Public construction projects almost always require surety bonds. As a type of insurance, bonds protect the government if the wheels come off a project, or the contractor absconds with the funds. Indeed, bonding has been mandatory on federal public works projects since the late 1890s.

But now, bonds are increasingly being required on private development projects as well. The reason why has everything to do with the tumult caused by the pandemic.

Supply chain issues, material shortages and increased costs of construction materials triggered by the COVID-19 crisis are a few culprits. The tight labor market, where subcontractors don't always show up to jobs, is another. Taken together, these factors have private owners — and their investors — looking for cover.

Surety bonds give them that. In an environment where private owners can face restricted cash flow while struggling to line up financing, they're mitigating their exposure to risk the same way public owners have in the past: via bonding.

How owners of private projects are limiting their risk

There are a number of recent examples that illustrate how and why surety bonds are being used on private projects today:

Impact of COVID-19: The owner of a privately-held, $50-million recreational complex did not originally consider bonding because of its belief that bonds were only for public projects. But as a result of COVID-19, the owner decided to require payment and performance bonding by its contractors to protect the project from the risk of supply chain delays, contractor failure and liens.

One bad experience: The developer of a mixed-use project elected to proactively include bonding as a requirement for the builder. This was due to a bad experience the developer had on a prior project, where an unbonded contractor's poor performance resulted in a number of liens.

Lender requirements: On a New York City hotel project, the lender accepted the bonds in place of a personal guarantee from the project sponsor.

What surety bonds do

A surety bond is a written agreement to guarantee compliance, performance or payment. All construction surety bonds are three-party agreements among the surety, the contractor and the project owner.

Two of the most important types on construction projects are the performance bond and the payment bond.

The performance bond

The performance bond ensures that the project will be finished.

If a contractor becomes unable to perform or is properly terminated by the owner, the owner calls upon the contractor's surety to complete the work under the performance bond.

The performance bond can also help maintain momentum on a project simply by providing cash flow the contractor needs. In other situations, the surety may provide construction management support to keep the contractor on track, or hire another contractor to complete the work.

In the worst case scenario where the contractor stops working, the surety instead pays over the penal sum of the bond (the amount of the contract, plus any change orders) to the project owner.

The payment bond

The payment bond guarantees that the subcontractors, vendors and suppliers on a project get paid.

By guaranteeing payment, this bond protects the contractor from subcontractors walking off the job, delays or refusals to deliver materials to the job site, and liens.

It also protects the project owner if the contractor doesn't pay subs on the job. When that happens,  subcontractors, vendors and suppliers can file a claim on the payment bond. After the surety investigates to make sure the work or materials were in fact used for the bonded project and not paid for by the contractor, it pays those claims.

A payment bond can also be triggered by a mechanic's lien. In that case, the surety pays the cost of discharging the lien. Subcontractors, vendors and suppliers then seek payment directly from the surety.

Pro and cons of bonding

Beyond protecting owners, contractors can see an upside from bonding, too. For example, a mid-sized contractor that wants to seek larger dollar value projects can offer to become bonded. 

They can then parlay each project success into better premium rates and larger bonding capacity in order to grow. If a project does run into problems, the surety helps the contractor avoid defaults and claims.

One downside of requiring surety bonds, however, is the cost. The bond amount is equal to the contract value, and the bond premium is generally 1% -3% of the bond amount.

But that cost is generally passed through to the owner, who's the ultimate beneficiary. While the bond is an additional expense, having it can save a fortune in the long run, especially if a project begins to unravel.

Takeaways

As surety bonds become more prevalent on private projects, contractors are well-advised to understand their pros and cons.

While the cost of surety bonds can be an issue, particularly in today's rising cost environment, when compared to project failure, they're a bargain.