Accounting for contingencies

Working at risk and its management

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A significant portion of the cost of property development is the contingent (or transaction) cost involved in undertaking the development.

Typically, these are research and information costs related to the product to be brought to market, the costs involved in coming to an acceptable agreement with each contractor in the supply chain necessary for the design, production and delivery of the product to market, the cost of finance, and the cost of policing and enforcing all the contracts necessarily concluded towards this end, including the cost of taking appropriate legal action to ensure compliance, if deemed necessary. In property development, the aggregated cost of the transaction can amount to between 30% - 40% of the total cost incurred, and even more than this figure in certain circumstances.

Under these conditions, it is not surprising that private sector developers will seek to limit their initial exposure to the transaction cost of the development by asking consultants to work ‘at risk’ until such time as the feasibility of a particular project can be determined. The incentive to agree to such an arrangement is based on the understanding that the consultant concerned will be awarded an appointment to render a full service for the delivery of the project should its feasibility be proven. It also means that the consultant will not receive anything should feasibility not be proven.

As defined in Part 1 of this series, work performed at risk means: ‘Work performed for, or on behalf of, a Client where payment of the fee for such work is deferred (partially or in full) until a specific agreed event(s) occurs, and which event may also be required to occur by a certain date. It being understood that should the event fail to occur, or fail to occur by the said date, that the Client would not be indebted to the Consultant in any way.’ [Adendorff C, Botha B, Van Zyl C, Adendorff G, 2012. Financial implications for built environment consultants working at risk in South Africa. Acta Structilia, 19(1), 126-152].

In coming to such an arrangement, the Developer limits research and information costs related to a perceived market opportunity, at least until its feasibility can be determined. Here, however, is the rub! The question is: ‘What is required to be known in order to determine whether a particular proposed property project is indeed feasible?” The answer to the question is both objective and subjective. The objective issues are mostly technical and the subjective issues relate mostly to the Developer and his circumstances. A third dimension is the market itself – ever shifting, fluctuating and changing its composition.

Given these parameters, it is important that formal agreement be reached with the Developer on what matters of feasibility need to be investigated and, most importantly, what process will be followed to do so. Ideally, a process model for the feasibility should be developed and agreed with the developer, and with all participating consultants.

For the sake of reference, I include a generic process model for establishing the feasibility of a mixed-use property development. The model has been divided into two work stages. The first work stage is undertaken to determine the merit of taking an ‘Option to Purchase’ a certain portion of land which has been identified for this purpose, and to define the terms on which the ‘Option to Purchase’ should be acquired. The purpose of the second work stage is to decide whether to purchase the land or not. A decision to purchase the land should, in effect, confirm the feasibility of the project and thus terminate the consultant’s work ‘at risk’.

Other feasibilities may have different purposes and should, therefore, be structured accordingly, both in terms of content and process. Typical feasibilities for property development include, but are not limited to: technical feasibility; economic feasibility; legal feasibility; operational feasibility; schedule feasibility; market feasibility; resource feasibility; cultural; feasibility; and financial feasibility, etc.

Part 3 in this series will explore the risks to which both the Developer and the Consultants are exposed by choosing to work ‘at risk’, and how best to manage these risks both from a commercial and ethical point of view.

Peter Richards (MSc); Pr. CPM; Pr.CM.

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