Canada’s economic landscape faces several challenges, including rising interest rates, labour shortages, supply chain disruptions, and the Ukraine war. Real estate markets across the country are being affected separately by these factors. To illustrate, the consumer shift from “bricks and mortar” shopping to e-commerce has increased demand for logistics, warehousing, and fulfillment. In contrast, retail and commercial real estate has experienced a decline due to the decrease in demand for retail properties such as malls and big box stores. In addition, the residential real estate market had been experiencing an overheating period in 2021.
However, with the succession of interest rate hikes from the Bank of Canada and high inflation, recent reports indicate that the current market is experiencing a cooling-off as residential real estate prices decline and fall into alignment with pre-pandemic pricing. Some pundits predict this is simply a correction, rather than a recession.
This article provides insight into proposed strategies to deal with the impacts of uncertainty and disruption in the various sectors of the real estate and construction market.
Real estate insolvencies jump higher in 2022
The impacts of the economic downturn have been relentless on the industry. According to Insolvency Insider’s Q3 2022 filings, real estate led all industries with eight insolvency filings this year, followed by manufacturing and technology with six, and cannabis with five filings.
Real estate filings are complicated and have common themes. These may include potential fraud, poor financial viability, severe cash flow problems, economic impasse, or significant loss to the builder. The viability and profitability of individual builders depend on accurate cost estimation, successful bidding, and proper pricing.
Residential construction slumps as costs soar
Real estate development is not for the faint of heart, and builders face many challenges that can derail a project.
- Residential construction costs: According to Statistics Canada, in its May 5, 2022, release, the cost of residential construction in Canada rose over 22.6% year-over-year in the first quarter of 2022, surpassing the previous quarter’s high.
- Pre-construction sales: Lenders typically require a new development to be 75% sold before construction commences, which means builders need to set home prices based on their construction budget plus markup and enter into binding agreements with buyers before a shovel hits the ground.
- Budget prediction: Builders must prepare a construction budget before construction begins. The budget typically includes material costs that are locked in for a limited period of between 30 to 90 days. Add labour costs, shortages, supply chain disruption, and rising fuel prices and budgets can quickly become outdated and not reflective of actual forecast costs.
- Construction financing: This is typically advanced through monthly draw requests reviewed by a quantity surveyor who reports on the status of construction, cost overruns and other critical details. Each advance under the construction loan is conditional on the lender receiving a satisfactory report.
Did you know
In the court-appointed receivership proceeding of Triumph Development HK Bradford Twin Regency Inc., which commenced in March 2022, the initial construction budget for the construction of a proposed seven-storey, 239-unit residential condominium development in Bradford, ON increased by $16.9 million from $83.1 million to $100 million from November 2020 to March 2021.
Similarly, in its April 2022 Companies’ Creditors Arrangement Act (CCAA) filing, Hazelton Development Corporation reported that construction costs for its 14-storey, 261-unit residential condominium complex, known as the Highlight of Mississauga, increased by $11.67 million from its original budget . In his affidavit in support of Hazelton’s CCAA application, the director of the company said:
“Like many other real estate projects in the Greater Toronto Area, the Project has suffered from dramatic escalating costs for labour and materials resulting from extended supply chain disruptions and labour shortages. This has undermined the economics and viability of the Project.”
How to mitigate these challenges
While it is best advised to consult an industry expert and professional advisor, here are some potential solutions that depend on the progress of a project and the critical nature of the issues faced by the builder:
- Hold the land in inventory until the market conditions stabilize. While inventory carrying costs can result in losses or lower ROIs, it may still be a better alternative than completing a proposed “loss” development.
- Equity finance the land purchase. If you decide to hold the land in inventory until the market stabilizes, there are no associated carrying costs.
- Incorporate a separate entity for each development and treat them separately from a financial perspective to mitigate director liability claims for breach of trust under the Construction Act.
- Increase contingency fee estimates in future construction budgets and pass along cost increases to the buyers through cost-escalation clauses.
- Try to lock in sub-trade contracts for the longest possible period, and work with familiar contractors to ease the possible renegotiation of prices and avoid construction delays.
