delays. Some suppliers require deposits to be paid? The more work you take on, the harder it becomes to manage and meet those requirements.

Do you have enough to meet the wages bill when customer payments are delayed? Can you pay your suppliers? Can you pay yourself? If you put money into the business is there or has there been a return on that investment?

There are many that allow themselves to take on more business than their capital base can fund at all, or fail to manage expenses properly placing their cash flow under stress and so flirting with disaster.

Inexperienced New Entrants

Boom conditions in the building industry also encourage new operators to enter the market. To them, there is money to be made. Many previously worked as employees or sub-contractors and so lack many of the real life business skills or the resources to run a business.

Similarly, many, while fine tradesmen, struggle with business administration such as filing, PAYE and GST, let alone paying business commitments, invoices on time or managing their cash flow effectively. Often the private commitments are not met by the business income. The private commitments get priority and the business suffers.

These tradesmen often operate their business account as their own personal bank account inviting calamity. They finance their ute or 4WD through a personal loan and put their tools on their personal credit card. {not sure what is wrong with that]

Common reasons for these new entrants failing include:

• Poor contracts
• High fixed overheads and thin margins
• Pricing mistakes
• Under-capitalised balance sheets
• Missed deadlines
• Contract disputes
• Cost overruns
• Overly aggressive tendering trying to increase market share at the expense of profit margins
• Poor estimating and job pricing
• Poor variation analysis with variation sign-offs not completed formally leading to contractor wearing additional costs
• Perhap’s incomplete level of technical building education and overall knowledge in the industry
• Unfamiliar with legal and statutory regimes and compliance costs compounded by poor documentation and record keeping for PAYE, GST and creditors.

High Costs Increasingly Drive Failures

A common issue with building firms is being crunched by labour and materials cost fluctuations while working on fixed price contracts. Labour and materials costs frequently increase during a boom (demand exceeds supply) and only fall when a slowdown hits the industry.

Final Observation

Few new business owners fully appreciate it is every bit as difficult to manage a building business during a boom as it is during a slowdown or recession. High operating costs inflated by sustained demand places cost pressures on many businesses locked into what are effectively fixed-price contracts while capital constraints cause issues when companies look to take advantage of boom conditions by taking on too much work.

Have enough staff that you trust. If you don’t then don’t take on new work. You are likely to fail.

If you have a bad feeling about a customer or how hard they are pushing you on price, then walk away. There are some people who will never be satisfied and these are the ones who will find a reason not to pay you, and there is plenty of other quality work/jobs around.

Once a project has started it’s a complex and harsh environment when things go “wrong” and wrong can start very early on in a building project. There is plenty of pressure on the industry participants as a result of growth that means things go wrong. The typical reaction these days seems to be to ignore the issue or to blame someone else. Neither of those responses solves anything. You feel better for a while and create a delay but it is short lived.

At the first sign of wrong communication is key. The builder needs to have everyone from the designer to the customer and the suppliers understand what the issue is and to we hope arrive at a solution that works for all.

Everyone involved may need to give a bit otherwise the project will fail probably impacting on the builder and any unpaid suppliers the most. Professionals can assist if instructed to.

An increasing number of building firms "went bust" in 2014 despite the building boom in Christchurch and Auckland, leaving homeowners, contractors, and the taxman out of pocket.  As the construction boom in Auckland gathers pace the situation is going to get worse.

Nearly 100 rebuild-related companies have gone into liquidation or receivership in Christchurch alone since the February 2011 earthquake. We see the same trend occurring in Auckland.

People often ask us why so many building firms are going under as they should be making a fortune.  The simple answer is that the good ones are, but there are many that have been caught out by over trading (transacting more business than the firm's working capital can normally sustain), thus placing serious strain on cashflow and risking collapse or insolvency.  Some of these companies shouldn't be in business in the first place.

This trend could worsen as mismanagement woes continue and big ticket construction projects open new avenues for white collar crime. 

More than half of the failures came in 2014

Construction-related liquidations more than tripled between 2013 and 2014 (mainly in Christchurch). Subcontractors were heavily represented in the liquidation numbers and the Serious Fraud Office ("SFO") received 29 complaints about suspect dealings in the rebuild and has launched six investigations.  As a result, the Government introduced new laws in 2015 to protect consumers, including mandatory written contracts, and builder requirements for residential building work costing $30,000 or more.

With an increasing number of small operators who were previously working as employees deciding to go out there and do it themselves there is increasing concern that many don't have the skills needed to run a business.  Many are good tradesmen, but not good businessmen.  Some don't manage their cashflow well and don't file PAYE returns, GST returns, or get their invoices out on time.  We often see overdrawn current accounts where the tradesman has operated the business account as their own personal bank account.

As the building boom gathers pace, tradespeople with varying levels of skills have poured into the industry as they see it as a cash cow. They often have little or no capital.  Many of them "gear up" with the latest tools and ute all purchased on HP.

New Zealand is an extremely expensive country in which to build houses.  McDonald Vague has recently been appointed over two large building companies (eHome NZ Limited and Shears and Mac Limited), both employing over 100 people and both manufacturing in a factory and then installing onsite.  eHome NZ Limited built houses in a factory and Shears and Mac Limited did commercial and shop fit-outs in New Zealand and Australia.  They operated in different sectors of the building industry but failed for similar reasons including:

• High overheads and slim margins;
• Missed deadlines;
• Contract disputes;
• Cost overruns;
• Unhelpful bureaucracy and compliance costs.

High costs driving failures

We provide consultancy and turn-around advice to a number of building firms and often the problems are the same.  Fixed price contracts stay constant but the cost of labour and materials constantly increases in a construction boom.  The costs of labour and materials will continue to increase until there is a slowdown in demand. 

