Continued from…
Important costs for your property development cost budget [Part 1-2]
Will the budget be under or over actual property development costs?
The borrower’s motivations for reducing or increasing the expense budget are contradictory. Each has advantages and disadvantages.
Under budget in real estate
The borrower may frequently predict a low-cost property development budget to put up less up-front equity.
He can then hope that money will emerge throughout or towards the end of the job due to expected equity sources, a lender’s loan increase, or anticipated cost savings.
Another benefit of submitting a low-cost budget in real estate is that it will result in project predictions that show a better profit margin. A lender will be more interested in this.
Over budget in real estate
The borrower may overestimate the budget to qualify for a higher loan in some cases. Then, as the job develops, if additional expenses arise that were not budgeted, the lender will have funds ready to cover part, if not all, of them.
Unfortunately, less scrupulous borrowers may be able to take out equity through periodic loan advances concealed in line items like general conditions or contingencies, thus reducing their equity and lowering their risk.
With an overinflated budget, a developer can recoup all his investment and make a profit in the end.
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The lender’s bias in the property development budget
Many lenders have discovered that their top credit officers tend to reduce the underwriter’s recommended loan amount on a commercial mortgage in the notion that this method decreases loan risk.
Regardless of how logical or valid the property development costs budget is, it can happen. Lenders’ biggest concern is that the borrower will receive money from construction loan advances rather than earnings.
The borrower will thus have a lower motivation to focus on, invest in, and work through challenging conditions if things go wrong. It increases the lender’s risk of being stuck in an expensive issue loan workout.
This policy may be beneficial for loans secured by existing income-producing assets. Lowering the loan amount lowers the loan risk by increasing the borrower’s equity and lowering the lender’s loan-to-value ratio.
Unfortunately, under lending frequently has the unintended consequence of increasing the risk for development loans. When the borrower requires operating money to keep the building project on track, he may be unable to obtain it.
If someone fails to pay contractors or professionals who, for example, can cause a project to slow or even shut down, the consequences can be severe.
In addition, ill will might be developed with a borrower who could otherwise generate significant future business for the lending institution.
The “arbitrary” loan reduction can strain the borrower-lender relationship, leading to anger that they may never resolve.
On the other hand, the lending institution may be better protected if there is a minor overloan position. The borrower is free to concentrate on completing the job rather than looking for a small quantity of money.
Even if there’s a chance the borrower will withdraw part of his equity, it’s better to err on the side of lending a bit more than a little less.
How to evaluate the borrower’s real estate budget?
After examining many loan offers, you should know how much a project should cost in terms of hard and soft costs per square foot in various geographic areas.
Suppose your financial institution makes development loans on apartment buildings, office buildings, warehouses, and strip centers.
In that case, you should learn how much a “typical” apartment building, office building, warehouse, and strip center costs per square foot in the areas where you lend and your financial institution operates.
Once you’ve mastered this skill, you’ll be able to assess new proposals and ask more educated inquiries more effectively. It can help you avoid becoming too engrossed in a lengthy underwriting review on a potential loan that later turns out to be unsuitable.
If you think a potential deal is favourable, but the borrower’s predicted costs look unusually high or low, you’ll be better able to inquire why.
Review budget line item
After forming an overall opinion, go over each budget line item for reasonableness. Starting with the “easier” known and calculable things, such as amounts set aside for the property’s purchase price and closing charges, including those related to the loan.
Because they depend on a percentage of the loan or the purchase price, you can quickly check items like transfer taxes, mortgage taxes, brokerage fees, and recording fees.
Fees for both your institution and the borrower’s attorneys, appraisal expenses, and inspecting engineer fees can all be approximated pretty correctly based on your department’s previous closing experience.
After you’ve gone over the easier closing charges, go over regular operational expenses, including real estate taxes, energy bills, security, management, lease-up or sales costs, and marketing costs.
A review of previous loan proposals and appraisals of similar projects in the area, the municipality where the project is located, and, if necessary, discussions with appraisers and brokers who practice and work in the area where the property is located can all provide benchmarks for these costs.
