A developer’s or owner’s construction budget should include an ample hard cost construction contingency. Accounting for hard costs is obvious to sophisticated owners, but the more difficult question is: “How much is enough?”
To answer this question, it’s helpful to clarify the purpose of an Owner’s Hard Cost Contingency. We’re going to discuss the appropriate uses and their associated risks and offer tools to help developers and owners arrive at an appropriate contingency amount when preparing the initial project budgets prior to a large construction project.
What is a hard cost contingency for?
An Owner’s Hard Cost Contingency (OHCC) is a line item within an owner’s project budget designated to cover construction hard costs unforeseen and unknowable at the time a construction contract is executed. Such costs are typically driven by unpleasant surprises; however, they may also cover costs of elective changes to the project scope initiated by the owner.
Unforeseen additional construction costs are inevitable, no matter how carefully a project is planned. But a well-funded and carefully determined OHCC serves as a reserve fund to keep these surprises from causing the project to run over your construction budget.
Working with a construction consultant is a great way to bring all the contractors, developers, and financiers together to discuss potential future expenses and hard costs. If you’re ready to have an expert construction consultant review your project, contact us here.
Some choose to determine a contingency amount by following precedent, (ie. “That’s the way we always do it.”), by making a wild guess, or by starting with an arbitrary contingency amount, then squeezing it down to get the owner’s overall project budget into a range acceptable to investors and lenders. A more systematic and objective approach will, in the end, serve everyone’s interests better and ultimately lead to more successful projects.
A project can experience setbacks caused by a wide range of hazards. While we cannot easily quantify these hazards in advance, many are somewhat predictable, especially if one draws from the experience of others.
Budget hazards that expand the scope and cost of construction occur in a few major categories:
- Unforeseen environmental, site, and underground conditions, and market conditions such as wage and material price escalations.
- Changes mandated by authorities having jurisdiction (local building officials, fire marshal, health department, state licensing authorities, etc.)
- Scope gaps / incomplete design / design errors
- Budget shortfalls due to inadequate allowances within the construction contract
- Necessary costs that are specifically excluded by the construction contract and not included elsewhere in the owner’s overall budget.
- Owner-elected discretionary changes.
Hazards that could affect your project budget
Unforeseen site, environmental, and market conditions present perhaps the greatest risk of all budget hazards because they are the most unpredictable and uncontrollable.
- A Phase I Environmental Assessment is a pre-development exercise necessary to discover environmental hazards on a construction site, specifically soil contaminants that may trigger ground cleanup efforts required by the EPA. However, a Phase I assessment is a survey and is by definition, not exhaustive. Only during construction will the full scope and cost of environmental remediation be discovered.
- Asbestos and lead paint abatement may be necessary if renovation of existing structures is part of the project scope, and their full scope is rarely known in advance. This work is often excluded from construction contracts.
- Unsuitable soils, groundwater, and other geotechnical issues are common unforeseen expenses. A geotechnical survey is necessary to determine the extent to which rock, water, or other unsuitable soils exist in areas to be excavated or built upon, and what mitigation methods may be necessary. If a geotechnical survey indicates unsuitable soils, an allowance should be established for remediation, but the full extent of such conditions and their associated costs may exceed that contemplated in the allowance.
- If historical artifacts are discovered during site work, a governmental historical commission may require the contractor to work around and protect the artifacts. Costs for the extra work will accrue to the owner.
- Protection of endangered species or certain seasonal migration patterns may be demanded by the EPA. The presence of endangered species may not be known before construction budgets are established. A construction schedule can be derailed by a delay of this sort, and the project budget will suffer accordingly. (Ref: the Snail Darter and Tellico dam construction project, 1973)
- Inclement weather can delay large construction projects, particularly during site work and before buildings are dried in. AIA construction contracts typically have provisions to allow the contractor to make claims for schedule extensions and potentially additional general conditions when weather conditions 1) are abnormal for a given period of time, 2) could not have been reasonably anticipated, and 3) are demonstrated to adversely affect the critical path of the schedule. If these conditions are met, the owner will likely be obligated for additional costs and may experience a delayed revenue stream due to late delivery.