Why so many fail

• Out of control pricing;
• Characterised by small businesses (a ute and a dog);
• Aggressive tendering trying to increase market share at the expense of margin;
• Poor estimates/pricing - running a project at a loss;
• Poor variation analysis;
• Undercapitalised balance sheet;
• Lack of building knowledge, the level of education in the industry is poor;
• Leaky buildings (warranties and guarantees) ongoing issue without provision;
• Desperate to climb the ladder - egos prevail in a testosterone dominated industry;
• Poor documentation/record keeping leads to failure (PAYE, GST, creditors);
• Variation sign-offs not formally completed leading to further costs borne by contractor;
• Low margins;
• Businesses are easy to establish and easy to close, with no capital requirements.

What can your clients do to protect themselves?

There are a number of things they can do, including:

• Register on the PPSR;
• Stop work when they don't get paid;
• Be familiar with remedies under the CCA;
• Do due diligence on developers or head contractors before doing work;
• Take personal guarantees;
• Enforce credit limits;
• Look at liquidated companies on the Companies Office;
• Be aware of phoenix companies;
• Make credit checks;
• Do directors' checks for liquidations;
• Get money held in trust where possible.

We can help

Please contact the team at McDonald Vague Limited if you would like to learn more about how your client can protect/mitigate the risk of a customer going into liquidation.

The earthquakes in Canterbury created a disaster on a scale not previously seen in New Zealand during our lifetime. Christchurch will be rebuilt and when it gets into full swing it will be the biggest building project in New Zealand history. Treasury has forecast that the cost of the rebuild will be circa NZ$40 billion. Fortunes will be made out of the rebuild, but like any boom, history tells us there will be some spectacular failures along the way.

In this article we will explore the issues facing construction companies waiting for the Christchurch rebuild, the chances of another large construction company collapse and some advice on how you as a professional advisor or construction industry contractor can help protect your clients or yourself from another construction company failure.

Issues facing the rebuild

The rebuild of the CBD hasn't started. The government announced the Christchurch CBD will be reconstructed around 10 major anchor projects. The city centre shows little evidence of activity or rebuild projects having been commenced. Private developers are waiting for the anchor projects to get started before they erect their buildings because of concerns of not being able to attract tenants to a building surrounded by empty sites.

Increased competition. A number of large offshore companies have indicated they will tender for some of Christchurch's anchor projects. For example a MOU has been signed between Arrow International, one of New Zealand's largest construction companies and global construction giant China State Construction Engineering Corporation Ltd targeting the anchor projects in Christchurch.

Labour shortage and small supply chain. Christchurch still needs to find another 17,000 workers, including carpenters, joiners, electricians and plasterers, before the rebuild reaches its peak. It is estimated the rebuild will need a total of 35,000 construction related workers. The shortage of skilled labour could result in poorly constructed buildings that could leak or fail.

Rising costs. Escalation in construction costs is already exceeding 10% per annum in the residential market, as a direct result of material shortages. This is likely to spill over into the commercial sector.

High compliance costs. The cost of constructing commercial property in the Christchurch CBD will be very high as the new buildings will require deep and expensive foundations. The draft plan wants to restrict CBD buildings to a maximum height of 7 storeys. The end result is that landlords will have to charge very high rents to get the same yield they had before the earthquake. Tenants may not accept these high rents and elect to keep their business in the suburbs.

Cashflow constraints while waiting for rebuild. Construction firms are desperate to hold on to their good workers and supply chains in anticipation of the rebuild. They have huge overheads to absorb while they wait for the profitable work to start. Initially, it looked as though the rebuild would peak in 2015/16 but it now looks as though it will be in 2016/2017. The flow on effect is that construction firms may have to accept a lower margin for another 12 months to keep their employees busy.

Insurance fraud. The vast sums of money involved in the rebuild and recovery create an unprecedented opportunity for fraud and corruption and we are now seeing large scale frauds being uncovered. International experience shows that, regardless of the country in which it occurs, fraud and corruption activity increases significantly following natural disasters.

What is the likelihood of another Mainzeal?

To answer this question we need to consider the common causes of construction firm failures. From our experience these usually involve:

• Tight margins
• Insufficient capital
• Lack of skills and experience
• Leaky buildings and non-compliant construction
• Over-investment in fixed assets
• Inability to manage growth
• Competition
• Lack of understanding for procuring products/supply chain
• Inaccurate estimates and tendering
• Poor pricing decisions
• Poor quality control
• Unsafe construction sites

How can you or your clients better protect themselves?

• Be familiar with the remedies under the Construction Contracts Act
• Keep good records and contract files
• Register on the PPSR a specific security over material supplies (a great defence if charged for a voidable transaction)
• Suspend work if not paid, or consider the adjudication regime
• Perform due diligence on developers or head contractors before commencing work
• Research/credit check developer or head contractors before starting/signing contract
• Get personal guarantees
• Moneys held in Trust accounts
• Set credit limits - enforce them!
• Search the directors on the companies office to see the number of liquidated companies (history)
• Be aware of phoenix companies and obligations of successor companies to give proper notice
• Get sign off from a quantity surveyor, architect or engineer before paying invoices/completing variations
• Review trading terms
• Get advice if you suspect the head contractor is insolvent. Any suspicion of insolvency can be detrimental when facing a voidable transaction claim from a liquidator

Conclusion

When you compare the list of the most common causes of construction company failures to the issues facing construction companies in Christchurch, it appears that there is a high chance of another significant construction company collapse.

As a first precaution we would advise you to look at the list we have provided to help protect yourself or your clients.

McDonald Vague has considerable experience advising clients in the construction industry. If you or one of your clients is facing financial difficulties in the construction industry please contact Tony Maginness or one of our other Partners.

DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.