If revenue is expected during construction due to remaining tenancies, new leases, or the purchase of a portion of the property, make sure the expenses associated with those revenues are budgeted for.
Deal with the Consulting Engineer for the Lender
In the case of construction lending, the lender hires a consultant engineer with experience in construction and hard costs. He could be an in-house employee, but he’s more likely to come from an outside firm that specializes in the subject.
The most crucial aspect of a hard cost budget validation is an engineer’s written assessment of the borrower’s hard cost estimates.
To ensure that the engineer has not just rubber-stamped the developer’s initial proposal, you should always query a few particular areas of his assessment.
In addition, asking questions shows the examining engineer and his firm that you anticipate a high degree of expertise and responsiveness.
How to estimate the hard cost budget in property development?
You should be aware that property developers and contractors utilize a variety of approaches to arrive at cost estimates when analyzing the borrower’s hard cost budget and the engineer’s report. All are supported by commercial software from a variety of vendors.
The viability of a project is determined using a top-down approach at the start. A broad overall hard cost number is calculated based on previous experience with criteria such as the kind, size, general construction, and location of the planned structure.
For example, a residential property development might cost $520 per square foot in hard costs.
Because there are fewer bathrooms and kitchens to install, minor plumbing to install, and less partitioning, an office building in that city may only cost $230 per square foot in hard expenditures.
In the first case, the hard costs of constructing a 100,000-square-foot residential structure are $52 million.
From the underwriting and loan approval procedure to the delivery of the commitment letter, the top-down strategy is the method you’ll use the most. An appraiser’s principal method is also the top-down approach.
A more precise estimate separates components and systems and calculates their costs based on the size of the structure and the function of each system.
Example:
A 23-ton air-conditioning system is required for a 3,500-square-foot retail space with 14-foot-high ceilings, a 2,500-square-foot cellar with 9-foot-high ceilings, and 180 square feet of doors and windows.
Condensers, evaporators, pipes, ducting, and electrical work are all part of the system. The cost of each tonne of air-conditioning capacity is $5,000. As a result, the air-conditioning system will cost $115,000
23 tons X $5,000/ton = $115000.
The take-off approach of the property development cost budget is the most comprehensive, with a high level of information based on the estimator’s objective, expertise, and software.
It is utilized by contractors and property developers when calculating an exact cost is critical to their success.
The property developers will have the advantage of contractors who have submitted bids based on take-off estimates. Based on the final bid, they will determine their final budget.
Units and costs are combined into small aggregates and then multiplied to get a total cost.
For example, all of the costs associated with installing a piece of 5/8-inch thick sheetrock add up to $25.50. After reviewing the designs, the estimator multiplies the $25.50 figure by the number of 5/8-inch sheetrock panels he believes are required.
Further refinements divide each work into units (linear feet, quantity, capacity, labor, energy, equipment, and so on) and multiply the number of units by the projected unit cost. When all products are added together, you can calculate the total cost.
The units are estimated from the plans (“taken off”) and then compared to the specifications, which specify materials and procedures.
For Example,
The estimator will calculate the cost of each 4-inch by 8-inch piece of 5/8-inch-thick sheetrock and the average time (labor) and material cost of taping, sanding, and priming following installation.
After bringing all of these parts together, the estimated cost will be $25.50. If it is decided that 1,000 sheets of sheetrock are required after collecting dimensions from the designs and calculating waste, the budget for this item will be $25,500 ($25.50 X 1,000).
The takeoff procedure takes a long time. It is not a necessary exercise for all professional developers, even though it gives a well-founded and defendable estimate. The method is also subject to errors and manipulation due to the numerous underlying assumptions (future labor prices, supply costs, etc.).
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The change in the property development cost budget
As cost estimates are refined, the allocation of the loan amount between and within the hard and soft cost categories frequently varies from loan approval to loan close and release of cash.
If the budget shrinks somewhat and “extra funds” become available, you can securely transfer them to line items like interest and contingency. Since the lender controls the discharge of surplus funds, the lender’s risk is low.
