Some New Zealand construction companies will begin to fail in the next 12 months as the impacts of a new law begin to bite.
So says James MacQueen, advisory partner in the construction and real estate sector for business advisory and accountancy firm BDO. He says the sector is largely unaware of the impact of amendments to the Construction Contracts Act which came into force on March 31.
"It's not all doom and gloom," says MacQueen. "Some construction companies will come out of this stronger and will be preferred partners for property owners and sub-contractors. But the current boom has provided an opportunity for many new constructions companies to set up - and some will not survive due to the change in the law."
That change was made after the 2013 collapse of Mainzeal, leaving unsecured creditor debts of at least $112 million of which a substantial portion were subcontractors.
The new law requires construction companies, developers and property owners having construction work done to make new provisions regarding retention payments - sub-contractors' pay held back for a period to ensure any remedial work required is completed, even if the project is finished. Retentions typically comprise 6-7 per cent of construction companies' total turnover.
There are two ways of safeguarding retentions, says MacQueen - cash placed in trust or an insurance product as an alternative.
"The catch is insurers will currently only provide insurance to companies whose financial statements they have reviewed and found satisfactory; in other words, an insurance product for those that don't really need it and no insurance for those that desperately do."
MacQueen says the confusing law will give rise to a two-tier construction industry - in the top tier, those companies which can afford to put cash aside or who have sufficient financial strength to gain insurance cover. The second tier will be those unable to find the cash and who are denied insurance.
Under the new law, sub-contractors can also inspect, on short notice, construction company records to see if they have the requisite funds in trust or adequate insurance.
"The sub-contract industry will very quickly realise some companies have been refused insurance and do not have adequate cash resources," says MacQueen. "Very quickly, subbies will prefer to work for those that have shown financial strength.
"That will make it increasingly difficult and most likely lead to ultimate failure for those that don't exhibit that strength.
"As we saw with Mainzeal and collapses prior to that, the failure of a significant construction company leaves behind a trail of unpaid creditors - putting those sub-contractors in serious financial risk and leaving buildings only partly constructed, and those completed, without any warranties."
MacQueen says he expects a number of construction companies to fail over the next 12 months. While he would not be drawn on the numbers, he says the rate of attrition will most likely be higher than the normal rate of failures at the end of a building boom.
"Some of these new companies set up during the boom have very capable directors but the majority are significantly under-capitalised. To win work, they are having to cut corners, particularly in relation to the quality of materials used and the quality of the work done.
"Some of these issues could result in a future version of the current leaky building fiasco," he says.
However, MacQueen was at pains to underline he was not predicting a disastrous loss of construction companies.
"There will be those that can get insurance and make this well known," he says. "There are a number of significant companies that have been around for a long time with experienced and capable directors - many already have the cash to hold in trust or will get insurance and will survive.
"They will be the preferred construction company for sub-contractors to work for and for property owners to contract with."
MacQueen expects the major impact to be felt in the commercial sector, rather than residential although some apartment development projects could be affected.
"As much as the public is concerned about the increased cost of building, the margins in commercial construction, in particular, remain too tight to allow an adequate profit," he says.
"So too many corners are cut. For those that do make a profit, it is often less than two per cent of turnover - and that profit is the difference between all the jobs going well and one project having significant issues."
MacQueen says BDO has been working with construction clients to help them build up reserves ahead of the law change and make changes to their record keeping systems, distinguishing between retentions on contracts entered into on or after March 31 and those prior to that date.
"The challenge most business face is that, because of those low margins, profits earned may not be enough to bridge the funding gap."
For more information on BDO's readiness review: www.bdo.nz/readinessreview