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Your Cost to Complete: Do You Have a Clear Picture?

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Anthony “Bud” Stewart
VP, Funds Control Division

Your cost to complete a project hinges on a variety of known and unknown factors.  On a prior blog post, we focused on the importance of a contract’s “Schedule of Values”.  As emphasized in that post, the Schedule of Values must be a well delineated listing of all the tasks that constitute the project.  The more detail, the clearer the project comes into focus.  However, even the most detailed Schedule of Values is only one half of the picture.  While the Schedule of Values describes the tasks that must be completed to produce revenue for the contractor, an important part of the picture remains undeveloped.  A Schedule of Values does not reflect the costs that the contractor will incur when accomplishing the defined tasks.  A lack of detail in this area creates a blurry image.  A properly designed and implemented Funds Administration process will produce a fully developed picture by zooming in for the details. 

When a project is being managed under Funds Administration, you can expect that each task will be associated with the party responsible for completion of that task.  If the task has been delegated to a subcontractor, the name of that subcontractor and the amount of the subcontract will be known.  Each subcontract is obtained to determine the subcontractor’s scope of work, and these defined tasks are compared against the Schedule of Values that the contractor submits to the owner.  When disbursing funds, the subcontractor’s requisition for payment is analyzed against the corresponding line item on the Schedule of Values, and the amount of that line item, paid by the owner.  These procedures ensure that the performing parties are satisfied.

Under Funds Administration, a sharp image of every function that has not been ‘subbed out’ is also developed.  A depth of field on each of the contractor ‘self-performed’ functions is ascertained.  The labor and material costs required to complete each item on the Schedule of Values is determined.  All material suppliers are identified, and the budget for each of these suppliers is revealed.  With this expense data, as the project develops, it will be determined if the material and labor costs will exceed the contractor’s expectations.

As you can clearly see, Funds Administration will produce a high-resolution picture.

The Schedule of Values: don’t skim over this important document

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Kevin Deasy, CPA
Chief Executive Officer
Dayhill Group

A project owner typically negotiates with a contractor over several months to finalize a construction project’s scope, schedule, price, and other important project details.  Then the culmination of these efforts gets memorialized in the construction contract.  Among the many details that are outlined in the contract is a Schedule of Values.

The Schedule of Values is often seen by the owner simply as a schedule used as part of the payment application when the contractor submits the monthly pay application.  While it certainly functions in this capacity, an owner should be careful to review the Schedule of Values as it would the other important components of the construction contract.

An owner may view the Schedule of Values and see some items that look a bit high but then see others that seem well priced, and overall, the lump sum is a price the owner is happy with.  So why worry about individual line items if the lump sum price is satisfactory?

Some of the potential problems with a Schedule of Values that contains line items with values that don’t match well with the market value of what that line item should be priced at can come into play if the contractor is terminated or if there are change orders.

It is common for a contractor to put more profit in the scope items that will be completed early in the construction schedule and less profit, sometimes no profit, in the items near the end of the construction schedule.  Why does a contractor do this?  Generally, it’s done so the contractor can use the owner’s money to help cash flow the project.  As an owner, you are either not aware of this practice or perhaps you accept this practice because you want to help the contractor.  But what if you need to part ways with the contractor in the middle of the project?  And the remaining items on the schedule of values have very little profit in them?  The chance of the owner getting a new contractor to complete the remaining work for the money left is going to be very difficult.  Even if the Owner can find another contractor to do the work for the remaining contract value, is it fair that the first contractor received payment on the items that had bigger profit margins?  Side note: If a contactor is in funds control, the profit and overhead is paid out based on the actual cost of the line items and not the “value” placed on them.

Another thing to consider is a change to the scope of work that results in a change to the contract value (change order).  Almost every project has them.  It is very important that there is language in the contract that is very specific as to how a change order is priced.  You certainly don’t want the price tied to an inflated Schedule of Values line item.

These are just some of the reasons that overlooking the importance of analyzing the Schedule of Values can cause an owner heartburn down the road.  It’s easy to understand why this document may get overlooked after months of negotiation and deal fatigue but it is certainly worth taking a hard look at.  The Schedule of Values can be created to handle cash flow concerns and still maintain credible values on the line items in the Schedule of Values.

How to Mitigate Construction Lending Risk

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Today’s lenders face high hurdles when it comes to mitigating risk on large-scale, long-term construction loans. From the contract phase to the final payment, the right tools are available to enable the successful completion of even the most complex projects.  Here’s what you need to know.

Lender Risks

Inappropriate Funding

Inappropriate funding is a risk that begins early, usually during the contract phase, in the lifecycle of a loan. This costly hazard to lenders occurs when a loan value is too little or too great for a given project. When a project is undervalued by the contractor, it can lead quickly to project completion delays or even outright failure. When a contractor or developer inflates the project cost, either on purpose or because of inexperience, it opens the lender up to recovering less than the loan value in the event of default. Either scenario leaves the lender with liability.

Funding Incomplete Work

Ideally, construction funding occurs on as-completed terms.  This means that the contractor may request a draw on the available funds according to the contract terms based on the level of completion.  Without a representative on the job site, lenders are left to trust the word of the contractor, which can be risky.  When payments are made in the blind, a contractor could walk away from the job not having completed the work. This leaves lenders open to having to finance the work a second time or project failure.

Subcontractor Non-Payment

When construction loans are paid directly to the general contractor, as they typically are, the general contractor will use the funds to pay expenses and overhead and then will pay the subcontractors on the project.  Where things can go awry is when the general contractor is unscrupulous or has higher than anticipated expenses, and then chooses not to pay his subcontractors.  In this case, the subcontractors have the option to file a lien against the property, which ultimately becomes the owner and lender’s liability.

Any one of the aforementioned pitfalls can leave lenders high and dry, but fortunately, there are ways to mitigate these risks.

 

Mitigate Lending Risks

While there is inherent risk in writing construction loans, lenders can avoid the snags and snares with the right mitigation tools.

Plan and Cost Review is the critical third-party report that helps lenders during the loan underwriting stage to determine if a project can be built as proposed by the borrower.  A proper Plan and Cost analysis evaluates project-related documentation combined with a project’s feasibility and potential risk factors. It will point out discrepancies in project cost, missing permits, and the lack of due diligence reporting such as environmental site inspections, geological surveys and other pre-construction studies.  Dayhill’s Plan and Cost Review is a recommended service for any commercial construction lender desiring a comprehensive look into the viability of the project at the cost stated before agreeing to fund it.

Site Inspection is the preferred method of determining if a contractor’s draw request is reasonable based on the level of completion of the project. This service puts a third party representative at the site after every draw request to ensure the work or materials being billed have been performed or are on site. Dayhill’s Site Inspection service provides lenders with a detailed report complete with photos and an analysis of whether the billing is appropriate. Dayhill provides recommendations when there are discrepancies to help lenders avoid the risks associated with funding incomplete work.

Funds Control is hands down the best way to mitigate payment risk that arises when a general contractor is dishonest, committing job borrow or is otherwise financially unstable. Funds control uses a third party disbursement administrator who the lender entrusts to make payments to subcontractors and suppliers on their behalf.  Dayhill’s flagship service VERIPAY: Intelligent Funds Control is a  transparent service that lenders have trusted for over 10 years. All escrowed funds are secured in project-specific, non-interest-bearing accounts backed by the FDIC. With VERIPAY, lenders are ensured that funds are disbursed appropriately to mitigate payment risk.

Dayhill offers unparalleled integrity and transparency affording lenders the edge required to stay ahead of the game.  To learn more about how to minimize construction lending risk, read The Value of a Property Condition Assessment.