- Practice due diligence on the sub-trades you contract to ensure you work with highly experienced and skilled workers.
- Include early termination clauses in your pre-construction sales contracts that cover secured financing, permits, and selling enough units to justify construction or access funding.
- While most builders try to avoid the negative publicity associated with this action, in dire situations, consider exercising early termination clauses and either asking the existing buyer for more money or exposing the property to the market at a higher price.
How to deal with the possibility of insolvency
If a situation arises where the construction financing has been terminated, or the development has effectively run out of cash, or has come to an impasse, consider seeking the advice of a licensed insolvency trustee. This will help you gain access to the available restructuring legislation such as the CCAA or Division 1 Proposal provisions under the Bankruptcy and Insolvency Act.
These restructuring options generally provide the builder with the following:
- A stay of proceedings from creditors to afford the builder time to restructure its financial and operational affairs associated with the development.
- The ability to access debtor-in-possession (DIP) financing to provide the necessary funds to complete a project. In most cases, the DIP is granted a priority charge over existing lenders’ security.
- The ability to terminate its pre-construction sales contracts as has been accepted in previous restructuring proceedings.
- The ability to deal and settle all lien claims in one forum.
- The chance to present its restructuring plan and allow a comparison to a possible recovery for creditors through either bankruptcy or receivership proceedings.
- If the restructuring plan is accepted, it allows the builder to delay and reduce overall payments to creditors.
- A restructuring plan could include the sale of the development by the builder and the sale proceeds utilized to pay existing creditors to improve overall recoveries for all stakeholders.
- The chance to disclaim onerous contracts or sub-trade contracts that could impede the completion of the development.
What precautions can buyers take when buying pre-construction properties?
Investing in a real estate project can be daunting, especially in pre-construction properties, where the fear of the builder delaying your closing, terminating your purchase agreement, or cancelling the development looms close. Home buyers, especially new home buyers in most jurisdictions are eligible for new home warranty coverage. Some ways to avoid property distress are:
- Research your builder to determine if they are licensed to build new homes or whether they have any complaints lodged against them with entities such as the Better Business Bureau.
- Review your purchase agreement with a real estate lawyer before signing, and make sure any verbal agreements are documented and incorporated into the purchase agreement and associated documentation which should stipulate the expected completion of the project, and the latest possible date for permitted extensions (i.e., Outside Occupancy Date or the Outside Closing Date).
- The Outside Closing Date and Outside Occupancy Date should be fixed and not dependent upon some other event which may or may not be permitted.
- In case the builder extends the above-mentioned dates, consider termination of the purchase agreement within the permitted time frame and seek return of deposits and other monies paid.
- If the builder has included standard early termination conditions in the purchase agreement, you may be entitled to a three-day cooling off period to consider your options. If project viability conditions are included, you may be entitled to a longer review period to consider whether you want to terminate the agreement.
- Review your rights under the purchase agreement for delayed closing compensation for closings occurring after either the Firm Occupancy Date or the Firm Closing Date for condominiums and freehold homes respectively.
- Understand your statutory deposit protection rights if you are purchasing a freehold home or condominium unit as the coverage varies case-by-case.
What if the builder cancels the project or terminates your purchase agreement?
If the builder terminates your purchase agreement, but is still contemplating the completion of the project, the first step would be to consider whether paying the extra cost being asked by the builder is worth retaining your purchase agreement. You could either choose to walk away and seek the return of your deposit or litigate. However, most builders typically incorporate a separate corporate entity with the sole purpose of completing the development, and likely have limited assets, if any.
How BDO can help
The disruption in the infrastructure sector will continue to impact builders, buyers, and all stakeholders. Our team of advisors can provide excellent start-to-finish professional services, successfully guide clients from the early stages of project preparation and mitigate challenges.
Contact us for more information.
Gary Cerrato, CIRP, LIT,
Partner and Senior Vice President, Business Restructuring & Turnaround Services
Josie Parisi, CPA, CA, CBV, CIRP, LIT,
Partner and Senior Vice President, Business Restructuring & Turnaround Services
Chris Bowra, CPA, CA, CIRP, LIT
Vice President, Business Restructuring & Turnaround Services