September 15, 2006

August 29th marked the one-year anniversary of Hurricane Katrina. The nation and the Gulf Coast are still recovering from the country’s worst natural disaster, but recovery efforts are significant and underway. On this historic occasion, we would like to give you an executive update on the status of development efforts in the construction industry. We hope this is helpful in understanding the true state of affairs and in considering opportunities in one of our nation’s largest reconstruction efforts.

Introduction

Hurricane Katrina was the costliest and one of the deadliest hurricanes in our nation’s history. It was followed within weeks by Hurricane Rita, causing further loss of life and property destruction. In addition to the personal tragedies suffered by individuals, Hurricanes Katrina and Rita adversely affected the commercial environment of the entire country including -- in no small measure -- the construction industry in the Gulf Coast region. Because of the property destruction, mandatory evacuations and displacement of employees in the storms’ affected areas, the operations of many contractors, material manufacturers, fabricators, suppliers, owners and design professionals were temporarily or permanently suspended.

On the anniversary of Hurricane Katrina’s landfall in Louisiana and Mississippi, construction industry participants in the Gulf Coast region are still experiencing various adverse impacts to their businesses and operations including increased costs, labor shortages, missing or insolvent contractors, payment slowdowns and regulatory obstacles. Nevertheless, major reconstruction work along the Gulf Coast is strong, and construction related opportunities exist. Increased Project Costs Project costs in the Gulf Coast region are higher than a year ago. Costs for property insurance, for construction materials, for delivery of materials and for labor have increased significantly.

According to the Insurance Information Institute, the insurance industry has estimated that insured losses from the 2005 hurricane season total some $60 billion dollars. Those losses, along with the uncertainty and instability in parts of the region plus the heightened concern for future storms, have caused the commercial property insurance market in many areas affected by the storm to experience extreme levels of volatility. Three hundred to five hundred percent increases in commercial property and builder’s risk rates have been reported. Furthermore, some commercial property insurers have increased wind damage deductibles and premium costs to unprecedented levels and/or imposed hefty percentage deductibles ("named storm deductibles"), for builder’s risk insurance covering Gulf Coast projects. Some have simply refused to write insurance in coastal areas.

Regarding construction materials, the storms have damaged production capacity, inventories and distribution systems for various building materials and supplies, and otherwise exacerbated problems for certain materials already experiencing price and availability problems due to trade restrictions, large global demand and the increases in petroleum prices unrelated to the storms. While materials price increases and volatility are expected to slow over the next year, construction material costs are still expected to continue to increase at a pace well above the inflation rate.

Labor Shortages

Labor costs in the coastal areas have increased significantly post-Katrina. In the New Orleans market, for example, the true minimum wage is approaching $10 per hour. The labor shortage along the coast is due not only to the amount of construction and repair work available, but also to the failure of many evacuees to return to the area, which is caused in large measure by a shortage of available housing. (Some experts believe that the lack of housing in the Biloxi-Gulfport, Mississippi, and New Orleans regions has significantly slowed recovery in these areas.) A general construction laborer in New Orleans can now expect $12 to $14 per hour instead of the pre-Katrina level of $9 per hour.

It is likely that a shortage in the labor supply and the corresponding cost will remain a challenge for at least two reasons in addition to the lack of available housing: First, a healthy construction market nationwide hampers efforts to attract workers to the area. Second, demand for labor will continue to rise as more of the billions of insurance, incentive (e.g., Gulf Opportunity Zone Act) and federal rebuilding dollars trickle down, and as commercial construction reaches full stride in the New Orleans and Gulfport-Biloxi regions.

Revised Building Codes

Another contributing factor to increased building costs in the Gulf Coast region is the adoption of stricter building codes. Both Louisiana and Mississippi have adopted the International Building Code/International Residential Code as the statewide standard for new construction, and Alabama is currently investigating the implementation of a statewide building code. These code upgrades will sharply affect construction costs in certain areas, especially in counties and parishes which were not previously subject to code requirements.

Recovering Increased Costs

Increased costs have particularly affected the bottom lines of contractors locked into lump sum contracts for Gulf Coast projects underway pre-Katrina. Some of these contractors must seek additional compensation to retain the original measure of profitability or, in many cases, to avoid losing money on a project caused by increased costs related to the storms. Absent contractual provisions allowing economic price adjustment or other contractual relief for force majeure events, a rare provision, most contractors have had to bear the risk of those increased costs, which were obviously no fault of the contractor. Delays caused by Hurricane Katrina, however, are typically considered excusable, noncompensable delays that should extend project completion dates. In those instances when owners require the project’s completion earlier than the appropriately extended contract time due to the delays caused by the storms, the contractor should, and typically will, recover additional compensation associated with its acceleration efforts.

Slow Payments for Emergency Work

In addition to increased costs and labor difficulties, Hurricanes Katrina and Rita have caused a myriad of other construction-related challenges in the Gulf Coast. One area of significant concern for some contractors is obtaining payments under slow-moving government funded contracts. Essentially, many contractors performing government work have had to cash flow the Gulf Coast region’s recovery. That problem continues.

Conclusion

Major reconstruction work is underway in the region and will likely increase significantly as more rebuilding dollars are injected into coastal economies. As a result of the increased work and the problems caused by the storms, owners and contractors can expect to continue to incur higher project costs for virtually all construction in the Gulf Coast region, to experience longer lead times on certain material deliveries and on the design and construction of their projects, and generally to meet storm related challenges that either did not exist, or did not exist to the same extent, before August 29, 2005.

For more information, visit Baker Donelson's Gulf Coast Reconstruction website or contact: Danny Shaw 985.819.8401 [email protected]