James (Jim) McGibney-Development Services Consulting and Support
Commercial and Industrial Facilities
Phil Macey-National Director Collaborative Project Delivery, JE Dunn
In the first Post regarding the Value Proposition of Money, the majority of the Post was devoted to the basics and nuances of financing a project. That post dealt with the requirements that are typically raised by the financing institutions and ownership and much of the post was dedicated to defining the areas of financial focus required to successfully fund a project, now, and in the near future as technology driven changes speed up.
As noted in the first Post, all money does not have the same value. In fact, your view of money may very well depend on your role in the project.
For this Post we define four major roles on a typical project which include: the owner; the design team; the builder or general contractor; and the financing entity. The specific roles of each of the players are different on each project and sometimes the developer can also be the owner; sometimes the construction contract is Design/Build, so the General Contractor can play the role of both Designer and Contractor; and sometimes the financing entity might be a specific real estate fund, so they might play the role of owner and financier. For now, we will focus on the four more typical roles.
There is also a corollary that for each of the four key team members money has a distinctly different value. That fact is not widely appreciated and can lead to considerable contention throughout the lifecycle of a building project. What makes the subject of money complex are the multiple ways money is used and discussed by each of the key players. In our experience it is the lack of a shared perspective of the values of money that can undermine even the best of intentions. Here is our short-list of the primary modes that money takes on in a capital project.
Money and the Clock – The Role of Time
Time is a major issue in how money is valued. The development time line for a new building or asset may vary from as short as 3 years to as long as 10 years, from land acquisition to occupancy. Stabilization may add two to three more years to that timeline. Timelines matter because the value of money diminishes or grows with the passage of time. The economy grows and contracts, markets shift and change, and each new development must take those changes into account. In a future Post we will address “Time” in more detail and how new technologies are working to speed project delivery.
Money and Risk – the role of capital at risk, which is parallel to work done ahead of confirmed funding (waiting for payment for work at risk = capital at risk)
Money as a commitment – commitment to make a purchase or complete a transaction, for work to be done, a guarantee of price, balanced by accuracy of information, terms of the work: what you will do to provide your ‘capital’ – be that work as capital, or hard funds.
Money as a substitute for knowledge – Contingencies, allowances and limited information: when information is not available, contingencies are a way to capture risk.
What You See depends on Where You Stand
Much like the proverbial elephant, each team member’s view of the value of money depends very much on the vantage point they have of the project and when and how you are paid. There are many participants in each project, but the critical viewpoints are those of the Owner; the Designer; the Builder; and the Financing entity.
–The Owner looks at project funds (money) as the key ingredient/ raw material they need to use to deliver all aspects of their project. From the land acquisition, to the payment for design and permitting, to the payment for construction of the building and interior, build out, and to the costs of acquiring and contracting a tenant or occupant. Money is also the measure of success for the developer whether the project is operated over many years or simply sold at completion and lease-up. If the market will not provide more money at the sale than the cumulative total of all funds spent, the project is quite likely not considered to be a success.
In terms of impact, the Owner has the largest and longest running risk with any development project. The earliest cost of any significance in a project is the cost of the land; and there are a number of excellent examples in every market as to how land costs can vary significantly over short periods of time and over very small geographic distances. For example, in the Denver Market, property in the Lower Downtown Development Zone and Union Station was priced in the $200 per sq. ft. range a short 8 years ago. Today that value has climbed by 100% or more — if you can even find land available for purchase. The same change is now underway in the River North neighborhood – a short 1/2 mile away. The best return to the developer is very early in the period of change, and that is also the riskiest time to invest in the land. However, without land there is no project. (Air rights are a unique subset of “land” acquisition.)
The Owner bears the cost-risk of the Design Phase— typically 100%. The definition of those costs is covered in the next section, the design team- in some detail. The Owner also bears the risk of the repayment of the construction loan for work completed in the construction phase – also detailed in following section.
Only when the building is complete and a tenant begins to make payments, or the building is put into full operation in build to suit scenario, is there any cost recovery of the owner/developer’s invested funds — which might easily be 10 years from the time the land is purchased. During that period the Owner is exposed to the full spectrum of project cost risks; changing market conditions; variations in expected lease rates; cost overruns in design and construction; changes in regulatory requirements; etc. With this level of risk exposure over an extended period of time, the Owner will typically look for a higher level of return on their investment in terms of lease rates or sale costs. The value of the owner/ developer’s money and expected returns are much different and typically much higher than any other team members. By any measure it is an earned value.