If the borrower does not requisition the money, he is protected against overruns and will not have to pay interest on the surplus funds.
However, if the project’s cost falls dramatically (which is extremely rare), the loan amount should be decreased to stay within your institution’s loan-to-cost ratio.
Initial budgets are frequently increased throughout time. Complexity and awareness rise when more detail is added to and handled in project planning. Costs frequently rise as a result of this.
For example, the cost of drywall may rise because a thicker partition is required for fire safety.
The ventilation system may require a “makeup air” unit to avoid air pressure problems, appliance brands may need to be upgraded to compete with local brands, or a separate sales office with a finished model unit is now deemed necessary.
What should be your loan amount?
Budget rises are more common among less experienced borrowers, who are prone to underestimating a project and under budgeting it.
Those borrowers may not realize that increasing the pledged loan amount is extremely difficult, if not impossible after a loan is accepted.
It is because it raises red flags among senior management and senior credit personnel in most firms when a borrower comes back for extra money before the loan closes after it has been approved.
For example, suppose the borrower is employing leverage (mezzanine financing) and isn’t particularly liquid. Top management may be concerned about the borrower’s capacity to complete a project financially if unforeseen costs arise later.
Or, regardless of the borrower’s financial situation, they may second-guess themselves, your underwriting, and the borrower’s construction skill, expertise, budget, and cost containment capacity.
It is especially true if the proposed loan is significant and must be reviewed by senior management, maybe requiring the approval of a senior credit committee or even the institution’s board of directors.
The original permission may not be maintained when brought to another round of inspection. That is to say; the loan proposal can be rejected a second time. This could be a source of professional embarrassment for you.
In some situations, your aversion to reintroducing a loan for a more significant amount may be in the borrower’s best interests.
Let the borrower know that you must fill the gap with equity rather than debt if costs exceed the due amount.
When analysing a loan proposal, don’t assume that just because the budget is presented in a different format than you’re used to, the borrower is inexperienced, or something is wrong with it.
A budget can be created in various ways, with different styles and elements.
It is particularly true at the first loan proposal stage, when the developer or his representative may create the property development budget rather than an architect, construction consultant, or estimator.
As mentioned earlier, budget divisions and subdivisions frequently evolve in tandem with project specifications. When working with a seasoned borrower, the budget may grow in complexity but not content.
Bottom Line
The bottom line is that a well-executed cost budget is the key to any successful property development. Whether you are over budget or under budget, it is important to understand why this has happened and how it will impact your overall returns.
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FAQs
How to estimate the cost of a new property development?
Here are a few things to keep in mind while estimating the cost of a new property development: -The cost of materials and labor can vary greatly depending on the location.
- Any permits or licenses that are required will add to the overall cost.
- The size and complexity of the project will also affect the final price tag. In general, you can expect to pay anywhere from 10% - 20% of the total development cost for architects and engineers fees. So if your development is expected to cost $1 million, you should plan on spending around $100,000 - $200,000 on design and engineering fees.
What are most common expenses involved in property development?
There are a lot of different expenses involved in property development, but some of the most common ones include:
- Acquisition costs - These are the costs associated with actually acquiring the property, such as purchasing it from a seller or taking out a mortgage.
- Development costs - These are the costs associated with actually developing the property, such as construction costs, architects’ fees, and permits.
- Holding costs - These are the costs associated with holding on to the property during the development process, such as interest on loans and taxes.
- Sales and marketing costs - These are the costs associated with selling and marketing the completed development, such as advertising and commissions.
How much does it cost to develop a property?
The cost of developing a property can vary significantly depending on the location, size, and type of property you are looking to develop.
Generally speaking, the cost of land development can range from a few hundred dollars per acre to upwards of $100,000 per acre.
The cost of construction will also vary depending on the type of development you are looking to do and can range from a few thousand dollars for simple repairs or upgrades to millions of dollars for new construction.
Other factors that will impact the cost of developing your property include the current state of the economy, availability of financing, and local regulations or restrictions.