- Labor conditions outside the contractor’s control may affect the project budget. Schedule delays and claims for extended general conditions can result from manpower shortages caused by pandemics, or by related government-mandated shut-downs as in the case of COVID-19. Construction contracts usually exclude costs related to these hazards.
- Labor or material cost escalation may also be the Owner’s responsibility unless the burden is shifted to the contractor as a matter of contract.
- Schedule delays and associated costs may result from war, strike, acts of terrorism, riot, pandemic, and other events outside the contractor’s control. Events of this sort are typically addressed in a Force Majeure clause in the construction contract and by applicable law governing the contract.
Design changes mandated by Authorities Having Jurisdiction
During their drawing review process, building officials will usually require additive changes to the design to meet their interpretation of prevailing building codes, and will not issue building permits until they are satisfied. Ideally, the owner and contractor will be made aware of these changes before negotiation of the construction contract, but if the construction contract is executed before the authorities having jurisdiction (AHJ) have completed their review and issued permits, design changes may become necessary, and additive change orders will likely result which impacts your overall hard costs.
The OHCC exists to absorb these costs, but the owner can minimize the impact to the hard costs and reduce risk by waiting to negotiate the construction contract until after the AHJ review process is complete and permits are issued. An owner assumes some unavoidable risk due to AHJ-driven scope changes, but the risk can be reduced by negotiating a contract only after all construction permits have been issued.
Despite an owner’s best-laid plans, however, it is not uncommon for fire marshals, county or city building officials, and state health departments to appear during construction or even after the project is complete, demanding changes that the contractor, construction consultant, and the design team did not anticipate. The owner should reserve some contingency funds as the project nears completion to address any added cost items resulting from these final inspections.
If you’re ready to have an expert construction consultant review your project to help you calculate the best plan of action for your contingency fund, contact us here.
Scope gaps resulting from incomplete or deficient design documents
Architects and engineers operate within industry-accepted “standards of care” which means they perform their services consistent with the skill and care ordinarily practiced by similar professionals working in similar conditions. In other words, their work product is not perfect; designers sometimes make errors and issue design documents that are not complete.
To address these shortcomings, contractors, during the course of construction, will issue RFIs, (requests for information) to the architect to clarify inconsistencies or incomplete information in the drawings, which many times result in additive change orders which must be funded from the project budget. This is a normal adjustment of hard costs and the expected function of the OHCC.
Budget shortfalls due to inadequate allowances within the construction contract
Construction contracts usually contain line item allowances for finish selections and other items where the owner or designer has not made final design decisions. The owner will be obligated for any costs above that allowance amount.
The use of allowances in a construction contract should be kept to a minimum and used only when necessary. Allowances should not be used for major building systems. To the extent construction costs in a contract are represented with allowances, your hard costs are at risk.
Costs that are specifically excluded by the construction contract
Construction contracts typically exclude certain hard costs which will be borne by the owner. Scopes we sometimes find excluded from construction contracts are landscape, irrigation, site lighting, low-voltage and security systems, signage, and builder’s risk insurance. The owner must ensure that those items excluded by the construction contract are specifically included in the project budget. Hard costs that are not covered by either the construction contract or the owner’s project budget will likely impact the OHCC. This is where having an expert construction consultant can help the project progress smoothly and on the same page.
One final category of budget hazards involves discretionary or elective changes initiated by the owner or developer. On nearly every project we’ve been involved in, opportunities to maximize marketability arise, and the wisest stewards of the OHCC have had the resources to fund these opportunities.
One developer told us they like to preserve enough contingency and determine their hard costs ahead of time so they have plenty of “walking around money” at the end of the project. They like to be able to walk around at or near the end of a project and say “we should have done [x],” or “we should have thought of that [critical design flaw],” and have the resources to do something about it.
