On today’s show we’re talking about how to make sure the budget for a construction project has integrity. I regularly receive questions from new developers looking to grow from buy-hold investment into new construction. The first thing I ask for is to see their budget and the pro forma. On today’s show we’re going to highlight the most common mistakes that I see in a construction budget.
Understand that when you’ve made mistakes in the initial analysis, there’s very little that can save you apart from a miraculous increase in rents.
The number one mistake that I see is having an incomplete list of construction expenses. This is where you need to adopt the discipline of a pilot and use checklists for your budget.
If you’ve ever flown an aircraft you’ll know that everything that happens in the cockpit uses procedures and checklists. Whenever there are a lot of items that need to be taken into account, the human mind is bound to miss a bunch. That’s when mistakes happen. If you don’t have a system, you’re going to make mistakes. The key is to have a systematic way of ensuring nothing gets missed.
When budget mistakes happen, they can come from one of two possible sources. The first is that things were more expensive than originally estimated. This is where people expect to find cost over-runs. Maybe there’s a material shortage and all of a sudden prices are higher than you originally forecast. These types of mistakes can result in modest increases in your overall budget.
But the biggest issue is when you have an expense that was missed from the budget altogether. You’ve budgeted zero for that line item and in reality, the number is not zero. That’s a huge problem because the entire amount is offside, not just a small mis-estimation of say 10%.
The most important thing you can do is make sure your list of budget line items is complete.
In addition, on today’s show I’m going to highlight 7 of the most often missed budget line items.
The first three relate to costs associated with the construction loan.
7) Title Insurance. Most lenders will want a title insurance policy issued in their name for the construction loan. Depending on the value of the project, this can add up to a lot of money.
6) Loan Fees. Most investors remember to include the lender’s origination fee, but often forget to include the cost of preparing the loan documents. When you convert from your construction financing to permanent financing there will be additional fees associated with the permanent loan. These need to be part of the project budget.
5) I often see new developers underestimate the cost of the architectural work. Architect’s fees can vary widely depending on how the project is structured. They sometimes hire the engineers for mechanical, structural, civil, plumbing, and electrical as subcontractors and simply pass through those costs. Unless you’ve got a quote for the engineering work, you can be fooled.
4) Site related work. This encompasses everything from drainage to landscaping. The number of times I’ve see a project fail to include the cost of removing the material excavated from the foundation is astounding. I’ve seen so many projects include the budget for the building, but fail to include any money for landscaping.
3) Draw Inspections. When a lender loans money for construction. They advance the funds in draws. At the end of each phase of the construction, the bank sends an independent 3rd party inspector to verify that the scope of work included in the most recent draw request was in fact completed. These inspection fees can vary widely from a few hundred dollars each to a few thousand dollars.
2) Initial Operating Deficit. This is when property takes longer to lease than you planned for.
1) I’ve seen many budgets where the borrower fails to include an interest reserve in the budget to carry the cost of the construction loan.