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Our Guide to Performance Bonds
March 17, 2021
Our Guide to Performance Bon

Our Guide to Performance Bonds

If you’re in construction or real estate development, you’ve probably heard of performance bonds. Put simply, these financial instruments are used to ensure the performance of a contract. They’re common in real estate development and construction because, in many states, they’re required.

On top of that, since 1935, all construction contracts issued by the federal government must be secured with a performance and payment bond. In some cases, private development or construction contracts will also require a performance bond.

Since they’re so common and come with various costs to you as a developer or contractor, it’s important to understand performance bonds. How they work and their relevance to you can be confusing, but we’ll explain everything you need to know about this type of bond.

Performance Bond Definition

To start, let’s answer the common question that many business owners have: “what is a performance bond?”

A performance bond is a financial arrangement between three parties: the principal, the obligee, and the surety. In the case of a real estate project, the principal would be the contractor and the obligee would be the contractor’s client. In all cases, the surety is a financial institution.

In this arrangement, the principal “buys” the bond for the benefit of the obligee. In the event the principal fails to perform, the obligee may make a claim against the bond to be made whole. After ensuring the veracity of the claim, the surety pays it out.

Also, while the principal is the one who pays for the performance bond, that cost is built into the principal’s bid. Therefore, while the principal may “buy” the bond, the obligee ultimately pays for it.

It might sound like it, but a performance bond isn’t insurance. While the surety will be required to pay out the obligee’s claim, it doesn’t end there. Once they’ve paid out the claim, the surety will pursue the principal for payment.

Why Performance Bonds Matter

If you’re not a contractor or real estate developer and you don’t plan on bidding on any government contracts, performance bonds don’t matter.

If you are planning on bidding on contracts, however, performance bonds come with costs and risks you can’t ignore. Typically, performance bond rates range between 0.5 and 2 percent. Therefore, the bond cost would be $500 to $2000 on a $100,000 contract.

Should you run into a client who requires this type of bond, you’ll need to know how to price it into the job. Plus, it’ll help to be familiar with the concept, so you can be proactive in educating clients about the additional cost of a bond.

Performance-Bonds

How Performance Bonds Work:

Other than for commodity trading, performance bonds are used in three contexts:

  • Some private real estate development and construction projects
  • All federal and some state government construction projects
  • Most public works projects

Regardless of the context, though, these bonds function in the same, chronological manner:

  1. The obligee makes a performance bond a requirement of a contract.
  2. The principal, assuming they agree to the contract, purchases the bond.
  3. If the contract is completed, the bond’s obligation is finished.
  4. If the principal fails to perform to the standards of the contract, the obligee can make a claim. Assuming the claim is valid, the surety pays.

What does change with performance bonds in different contexts is their price and terms. Since sureties price these bonds based on their risk, prices vary based on the type of project and the principal.

For example, a contractor with a history of success on similar projects will pay less than an inexperienced contractor would. Also, very large projects, which have lots of downside risk, tend to require more expensive performance bonds.

Finally, depending on the project and other factors, performance bonds may have coverage limits. Typically, coverage will range from 50 to 100 percent of the contract value.

Performance Bonds, Payment Bonds, and Bid Bonds

Performance bonds are often associated with two other types of bonds:

Payment Bonds: While they’re usually included together as a P&P bond, payment and performance bonds are two separate bonds. The payment bond guarantees that all laborers, subcontractors, and suppliers are paid.

Bid Bonds: On projects that require performance bonds, there’s also a bid bond. The bid bond is required before the bidding process begins. This bond protects the client from bidders submitting inappropriately low bids to win a contract.

Conclusion: Master the Basics

Since they’re generally a contractual requirement, there’s not much to do about performance bonds; you either work on that contract or you don’t. If you choose to work on contracts with performance bonds, though, it’s definitely something you should be familiar with.

Fortunately, the basics, which we covered in this article, are enough to get you started. With this basic knowledge, you’re prepared to deal with these bonds if and when you run into them.

Just keep in mind that performance bond coverage, terms, and pricing are always ultimately dependent on risk.

Fora Financial

Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.

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