Letters Of Credit and Construction Obligations

LettersOfCredit.html June 7, 2004

Construction and Letters of Credit

Or Why the Big Get Bigger and the Small PAY and PAY

Is there any other business on the planet where you have to pay for things twice? Maybe it’s only the real estate business where this happens to such an extent.

Typically, a City wants a developer to post a Letter of Credit (LC) to guarantee that the work they have committed to the City that they will do under their legal agreements with the City, will, in fact, get done. These legal agreements can be a site plan agreement, a subdivision agreement or a myriad of other documents that a developer has to agree to and sign before they can proceed with construction.

Let’s look at a recent example of a client of mine—a small enterprise that is constructing mini storage buildings in Kanata, Ontario. They (we’ll call them Acme Storage, obviously not their real name) have to post a LC with the City of Ottawa in the amount of $22,000 which guarantees their obligations under their site plan control application for works to be built in that estimated amount.

These works include some paving, landscaping, a gate, construction of a garbage enclosure and a few other miscellaneous items.

Now Acme is a small company—so they can’t simply ask their Bank to issue a LC in favour of the City of Ottawa in the amount of $22,000. For larger companies with large pre-approved Bank lines, this is exactly what they would do.

But for Acme, they need to post $22,000 IN CASH with their Bank (the TD Canada Trust) in a cash collateral account. They then must buy a one year GIC (Guaranteed Investment Certificate) to secure the one year term for their LC. By the way, the GIC pays just 1.7000% p.a. interest. This amounts to the princely sum of $386.50 on maturity of the GIC. (See the GIC confirmation notice from the Bank, reproduced below).

Now Acme’s borrowing cost for this money is 10%; so it is costing them $2,200 in interest payments to make $386.50 in interest. In addition, their Bank is charging them $100 to prepare the LC and a 2% fee ($440). Their fees alone are more than the interest they will receive from their one year term GIC. (I don’t mean to pick on the TD Canada Trust here; they are just doing their J.O.B. and doing it no differently (and frankly probably better) than any other Bank would do for a SMEE (Small and Medium Sized Enterprise).

TD Canada Trust GIC Confirmation Notice—“Just doing our J.O.B.”

There is also an opportunity cost in having $22,000 of their cash tied up. Now they are building storage buildings that return about 30% p.a. So we could say that their opportunity cost is (approximately) another $4,400 (30% minus the cost of borrowing (10%) times $22,000).

But that’s not all—they still have to pay for the works to be built. Their suppliers are not going to wait a year to be paid. That means that Acme has to find the money twice—once to secure it with the City and once to actually pay for it.

Basically then the numbers for Acme’s LC look something like this:

	Company-- Acme Storage	Company-- MegaCorp Storage	Company— Acme Storage	Company— MegaCorp Storage

LC Amount	$22,000	$22,000

Cash Account GIC	($22,000)	NA

Interest received on GIC	1.7000%	NA	$386.50	0

Financing	10%	5%	($2,200)	0

Bank Fee	2%	1%	($440)	($220)

Bank Charge	Set Fee	Set Fee	($100)	($100)

Opportunity Cost (Approx.)	30%	NA	-4400	0

Total Cost of LC			($6,753.50)	($320)

As you can see, it costs Acme Storage about $6,700 to maintain their LC in place for one year. But for a much larger competitor like MegaCorp Storage, the numbers look very different.

First of all, they don’t need to create a cash collateral account—they simply call their Account Manager at their Bank and use part of their pre-approved credit facility to secure their LCs. So, right away, they have an advantage over their small competitor—the financing cost of having their cash tied up is nil since they don’t actually have to borrow any funds specifically to back up their LC. MegaCorp’s cost of borrowing is much lower than Acme’s but this doesn’t play any role here means because they don’t actually have to use any of their borrowed cash for these purposes.

MegaCorp can also get their Bank to issue a LC for a lower annual fee: probably just 1% or so. That means their total cost for a LC is a measly $320 per annum while Acme is spending $6,753.50. The big are getting bigger and the small are PAYing and PAYing.

It would certainly be fairer if Acme could at least put $22,000 on deposit with the City and then pay for the required works from this account as they go along. However, the City doesn’t want to be bothered with 101 suppliers asking the City for money and interposing themselves between the developer and their contractors. Plus the City usually wants to keep these irrevocable LCs in place for at least a year and maybe longer. If the works are substandard or need to be modified in any way to meet City imposed conditions, the City has the absolute right to present these LCs at the Bank and cash them. That’s what irrevocable means. Then the City can perform the required works if the developer refuses to complete the works or can’t. They pay for the work out of these funds and remit the balance, if any, to the developer.

These LCs guarantee performance by developers of their obligations to the City but unfortunately they fall disproportionately on smaller enterprises.

As projects get bigger, these LC obligations become huge—for just modest sized residential or industrial subdivisions, they can reach into the millions and millions. You can just imagine the difference between what MegaCorp pays to put LCs in place and what Acme would have to pay to play at this scale. In fact, the LCs alone would prohibit Acme from participation in the higher end of the real estate market.

This may explain, in part, why in most cities around the world, landownership seems to be highly concentrated in just a few hands. Other government regulations also contribute to land markets becoming oligarchies. For example, zoning and master planning rules are often so complex and picayune that only companies with deep pockets and highly paid lobbyists, lawyers, planners and other specialists can get through the land approval process.

Zoning rules, Letters of Credit requirements and many other forms of regulation are the great friends of large developers—they serve to filter out competition and keep land prices higher than they would otherwise be.

www.SaragassoCity.com

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