How blockchain can benefit the construction industry with next generation performance bonds
At REX, we are building a multi-layered real-estate application that connects the real estate community worldwide. REX is launching it’s open marketplace for real estate data and global data transaction portal using blockchain technology.
The utility of blockchain technology can extend to every facet of real estate. In this post, I’d like to talk about how the construction industry in particular can benefit from smart contracts, a utility that provides a major aspect of what allows the Ethereum blockchain network to enable such remarkable innovation.
I’ll explain by example. Let’s start by exploring performance bonds in detail…
In most public construction projects, the contractor is required to obtain a performance bond. The performance bond acts as a guarantee that the project will be completed by the contractor. The process of obtaining a performance bond takes time, costs money, and often results in miscommunication between parties. A performance bond isn’t insurance, but rather a guarantee that a contractor will complete a construction contract. The contractor is guaranteeing they will complete the job and pay subcontractors and suppliers.
How Performance Bonds Work
Performance bonds provide legal and financial protection for those involved in construction projects. The contractor secures the bond through a surety agency to guarantee that that the project will be completed according to the terms outlined in the contract. There are three parties in a performance bond:
- Contractor (Principal)
- Town or Owner (Obligee)
- Surety Agent/Bank (Underwrites Bond)
The contractor’s job is to build and complete the project. The obligee’s job (typically a township official in civil construction projects) is to track the development and ensure it is being built according to the terms in the contract. A surety agent is the intermediary between the contractor and obligee that underwrites and guarantees project completion. If the contractor defaults, the surety agency must step up to fulfill the terms in the contract, either through payment, or hiring a new contractor. Performance bonds provide assurance to the obligee that the contractor or the surety agent will complete all or a specified portion of the project in its entirety.
Obtainment, Cost, and Obligations of a Performance Bond
Once the contract is awarded to the contractor, the surety agency will issue a performance bond to the obligee. The contractor is typically required to post between .5% – 5% of the bond’s face value of the project. If the contractor fails to perform the duties stated in the contract, the contractor and the surety agent are liable for the bond. The entire liability may be collected from either the contractor or the surety agent.
Performance bonds encompass dense contracts between the the contractor, township and surety agent. The contractor establishes a development agreement with the municipality, simultaneously entering into a financial agreement with the surety agent. The surety agent is then named in the development agreement as a guarantor. The process entails endless paperwork and vast communication delays.
Ethereum & Smart Contracts
Performance contracts are complicated. Variables change, contracts are delayed and contractors (and towns) go bankrupt. Smart contracts can simplify this process. Smart contracts are a digital set of instructions intended to facilitate, verify, or enforce the negotiation or performance of a contract. They allow the performance of credible transactions without third parties. Smart contracts will prove excellent financial mediums for storing deposits, escrow funds, brokerage commissions and tenant improvement allowances.
Let’s look at an example:
Robbinsville, a New Jersey Township, owns 45 acres of vacant land in a zone they want to see developed. The town releases a Request for Expressions of Interest (RFEOI) to attract developers and explore concepts. ISP Development, LLC submits a proposal for 500 apartments and 200,000/SF of retail. The town, keen on commercial ratables, selects ISP Development as the developer/contractor.
ISP Development estimates total project costs at $250,000,000. After finalizing plans, ISP Development and Robbinsville Township enter into a development agreement. The development agreement stipulates the following terms:
After receiving all municipal, state, and federal approvals, ISP Development has 12 months to complete the following site work improvements:
Curb cuts for access and parking
To avoid project insolvency, the contract requires that ISP Development obtain a performance bond for 5% of the total cost: $12,500,000 (250,000,000 x .05). The bond provides assurance to Robbinsville Township that if ISP Development goes bankrupt, they have enough capital to hire a new contractor to complete the site work.
ISP Development enters into a bond contract with Surety Agency, LLC. Surety requires ISP Development to post a $12,500,000 deposit (250,000,000 * .05) with a 1% ($125,000) management fee. The deposit will sit idle in Surety’s escrow account until the completion of the contract earning 0.5% interest.
Next, the development contract is finalized between the ISP Development and Robbinsville Township naming Surety Agency, LLC as the bond issuer.
During this process time, money and paperwork are juggled between Surety Agency LLC, ISP Development and Robbinsville Township. This causes project delays and inefficient communication. In addition, ISP Development has $12,500,000 tied up accumulating high fee’s and earning little interest.
Smart Performance Bonds Built with EthereumISP Development is designated the redeveloper and enters into a development contract with Robbinsville Township. The contract stipulates the ISP Development must guarantee completion of the following improvements before day 365:
All curb cuts for access and parking (approved by the department of transportation): $4,000,000
Sewer systems: $2,000,000
Utility hookups: $3,000,000
Drainage Swales: $2,000,000
Detention Basins: $1,500,000
ISP Development and Robbinsville Township create a Robbinsville Surety Contract set to be deployed on the Ethereum Blockchain. The contract states several variables including a $12,500,000 deposit by ISP Development in the form of ETH to cover Performance. Next, the contract variables are encoded:
The contract benefits ISP Development by reducing escrow costs and liquidating drawdowns as milestones are met. ISP Development can redeploy their capital to other projects while staying motivated to complete the tasks outlined in the Surety Contract. The contract benefits Robbinsville Township by providing a virtual guarantee of project completion, while also providing an accessible public record for the community.
The Surety Contract would require verification methods to confirm work is being completed according to the agreement. Therefore, ISP Development and Robbinsville Township would elect a mutual third party (attorney) to act as the Surety Contract Oracle.
Paper contracts are malleable and can be amended. Smart contracts are fixed and immutable. Therefore, we must create an amendment clause that could void the original contract and reissue a new one.
The amendment clause states that if by day 400, addresses 0x009 and 0xAbb agree to exercise amendment clause, the original contract is to be voided and all remaining funds are to be withdrawn to address 0x009 (ISP Development).
The remaining funds would be any funds that had not already been released to Robbinsville Township.
The next statement would establish a fixed time for the amendment contract to be deployed:
After 50 days from exercising the amendment clause, amendment contract must be deployed or void the entire transaction. The amendment contract would identify the original contract by hash thus creating an extension of the original contract.
There are more complexities not accounted for in the above example. However, the goal is to start a dialogue in the construction community and apprise them of the coming efficiencies offered by Smart Contracts.
Performance bonds are just the beginning. Bid bonds and payment bonds will quickly follow suit. There are legal and contractual obstacles not addressed above that will take time to resolve. However, with the maturing of the technology and continued adoption in the real estate industry I believe it is just a matter of time before they are resolved.
Co-Founder & CEO, REX
Additional resources on smart contracts and how they operate: