Developing a construction budget

Inadequate building budgets can lead to higher loan fees, low appraisal for developer

Chuck Miller
Guest Columnist

Is your land development construction budget adequate? This is quite possibly one of the most complicated aspects of land development lending. Though many formulas have been devised and many opinions offered, the fact remains that adequate construction budgets and more specifically, the contingency funds and interest reserve set aside in those budgets can be a bone of contention between lenders and their developer clients. Of additional concern is the effect that a rising interest rate environment has on the interest carry cost of a project. As a result, many banks are requiring independent, third party reviews of construction budgets presented to them for financing.

Requiring such reviews will help assure that developers, contractors, appraisers and lenders have adequate costs and haven’t overlooked a budget item.

The reason this is such a hot topic is that when a construction budget is presented to a lender on a specific project, the lender takes that budget and evaluates whether the various categories, including contingency funds, set aside in the budget are adequate. If deemed to be inadequate, the lender has the responsibility to increase the budget to provide a larger allowance for various items. Doing so however, has a negative impact on the developer. For instance, when the overall budget is upped by an increase to the contingency allowance or interest reserve, the loan amount is increased as well. Most banks charge loan fees based on a percentage of the total amount of money lent. As such, increasing the budget increases the loan fee to the client, sometimes substantially. Another impact of an inadequate budget can be that once presented to an appraiser, it may cause the appraisal to come in low. A low appraisal will result in a higher equity contribution requirement for the developer.

Recently, I attended a presentation by Alison Chamberlain of the Washington Department of Ecology. The subject was the new stormwater pollution prevention requirements during the course of land subdivision construction projects. The presentation covered the various aspects of these requirements, including erosion control, monitoring of construction projects, site inspections, discharge sampling and the log book requirements for recording findings and corrective actions as the project is undertaken. Bottom line? What this means for local developers is increased costs.

If you are a developer looking for the lowest or nearly lowest bid from the general contractor on your subdivision project, make sure that the budget item for stormwater and erosion control is sufficient. Pencils really must be sharpened here. If the budget is inadequate and the loan is made, cost overruns will be the responsibility of the developer or possibly the general contractor if incorrectly bid.

Adding to the importance of adequate allowances in this area are the substantial penalties for failure to keep stormwater clean and prevent erosion. As an example, take a site that includes three small catch basins. Law currently allows a fine of $10,000 a day for each catch basin that does not function properly. If the developer or site has previous violations, fines triple. In this example, that would equate to $90,000 a day in fines for three small, improperly functioning catch basins.

Make sure you are working with a lender who understands the complexity of this issue and land development in general. If you work closely with your lender and general contractor, you will avoid a costly mistake – one that could substantially reduce the profitability of your project.

Chuck Miller is vice president and commercial loan officer with Bay Bank. He can be reached at 360-892-5121, ext. 527.