John F. Kennedy coined the phrase, "A rising tide lifts all boats," or in other words, improvements in the general economy will benefit all participants in that economy.  But what happens when the tide is declining, as our business climate appears to be doing?

It is no secret that the residential real estate market in the nation is undergoing a significant correction. The implications will likely affect all sectors of real estate development, including commercial and industrial construction, lending, leasing and sales activity. The more abrupt the correction, the more contractors need to increase vigilance and sharpen business practices to ensure they weather the correction and are in a position to prosper when conditions improve.

A boom cycle forces a contractor to move quickly and sometimes ignore basic business principles. Until the recent correction lenders lent quickly, subcontractor failures were rare, and change orders were subject to little scrutiny. Many construction contractors stopped analyzing the owner's ability to pay and subcontractors' ability to perform, and contractors were lax in properly documenting contracts.

Today, lenders are quick to declare defaults, rendering owners unable to pay construction contracts. Lien filings and subcontractors' defaults are increasing dramatically. Declining real estate prices are causing owners to resist even legitimate change orders. In today's market, contractors must analyze and monitor the credit of the parties with whom they contract. Contracts must include adequate protections and should be updated as changes occur.

When a contractor signs a construction contract he essentially is agreeing to loan the owner the costs of a month and a half of construction. Typically billings are made once a month and the owner has a number of weeks to make the payment. On a five month, one million dollar job, this means the contractor is essentially loaning the owner approximately three hundred thousand dollars at any given time. While the subcontractors and suppliers in turn effectively loan the contractor a significant portion of this amount, if the owner becomes insolvent, the contractor is usually liable to the subcontractors and suppliers.

Accordingly contractors should analyze the owner's credit like a lender would. Simply confirming the owner has a bank loan is probably not sufficient. At a minimum the loan should be for an amount equal to or greater than the construction contract. Typically the contractor's lien rights are subordinate to a construction loan. In other words, if something goes wrong the loan gets paid first. If it is not, the contractor should insist the owner demonstrate it has available liquid sums to pay the balance. In marginal cases an escrow account can be employed to ensure that the owner's money will be available if needed. Additionally, the contractor should insist on contract provisions that ensure that loan proceeds are applied to the construction contract. Throughout the contract, the contractor should monitor the loan to ensure compliance.

Contractors should be very skeptical of owners who promise that any shortfalls will be made upon the sale of the project. If the project value is less than the loan amount, the odds of the contractor getting paid drop dramatically. For such a plan to offer protection the project has to be completed and the sales projections must be realistic. Insist on seeing recent appraisals. Recognize the appraisal may not accurately reflect the market upon completion of the project. Conservatively, in today's market contractors should estimate actual sales could be 20% or more below appraisal. The contractor should also be aware that even a properly priced property may take a year or two to sell in a down market.

In analyzing the owner's credit, the contractor needs to distinguish the credit of the entity signing the contract versus the credit of the owner of the entity. Just because a shareholder or member of the entity has a strong net worth, does not mean the entity is solvent. Insist on personal guarantees when solvency is in question, and request security interests in the property of the guarantors to ensure payment.

Given the tight credit environment, financing delays can delay construction starts. Contractors should have clear contract provisions to provide for increased costs in the event of delays.  In addition, change orders should be executed as soon as possible after approval, and contractors should insist on a signed change order prior to commencing work.

The contractor should also ensure subcontractors' credit is sufficient to complete the job and pay the bills. When solvency is at issue, insist on personal guarantees from guarantors with adequate net worth. If a subcontractor doesn't pay his suppliers or sub-subcontractors, the contractor may be forced to pay twice for work or materials. Contractors should insist that subcontractors provide lien waivers for themselves, their suppliers, and sub-subcontractors in support of their payment applications. In some cases, joint checks may be appropriate to ensure suppliers and sub-subcontractors are paid. Now more than ever, be very suspicious of bids or quotes that appear to be too good to be true.

Finally, get it in writing. While it may be true that a good economy lifts all boats, in a declining economy it can be every man for himself. An insolvent owner's memory is rarely as good as it was when the owner was awash with profits. Contracts need to be in writing. In short, document your deals as though they must hold up in court. Unfortunately, they may have to.

Mike Baldner is a partner with the law firm Meuleman Mollerup LLP, practicing in the area of real property law including drafting and negotiating purchase and sale transactions, leases, tax deferred exchanges, restrictive covenants, easements, and litigation relating to real estate development   Mr. Baldner can be reached at 208.342.6066 or by email at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it .  More information at http://www.lawidaho.com/