Determining the appropriate level for an OHCC
Some of the hazards discussed above can be eliminated or reduced by completing the requisite pre-construction due diligence. Some level of risk remains, however, even after the most diligent pre-construction preparations, because some budget hazards cannot be controlled, meaning you won’t always be able to predict the effectiveness of what you determine as your hard costs. We’ll refer to these risks as uncontrollable variables. A certain minimum level of hard cost contingency should be established in the project budget to hedge against these uncontrollable variables.
We have found that owners who enter a project with less than 3% of the construction contract amount as an OHCC, often end up short on funds before the project is complete. If 3% is the minimum threshold to cover uncontrollable variables, how much should the owner add to the OHCC and their hard costs to hedge against controllable variables? The answer depends on how well these variables are controlled prior to financial closing. Establishing this amount is more art than science and is best established with a construction monitor professional or top construction consulting firm.
Questions to ask when determining hard costs and your OHCC
Here’s an abbreviated checklist of items representing controllable variables that should be considered when establishing the OHCC and your hard costs. If, after thorough evaluation, you cannot answer “yes” to all these questions, more contingency dollars should be added to the 3% floor:
- Have all design documents been completed to 100% and issued for construction?
- Have all permits been issued? (Building, land disturbance, wetlands, etc.) Or have AHJs provided letters of intent to issue permits upon payment of fees with no further design revisions required?
- Have the drawings been reviewed and approved by experts specifically for ADA/FHA compliance and for building envelope integrity, and have those comments been incorporated into the design?
- Have the conclusions of the geo-tech survey been considered and incorporated into the civil and structural drawings?
- Has an adequate allowance been established in the construction contract or owner’s budget for remediation of unsuitable soils?
- Have the conclusions of the Phase I Environmental Assessment been incorporated into the design documents and project budget?
- Is the construction contract backed up by subcontracts or letters of intent by subcontractors for all major trades to at least 80% of the contract amount?
- Are all construction hard costs excluded by the construction contract included by a specific line item in the owner’s budget?
- Does the construction contract contain liquidated damages provisions?
- Are allowances in the construction contract adequate in scope and price?
- Does the construction contract clearly spell out conditions required to consider schedule extensions due to weather delays?
- Does the construction contract contain provisions for payment and performance bonds?
- Is the contractor financially stable? Is the contractor experienced in the appropriate construction types and markets?
- Has the contractor provided a Gantt chart construction schedule? Is the proposed construction duration reasonable?
- Is all necessary off-site work such as utility extensions to the site included in the construction contract, or carried separately in the Owner’s overall project budget?
If the answer to all these questions is a confident “yes”, a hard cost contingency of 3% of the construction contract amount is normally adequate to cover remaining uncontrollable variables. But if the answers to these questions are not favorable, then a cure becomes necessary. The safest response is to address those issues by delaying the financial closing until the necessary cures have been made.
If market conditions do not allow time to address these issues, it is critical that the contingency be increased to account for the added risks. Without adequate funding, a project may be forced to find alternate funding sources to make up for the shortfall. It’s always better to end a project with a little money left over than to find that you’re out of money before the project is complete. If you’re ready to keep your next construction project on time and on budget through budget planning and risk management protocols, contact us here.
A Side Note:
The OHCC should remain completely in the owner’s control and should not be conflated or confused with a contingency inside the construction contract, a.k.a. Contractor’s Contingency. We often see owners erroneously attempting to rely on contingencies inside construction contracts to cover the budget hazards discussed above. It is important to understand that this internal contractor’s contingency is there, if allowed, for the benefit of the contractor to help cure scope gaps in their subcontracts or address subcontractor concerns related to non-performance.
Usage and control of this internal contingency should be carefully negotiated and the terms should be included in the construction contract. To be conservative, the owner should assume that the contractor will utilize all of this internal contingency and none of it will be available for owner-directed changes during construction.
The budget hazards discussed here only scratch the surface of considerations that should be studied before moving forward with a construction contract. At zumBrunnen, we make it our business to examine and evaluate the impact of all these budget hazards, and many more, in our Pre-Closing Document Review. Our team of seasoned construction consultants can assist and advise you in determining what contingency level should be incorporated into your project budget and help to minimize surprises in your next development deal. Contact us for more details.