–The design team views project funds, first, as the source of payment for their fees. They also look to the developer or Owner for a confirmation that the required funds are in fact in place and the Owner is committed to move forward. And similar to the CM/GC, they look to the project funds as a way to grow their business. Project funds are also used to build the project so project construction cost is one, perhaps the most critical, benchmark the project design must conform to. And an important distinction enters the dialog– the construction cost, which is just a portion of the total Project Cost that the Owner/Developer is exposed to.
The Engineering and Architectural teams typically join the Owner’s team at the point the land purchase is being finalized. The design team will then analyze the land and its uses, design all aspects of the building from the form and materiality, to the internal systems, to all furnishings and interior design. The design team also provides required studies and analyses to local code authorities to comply with all regulatory agency requirements, such as EPA, the building department etc. The design team will typically spend two to three years on the documentation of all systems and materials required in a building, including many alternative system studies and many alternative designs, all of which will need to be evaluated and priced by the selected general contractor/construction manager. And it is at this critical interface that understanding your fellow project partners perspective on money comes into play.
The design team also coordinates all required documentation to the City Building Department to make certain those systems comply with current codes. After approval, the City will issue a building permit or permits which allow construction to begin. A portion of the design team will typically remain engaged throughout construction and occupancy to monitor the construction process, approve changes, approve pay applications and provide certifications that the project is complete and in compliance with the design documents.
During this total time period the design team is typically paid a negotiated fee for each phase of the work. They bear the professional risk of designing the building and systems correctly, but do not bear any of the capital risks that the Owner does. In an earlier Post, I outlined the current state of the design process and how technology is changing the design team’s place on each project. Please refer to The Development Professions – Commodity Technology or Growing Value Add?
–The Construction Manager / General Contractor (CM/GC) views project funds as; 1- The resource that they can use to pay their subcontractors, suppliers, staff, regulatory agencies and all other construction costs; 2- A key measure of their risk exposure; 3- A source of funds to cover their own staff costs and related expenses; 4- A source of the profits that will be used to grow their firm. They also view the budget they provide their client as a key means of securing that work – especially in a highly competitive bidding business climate.
Construction is a very complicated process, and becoming more so as technology-driven changes are being adopted across the industry. A contractor will provide project estimates during the design phase and will provide the owner with a total cost for all of the construction before work begins, and most often before construction documents are complete, introducing the element of contingencies and allowances for as yet undefined parts of the project.
The project cost can be in the form of a fixed price; a cost plus a fixed fee; guaranteed “not to exceed”; or other format that fits the Owner’s requirements. Those costs, regardless of format, are assembled as much as two years before the materials are actually installed on the site, and much can change in those 2 years. So, similar to the Owner, the CM/GC carries a distinct perspective of money, the risk over time.
The contractor’s pricing will usually recognize the risk of change while construction is on-going— but the contractor is held responsible for completing their work at the agreed price – so project funds are a measure of their project risk of the work as well as a means to pay for the work to be completed.
–The financing/ capital provider– We have included the financing entity in this discussion, whether that is a bank, investment firm such as an REIT or other, because they bring a very different understanding of project funds to the process. First and foremost, the bank views project funds as the raw material they lend or rent to the project team, under very specific terms to build the project. Their measure of success is the return of the “rent” on those funds which includes interest payments in addition to the loaned, or principal, amount. This topic is covered in considerable detail in the first of these 2 Posts.
When all City fees are paid and the building permit is in hand, construction can begin, and that is typically the point at which a bank loan will be provided to cover project construction (and sometimes a portion of the design costs). The land acquisition and other early payments that the Owner/Developer makes are typically considered as the Owner’s equity and they are paid “out of pocket” by the Owner.
The Construction process for most buildings will take from 18 to 24 months (or longer), and during the construction process the bank loan is covering all of the money requirements, although the owner/developer remains responsible for eventual repayment. The bank or financial institution normally pays these funds out in “monthly draws” which are approved by the project team members prior to any payment.
During this period, the Owner/Developer will also contract with a Real Estate brokerage team to attract tenants to the building. If a tenant contracts to lease a specific space, the Owner/ Developer will also provide a “tenant finish allowance” to cover a significant portion of the interior design and construction costs for the tenant spaces. These costs are paid to the tenant on a monthly draw basis and these funds will typically come from the bank loan. The Owner will not recover any of these costs until the tenant begins to pay rent- which could easily be 6 months after move in— depending on the lease terms.
The nuances the bank introduces into the understanding of money also include:
1- What is the risk of completion? The general contractor’s contract with the owner will often include a “guarantee” that they will actually complete the work. As the bank can’t be repaid until the project is completed and actually cash flowing (or sold) that guarantee is critical. The bank will often help establish the terms of that guarantee.
2- The bank will establish the loan draw approval process and will often hire a third party for technical review of the progress of the project. This approval process is now undergoing changes as more and more prefabricated work— which requires much different payment terms.
3- The bank will often establish closing requirements including a complete list of all items that must be “signed off” by the building department, regulatory agencies, etc. The bank will often provide the form that those closing requirements must be in.
4- The bank will require that all subcontractors and suppliers be paid completely and that all liens that may have been filed are “released”.
5- There are a number of additional project requirements that the bank will bring to a project— so their view of project funds and money is quite robust, and extends well beyond simply covering project construction costs.
There are even more “nuances” addressed in the first of these 2 Posts.
By whatever name, money, capital, funding, etc, is a unique part of any project development.
It is used to pay all parts of the project development; it is the key measure of the project cost; it is used to assess risk; it is used to measure success (or failure); it is used to buy services for all aspects of design, and assessment (studies, etc.); it is used to reach sign off with the regulatory agencies in terms of permit fees; it is required to reach a basic understanding of the property attributes, such as soil bearing capacity, ground water locations and quantities; it is literally integral to every project step—- yet it has different meanings to all team members.
In short, money is the most nuanced raw material that is used in the delivery of a new capital asset, and the raw material that requires the broadest project team knowledge to have it deployed appropriately.
The major risk in both CD and BT is in time and management. Technology may work agains the project in both cases; tis sometimes is true in BT, but the real cause for failure in BT almost always is in management. Management believes in the science but fails to do the critical experiment that will bring down the structure – this experiment rarely is done because then everyone in the company is out of a job. The best VC groups never take the “story” at face value and always look hard at the science. Generally, however, the science is good and it is the predictions and projections that are faulty. They are based upon enthusiasm, probably the same way as CD project projections are. Management usually is the greatest risk in BT investing. The next is the interference by VC investors in the scientific development of the BT company. Investors have a short-term view and the scientists always have a long-term view. Management must reconcile these, and rarely does; usually it picks one
side and that causes failure. After a few years, BT investors want to see progress – drugs or devices in Phase I or II testing – if that does not occur, subsequent rounds of investing either do not occur, are done by fresh investors, or by old and new investor combinations. In any case, the downstream rounds are done at punishing valuations and reverse splits. it is the only way to mitigate the intangible risks of time and biological surprises.
Finally, technology may work agains CD investors, but it is an enormous threat for BT investors. The slow development of a device may allow gains in technology (I include drugs here) to make the product obsolete in a very short time. When that happen, a good device or drug that does not change intrinsically, is nevertheless no longer worth developing. The same may be true in CD investing, but the time required for a way of life or way of working to be superseded is measured in much longer times. For example: working at home or elsewhere on-line instead of gathering in an office.
An extreme example of how technology can change an entire industry, and that probably is the correct word, is in the delivery of healthcare. The appearance of paramedical personnel (helicopters, ambulances with life saving electronics) that we saw in the 1960s, the alterations in diagnostic testing and imaging that appeared in the 1970s, the laparoscopic surgical techniques in the 1980s, the advances in drug therapy in the 1990s and 2000s, and robotic surgery since about 2010 have altered healthcare well beyond anything that could have been conceived in the mid-latge twentieth century. An entire way of life for physicians disappeared; new careers in medical management appeared; major corporations appeared to manage healthcare; and, patients no longer were the focus of medical care. Quarterly earnings took their place. I have chronicled this in my book Fall from Grace. It is almost impossible to overestimate the role that technology played in all of this.